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Chapter 8 Stock Valuation 1 Stock Valuation Learning Goals 1. Explain the role that a company’s future plays in stock valuation. 2. Develop a forecast of a stock’s cash flow, expected dividends and share price. 3. Discuss the concepts of intrinsic value and Required Rates of Return. 4. Calculate the underlying value of a stock using various dividend valuation models. 2 Stock Valuation Learning Goals 5. Use other types of present-value-based models to derive the value of a stock as well as alternative pricerelative procedures. 6. Gain a basic understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growthoriented stocks. 3 Valuing a Company and Its Future The single most important issue in the stock valuation process is what a stock will do in the future Value of a stock depends upon its future returns from dividends and capital gains/losses We use historical data to gain insight into the future direction of a company and its profitability Past results are not a guarantee of future results 4 Comparative Dollar Based and CommonSize Income Statements 5 Steps in Valuing a Company Three steps are necessary to project key financial variables into the future: Step 1: Forecast future sales & profits Step 2: Forecast future EPS and dividends Step 3: Forecast future stock price 6 Step 1: Forecast Future Sales and Profits Forecasted Future Sales based upon: “Naïve” approach based upon continued historical trends, or Historical trends adjusted for anticipated changes in operations or environment Forecasted Net Profit Margin based upon: “Naïve” approach based upon continued historical trends, or Historical trends adjusted for anticipated changes in operations or environment, or Earnings forecasts from brokerage houses, Value Line, Forbes, or other sources 7 Step 1: Forecast Future Sales and Profits (cont’d) Future after-tax earnings in year t Estim ated sales for year t N et profit m argin expected in year t Example: Assume last year’s sales were $100 million, revenue growth is estimated at 8% and the net profit margin is expected to be 6%. So $100M x 8% = $8M Growth $100+$8 = $108M Future after-tax earnings next year $108 m illion 0.06 $6.5 m illion 8 Step 2: Forecast Future EPS Forecasted outstanding shares of common stock based upon: “Naïve” approach based upon continued historical tends, or Historical trends adjusted for anticipated changes in operations or environment Forecasted Earnings Per Share (EPS) based upon: E stim ated E PS in y ear t Fu ture after-tax earnings in year t N u m ber of sh ares o f com m o n stock outstan ding in year t 9 Step 2: Forecast Future EPS Example: Assume estimated profits are $6.5 million, 2 million shares of common stock are outstanding, and the dividend payout ratio is estimated at 40%. E stim ated E PS next year $6.5 m illion 2 m illion $3.25 10 Step 2: Forecast Future Dividends Forecasted Dividend Payout ratio based upon: “Naïve” approach based upon continued historical trends, or Historical trends adjusted for anticipated changes in operations or environment E stim ated dividends per share in year t E stim ated E PS in year t E stim ated payout ratio 11 Step 2: Forecast Future Dividends Example: Assume estimated profits are $6.5 million, 2 million shares of common stock are outstanding, and the dividend payout ratio is estimated at 40%. E stim ated dividends per share next year $3.25 .40 $1.30 12 Step 3: Forecast P/E Ratio Estimated P/E ratio based upon: “Average market multiple” of all stocks in the marketplace, or “Relative P/E multiple” of individual stocks Adjust up or down based upon expectations of (1) economic conditions, (2) general stock market outlook in near term, or (3) anticipated changes in company’s operating results 13 Step 3: Forecast P/E Ratio Estimated P/E ratio is function of several variables, including: Growth rate in earnings General state of the market Amount of debt in a company’s capital structure Current and projected rate of inflation Level of dividends 14 Step 3: Forecast Future Stock Price E stim ated share price at end of year t E stim ated E PS in year t E stim ated P/E ratio Example: Assume estimated EPS are $3.25 and the estimated P/E ratio is 17.5 times. Estim ated share price at the end of next year $3.25 17.5 $56.88 To estimate the stock price in three years, extend the EPS figure for two more years and repeat the calculations. 