Ch 8

• Stock valuation


  Investors attempt to resolve the question of whether and to what extent a stock is under- or over-valued by comparing its current market price to its intrinsic value
• Valuing a Company Based on Its Future Performance

  • The future matters more than the past
  • Historical data are used to project key financial variables into the future
• Forecasting Sales and Profits

  1. Forecast Future Sales

  2. Forecast Net Profit Margin using common-size income statement
• Equation 8.1

  Future after-tax earnings in year t = Estimated sales in year t x Net profit margin expected in year t
• P/E ratio


  Generally a function of growth rate in earnings, general state of the market, amount of debt, current and projected rate of inflation, dividend payout ratio
• Average market multiple


  Average P/E ratio of all the stocks in a given market index, like S&P 500 or DJIA
• Relative P/E multiple


  Calculated by dividing a stock's P/E by a market multiple
• Equation 8.2

  Estimated EPS in year t = Future after-tax earnings in year t / Number of shares of common stock outstanding in year t
• Equation 8.3

  EPS = After-tax earnings / Book value of equity x Book value of equity / Shares outstanding = ROE x Book value per share
• Return on Equity (ROE)


  Measures the return to the firm's shareholders by relating profits to shareholder equity
• DuPont Identity


  ROE = Profit Margin x Asset Use x Leverage
• Equation 8.4

  Estimated dividends per share in year t = Estimated EPS for year t x Estimated payout ratio
• Equation 8.5

  Estimated share price at end of year t = Estimated EPS in year t x Estimated P/E ratio

  
• If the company had two million common shares outstanding, then given the estimated earnings of $6.5 million obtained Eq(8.1) the firm should generate earnings per share next year of 3.25
• Payout ratio is 40%, so dividends per share next year will be 1.30
• Suppose estimated P/E ratio is 17.5, then the share price will be 56.88

  
• Valuation


  The process by which an investor determines a security's worth, keeping in mind the tradeoff between risk and return
• Required Return


  The return that an investor requires to compensate them for the investment's risk
• Equation 8.6

  Required rate of return = Risk-free rate + Stock's beta x (Market return - Risk-free rate)
• Key inputs for valuation


  • Amount and timing of future cash flows
  • Required return on the investment
• Valuation models


  Help determine an expected rate of return or the intrinsic worth of a share of stock
• Criteria for a worthwhile investment candidate

  • Expected rate of return equals or exceeds the return that is warranted given the stock's risk
  • Intrinsic value is equal to or greater than the current market price
• There is no assurance that the actual outcome will match the expected (projected) outcome
• Calculating Required Return


  1. Risk-free rate

  2. Stock's beta

  3. Market return
• Stock Valuation Models


  • Dividend Valuation Model
  • Other Approaches to Stock Valuation
• Dividend Valuation Model


  Approach which holds the value of a stock depends on its future dividends

  
• Versions of the Dividend Valuation Model

  • Zero-growth model
  • Constant-growth model
  • Variable-growth model
• Zero-growth model


  Assumes dividends will not grow over time
• Constant-growth model


  Assumes dividends will grow over time at a specified rate
• Estimating dividend growth rate


  Look at historical behavior of dividends, assume growth will continue at (or near) that average rate
• Variable-growth model


  Allows for variable rates of growth in dividends over time
• Defining the expected growth rate is one of the most difficult and important aspects of the DVM
• Price-to-Earnings (P/E) Approach


  Simpler approach, favorite of professional security analysts
• Other Price-Relative Procedures


  • Price-to-cash-flow (P/CF) ratio
  • Price-to-sales (P/S) ratio
  • Price-to-book-value (P/BV) ratio