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Chapter 7

Chapter 7. Valuation of the Individual Firm. Objectives. Understand the basic valuation process as it relates to earnings and dividends Explain the related concepts of risk and return Be able to use various present value-oriented valuation models. Objectives continued.

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Chapter 7

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  1. Chapter 7 Valuation of the Individual Firm

  2. Objectives • Understand the basic valuation process as it relates to earnings and dividends • Explain the related concepts of risk and return • Be able to use various present value-oriented valuation models

  3. Objectives continued • Describe the role of the price-earnings ratio in determining value • Explain how an individual stock’s price-earnings ratio is related to the market • Explain techniques for forecasting earnings per share

  4. Valuation of the Individual Firm • Basic Valuation Concepts • Review of Risk and Required Return Concepts • Dividend Valuation Models • Earnings Valuation Models • The Price-Earnings Ratio

  5. Valuation of the Individual Firm continued • Other Valuation Models Using Average Price Ratios and 10-Year Averages • Forecasting Earnings per Share • Growth Stocks and Growth Companies • Assets as a Source of Stock Value • Appendix 7A: Sustainable Growth Model

  6. Basic Valuation Concepts • Dividend valuation models • Based on dividends expected to be received • Earnings valuation models • Based on earnings as the income stream • Price-earnings ratio • Multiplier of earnings • Long-run historical relationships • Market price and sales per share • Market price and book value per share • Market value of assets • Cash • Liquid Assets • Replacement value • Hidden assets

  7. Review ofRisk & Required Return Concepts • Required rate of return: • Investor must know the required rate of return on the various RISK CLASSES of assets

  8. Risk & Required Return Concepts cont. • The risk-free rate is a function of both the real rate of return and an inflation premium: RF (Risk free rate)= (1+ Real rate)(1 + Expected rate of inflation) – 1

  9. Risk & Required Return Concepts cont. • The risk-free rate is a function of both the real rate of return and an inflation premium: RF (Risk free rate)= (1+ Real rate)(1 + Expected rate of inflation) – 1 • The required rate of return is a function of the risk-free rate plus a risk premium for a specific investment • We can use the Capital Asset Pricing Model to determine the required rate of return when valuing stocks in a diversified portfolio

  10. Risk & Required Return Conceptscont. Adding a “risk” component to the risk free rate Ke = RF + b (KM- RF) Ke = Required rate of return RF = Risk free rate b = Beta coefficient KM = Expected return for common stocks in the market (KM - RF ) = Equity risk premium (ERP) beta risk free rate Equity risk premium

  11. Risk-free rate (Ke) • Normally assumed to be the return on U.S. Treasury securities

  12. Beta (β) b • Measures individual company risk against market risk • Usually — S&P 500 Stock Index • b > 1 → more risk than the market • b < 1 → less risk than the market • b = 1 → same risk as the market

  13. Equity Risk Premium (KM – RF) • Not readily observable • Based on investor expectations • Represents the extra return (premium) the stock market must provide to investors compared with U.S. Treasury securities

  14. Dividend Valuation Models • General Dividend Model • Constant Growth Model • A Nonconstant Growth Model

  15. General Dividend Model …+ P0 = where: P0 = Present value of the stock price Di = Dividend for each year, e.g.1, 2, 3,..∞ Ke= Required rate of return (discount rate)

  16. Constant Growth Model P0 = where: P0 = Present value of the stock price Ke = Required rate of return (discount rate) D0(1+g)1 = D1 = Dividends in the initial year D0(1+g)2 = D2 = Dividends in year 2, and so on g = Constant growth rate in the dividend

  17. Constant Growth Model cont. If the following two conditions are met • Growth rate (g) is constant • Required rate of return (Ke) > growth rate (g) Then the Constant Growth Model formula becomes:

  18. Numerical Example

  19. A Nonconstant Growth Model Example: Constant growth in dividends, 20% per year for the first 10 years, and 8% perpetual growth rate after that Application Example – Please click on the Excel to see calculations for JAYCAR Also, Figure 7-1 on page 148 in the textbook

  20. Earnings Valuation Model • The Combined Earnings and Dividend Model • More comprehensive, using both EPS (earnings per share) & P/E (earnings multiplier, or P/E Ratio) Combined with a Finite dividend model Application Example – Please click on the Excel to see calculations for J&J I. II.