15 Using Stock Valuation Once we have an estimated future stock price, we can compare it to the current market price to see if it may be a good investment candidate: current price < estimated price undervalued current price = estimated price fairly valued current price > estimated price overvalued 16 The Valuation Process Valuation is a process by which an investor uses risk and return concepts to determine the worth of a security. Valuation models help to find How Much a stock ought to be worth If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment. If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment. There is no assurance that actual outcome will match expected outcome 17 Required Rate of Return Required Rate of Return is the return necessary to compensate an investor for the risk involved in an investment. Used as a target return to compare forecasted returns on potential investment candidates R equired rate of return R isk-free rate Stock's beta R isk-free M arket return rate 18 Required Rate of Return Example: Assume a company has a beta of 1.30, the risk-free rate is 5.5% and the expected market return is 15%. What is the required rate of return for this investment? R eq u ired retu rn 5 .5 % 1 .3 0 1 5 .0 % 5 .5 % 1 7 .8 5 % 19 Other Stock Valuation Methods Dividend Valuation Model Zero growth Constant growth Variable growth Dividend and Earnings Approach Price/Earnings Approach Other Price-Relative Approaches Price-to-cash-flow ratio Price-to-sales ratio Price-to-book-value ratio 20 Dividend Valuation Model: Zero Growth Uses present value to value stock Assumes stock value is capitalized value of its annual dividends Potential capital gains are really based upon future dividends to be received Assumes dividends will not grow over time Value of a share of stock A nnual dividends R equired rate of return 21 Dividend Valuation Model: Constant Growth Uses present value to value stock Assumes stock value is capitalized value of its annual dividends Assumes dividends will grow at a constant rate over time Works best with established companies with history of steady dividend payments V alue of a share of stock N ext year's dividends R equired rate of return C onstant rate of grow th in dividends 22 Dividend Valuation Model: Variable Growth Uses present value to value stock Assume stock value is capitalized value of its annual dividends Allows for variable growth in dividend growth rate Most difficult aspect is specifying the appropriate growth rate over an extended period of time Present value of V alue of a share of stock future dividends during the initial variable-grow th period Present value of the price of the stock at the end of the variable-grow th period 23 Dividends-and-Earnings Approach Very similar to variable-growth DVM Uses present value to value stock Assumes stock value is capitalized value of its annual dividends and future sale price Works well with companies who pay little or no dividends Present value of a share of stock Present value of future dividends Present value of the price of the stock at date of sale 24 Price/Earnings (P/E) Approach Future price is based upon the appropriate P/E ratio and forecasted EPS Simple to use and easy to understand Widely used in stock valuation Stock price EPS P/E ratio 25 Price-to-Cash-Flow (P/CF) Approach Similar to P/E approach, but substitutes projected cash flow for earnings Widely used by investors Many consider cash flow to be more accurate than profits to evaluate a stock P/C F ratio M arket price of com m on stock C ash flow per share 26 Price-to-Sales (P/S) Approach Similar to P/E approach, but substitutes projected sales for earnings Useful for companies with no earnings or erratic earnings P/S ratio M arket price of com m on stock Sales per share 27 Price-to-Book-Value (P/BV) Approach Similar to P/E approach, but substitutes book value for earnings P/B V M arket price of com m on stock B ook value per share 28 Review 1. Explained the role that a company’s future plays in stock valuation. 2. Developed a forecast of a stock’s cash flow, expected dividends and share price. 3. Discussed the concepts of intrinsic value and required rates of return, and noted how they are used. 4. Calculated the underlying value of a stock using various dividend valuation models. 29 Review 5. Used other types of present-value-based models to derive the value of a stock as well as alternative pricerelative procedures. 6. Gained a basic Understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks. 30 T h e E n d ! 31 Chapter 8 Additional Chapter Art 32 Average Market P/E Multiples 1977– 2006 33 Selected Historical Financial Data, Universal Office Furnishings 34 Using the Variable-Growth DVM to Value Sweatmore Stock 35