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Introduction to Valuation

Introduction to Valuation. Chapter 3. Price vs. Value. Price cost to acquire something “willing buyer and willing seller” market clearing amount Value measure of “worth” an opinion, not a certainty. Valuing Coca-Cola at Different Discount Rates.

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Introduction to Valuation

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  1. Introduction to Valuation Chapter 3 Chapter 3: Introduction to Valuation

  2. Price vs. Value • Price • cost to acquire something • “willing buyer and willing seller” • market clearing amount • Value • measure of “worth” • an opinion, not a certainty

  3. Valuing Coca-Cola at Different Discount Rates • Coca-Cola (ticker symbol: KO) is currently selling for $54 • You expect the selling price in one year to be $64 and that KO will pay $0.80 in dividends during the year • Based on that information, your expected rate of return would be: Chapter 3: Introduction to Valuation

  4. Coca-Cola; Price =$54

  5. Time Value of Money: Multi-Period Models • Present value model can value investments that span multiple time periods • Since some cash flows can be expected to last forever, sometimes the terminal time period is infinity Chapter 3: Introduction to Valuation

  6. Time Value of Money: Multi-Period Models • The value of a cash flow series is the discounted present value of all future cash flows • Where the discount rate, k, represents the cash flow’s appropriate required rate of return Chapter 3: Introduction to Valuation

  7. Time Value of Money: Multi-Period Models • Cash flows can be • Cash dividends • Coupon interest • Rent income from real estate • Asset’s selling price, etc. Chapter 3: Introduction to Valuation

  8. Example: PV of a Bond • Bond investors receive periodic coupon payments and a principal repayment upon maturity • For a three-year T-note this can be represented as:

  9. Example: Estimating Value of Stock • You are considering purchasing stock • You think you should earn a required rate of return of 14.5% based on the stock’s risk level • You expect to sell the stock for $40 in two years • You expect to receive $2 in cash dividends each year for the next 2 years • What is the most you would be willing to pay for the stock?

  10. Example: Estimating Value of Stock Chapter 3: Introduction to Valuation

  11. Example: Stock With Constant Perpetual Growth Rate • You are considering purchasing stock in a large corporation: • The current price of the stock is $51.50 • You believe the current dividend of $3 will grow at a 3% rate in the future • You think 13% is a fair discount rate for stock of its risk level • What is the most you would be willing to pay for the stock?

  12. Example: Stock With Constant Perpetual Growth Rate Chapter 3: Introduction to Valuation

  13. Making Buy-Sell Decisions • Professional investors use their value estimates to make buy-sell decisions • If an investor could compute the value of an investment with certainty, the following simplified buy-sell rules would apply • If a security’s price < value it is underpriced and the investor should buy • If a security’s price = value it is correctly priced and the investor should not trade • If a security’s price > value it is overpriced and the investor should sell (or sell short) Chapter 3: Introduction to Valuation

  14. Making Buy-Sell Decisions • Selling overpriced securities brings their price down • Buying underpriced securities brings their price up • Security prices are constantly changing as new information arrives • In a world of uncertainty it is impossible to know the value of an asset with certainty Chapter 3: Introduction to Valuation

  15. Comparing Differences Between Prices and Values • Consensus value estimate • Will be narrow if most security analysts have similar value estimates • Security’s price will fluctuate in a narrow range around this value estimate • Will be wide if there is a great deal of variability in security analysts’ value estimates • Security’s price will fluctuate wildly Chapter 3: Introduction to Valuation

  16. Active Investment Management • You forecast a P-E ratio of 40 times 2003’s estimated EPS of $2.09 • Your expected price in year 2003 is • 40 x 2.09 = $83.60 which has a present value (in 2000) of $51.27 • Your estimate of KO’s value in 2000 is • $2.18 + $51.27 = $53.45 Chapter 3: Introduction to Valuation

  17. Passive Investment Management • Many studies suggest that the market is efficient in the semi-strong form • Suggests that the search for incorrectly-valued stocks may be too much trouble • Many passive investors invest in index funds • Mutual funds designed to track a particular market index • S&P500 Composite Index is the most popular Chapter 3: Introduction to Valuation

  18. The Bottom Line • Value estimates form the basis for wealth-maximizing investment decisions • Security prices fluctuate due to changing value estimates by investors • Some investors follow an active investment strategy while others follow a passive one • Market prices adjust to rapidly reflect new information • Actions taken by profit-seeking speculators, short sellers, hedgers and arbitrageurs help allocate scarce resources Chapter 3: Introduction to Valuation

  19. Problem 3-4

  20. Problem 3-4

  21. Problem 3-8

  22. Problem 3-10-a

  23. Problem 3-10-b

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