  21. EVA: Economic Value AddedThe Real World of Investing • New valuation concept • Considered by • Coca Cola • Eli Lilly • Merrill Lynch • Monsanto • Emphasize maximizing EVA • Less interested at generating EPS Continued

  22. EVA cont. (Capital) Investment decision made or projects accepted ONLY IF > Founders of EVA www.sternstewart.com

  23. The Price-Earning Ratio • Mathematically P/E ratio = (1) Price per share (2) Earnings per share • Ultimately P/E ratio is set by investors • Bid price up or down in relation to earnings • (1) Today’s price • (2) Latest 12-month earnings per share

  24. Factors Affecting P/E Ratio • Expected growth in EPS • Historical analysis • International factors • Leading indicators • Government monetary and fiscal policies • Mood and confidence of the public • Overall conditions in the stock market • Growth prospects in the economy • Inflation inversely related to P/E ratio • CPI goes down → P/E ratio goes up • CPI goes up → P/E ratio goes down

  25. Inflation and Price-Earnings Ratios

  26. The S&P 500 Index with Earnings per Share and Derived Price-Earnings Ratio

  27. P/E Ratio for Individual Stocks 1. Growth prospect 2. Risk associated with future performance 3. Debt to equity ratio Continued

  28. P/E Ratio for Individual Stocks continued 4. Dividend policy • Low dividends preferred with superior internal reinvestment opportunities • High dividends preferred for maturing companies 5. Quality of management, capable, innovative 6. Quality of earnings (accounting practices) 7. Technology and research 8. Government policy and politics 9. Fads and other factors 10.Can you think of any other factors that could affect the P/E ratio of an individual stock?

  29. P/E and Expected Growth in EPS

  30. P/E Ratio for Individual Stocks continued

  31. P/E Ratio for Individual Stocks continued • Firms expected to provide returns greater than the overall economy, with equal or less risk, will generally have superior P/E ratios

  32. The Pure, Short-Term Earnings Model • Investors/speculators • Short term view • Ignore present value analysis of • Dividends & • Earnings per share Instead Compute estimated value of stock

  33. Johnson & Johnson Relative P/E Model and Historical Ratio Models

  34. Relating an Individual Stock’s P/E Ratio to the Market • Sales per share (SPS) • Dividends per share (DPS) • Cash Flow per share (CFPS) • Book Value per share (BVPS) Continued

  35. Relating an Individual Stock’s P/E Ratio to the Market cont. • Stock Price • P/E Ratio of a stock (JNJ • P/E Ratio of S&P 500 • Relative P/E Ratios Relative P/E Ratio = See Table 7-4 on page 156 Company P/E S&P 500 P/E

  36. Projected Earnings and relative P/E Valuation Model

  37. Other Valuation Models Using Average Price Ratios and 10-Year Averages A. Avg. Price/Avg. Sales per share (SPS) Example: Price-to-SPS Ratio = $49.66/$12.59 = 3.943 Price-to-SPS Ratio x Est. SPS = Projected Price 3.943 x $20.04 = $79.02 Please refer to Table 7-5 on page 157

  38. Other Valuation Models Using Average Price Ratios and 10-Year Averages cont. Similar calculations shown on the previous slide for: B. Price to dividends per Share (DPS) C. Price to cash flow per share (CFPS) D. Price to book value per share (BVPS)

  39. Forecasting Earnings per Share • Investors get earnings forecasts from: • Brokerage house research • Investment advisory firms • Value Line • Standard & Poor’s • Financial magazines • Forbes • Business Week • Worth • Money • Do it themselves

  40. Forecasting Earnings per Share • Least Squares Trendline • The Income Statement Method

  41. Forecasting Earnings per ShareLeast Squares Trendline • Regression – least squares trend analysis • most common • Statistical method • Trendline fitted to a time series of historical earnings (observations) • A straight line that minimizes the distance of the individual observations from the line

  42. Least Squares Trendline for EPS of XYZ Corporation

  43. Forecasting Earnings per Share continued • Cyclical Companies • More sensitivity to swings in economy • High priced durable goods • Automobiles • Airlines • Seasonal Companies • Variability due to seasonal demand • Heating fuel • Air conditioning • Snowmobiles

  44. Trendlines for Cyclical and Consistent Growth Companies

  45. Forecasting Earnings per ShareThe Income Statement Method • Start with sales forecast • Create standardized set of financial statements • Based on historical relationships • Sales forecast must be accurate to give a meaningful EPS • Important factors • Profitability • Fluctuations in profit margins Before tax After tax

  46. Abbreviated Income Statement Method — Hutchins Corporation

  47. Growth Stocks • In assessing the worth of an investment, the term growth stock is used by • Stockholders • Analysts • Investors • Common stock of a company growing faster than the economy or market norm • Predictable earnings growth Definition

  48. Growth Companies Definition • Companies that exhibit rising returns on assets each year • Sales growing at an increasing rate (growth phase of the life cycle curve) • Usually, not as well-known as growth stocks Continued

  49. Growth Companies cont. Example of industries: • Computer networking • Cable television • Cellular telephones • Biotechnology • Medical electronics • Can you suggest any more industries?

  50. Assets as a Sources of Stock Value • Consider assets as opposed to earnings and dividends • Cash & marketable securities • Buildings • Land • Timber • Old movies • Natural resources Continued $ $ $

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