CHAPTER 6

1. CHAPTER 6

2. Common Stock Valuation Stock Valuation The process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance At any given time, the price of a share of common stock depends on investors� expectations about the future behavior of the security A fundamental assertion of finance holds that the value of a stock is based on the present value of its future cash flows (a.k.a. earnings)

3. Common Stock Valuation Stock Valuation �The most fundamental influence on stock prices is the level and duration of the future growth of earnings and dividends. [However,] future earnings growth is not easily estimated, even by market professionals.� � Burton Malkiel, A Random Walk Down Wall Street

4. Security Analysis Security Analysis The process of gathering and organizing information and then using it to determine the value of a share of common stock Intrinsic Value The underlying or inherent value of a stock, as determined through security analysis

5. Fundamental Analysis Fundamental Analysis Examination of a firm�s accounting statements and other financial and economic information to assess the economic value of a company�s stock Examples of some of the Fundamentals: The competitive position of the company Growth prospects for company and its market Profit margins and company earnings What assets are available The company�s capital structure How much debt, how much equity

6. Financial Ratio Analysis Financial Ratio Analysis One method of security analysis involves looking at certain financial ratio measures Financial ratios give us a quick and easy method for comparing one company to other companies within their industry or the stock market as a whole The problem with financial ratios is that there is no single financial ratio that can adequately sum up or summarize the overall general state of affairs, situation, predicament, etc., that a company finds itself in

7. Price to Earnings Ratio Price to Earnings Ratio (Review) a.k.a. Price-earnings Ratio, P/E Ratio, P/E, PE Current Price divided by Earnings per Share Examples: Nokia (NOK), Nike (NKE), Novo Nordisk (NVO), Netflix (NFLX)

8. Price to Earnings Ratio Historically, A company�s P/E Ratio was supposed to match its growth rate. If a company was growing at 20% per year, then a P/E of 20 was justified. During the Internet bubble, many companies had P/E ratios in the hundreds eBay�s P/E was 10,000 for a time during the mania! At that P/E, it would take eBay 10,000 years to earn its price �Growth� stocks typically have high-P/E Ratios �Value� stocks typically have low-P/E Ratios But remember our discussion of �growth� vs �value� A �value� stock might not necessarily be a good value!

9. P/E to Growth Ratio (PEG) Price/Earnings to Growth Ratio � a.k.a. PEG P/E Ratio divided by Rate of Growth Compares the P/E ratio to the Rate of Growth

10. Price-to-Cash Flow Ratio Price-to-Cash Flow Ratio Current price divided by current cash flow per share Cash flow often differs from earnings per share For several reasons � one major reason is� Depreciation is not an actual cash expenditure But there are many reasons cash flow & earnings differ �Good quality� versus �poor quality� earnings

11. Price-to-Sales Ratio Price-to-Sales Ratio Current price divided by annual sales per share Historically, a higher Price-to-Sales Ratio suggested a higher sales growth And a lower Price-to-Sales Ratio suggested a lower sales growth

12. Price-to-Book Ratio Price-to-Book Ratio Current price divided by book value Historically, if the Price-to-Book Ratio was greater than 1.0, then shareholders believed that the firm was creating value above and beyond the physical assets of the corporation

13. Applications of Price Ratio Analysis To predict future stock price using price ratios, Multiply a historical price ratio by the expected future value price-ratio denominator (�What? Huh?�) Price-to-Earnings Per Share Example Page 185:

14. Applications of Price Ratio Analysis Applications of Price Ratio Analysis (continued) Price-to-Cash Flow Per Share Example Page 185:

15. Applications of Price Ratio Analysis Applications of Price Ratio Analysis (continued) Price-to-Sales per Share Example Page 185:

16. Reality Check! Can we reasonably assume that the formulas on the previous slides will give us realistic figures? For many companies, yes For many companies, no But there are countless other factors at work It is like trying to predict the weather � only worse!

17. Reality Check! For the record, the price of Intel one year later in mid-2006 was around $17! Much lower than the mid-2005 price! The P/E was hovering around 21 So much for our predictions! The price today is around $22 after rising to over $25 and then falling to $12 at the bottom of the market plunge in March of 2009 The P/E is around 11

18. Applications of Price Ratio Analysis For those of you who have the 3rd edition, Price-to-Earnings Per Share model (page 197) $19.61 = 38.72 (P/E) x $0.48 (EPS) * (1 + 5.5%) Price-to-Cash Flow model (page 198) $27.54 = 21.55 (P/CF) x $1.20 (CFPS) * (1 + 6.5%) Price-to-Sales model (page 198) $31.63 = 7.50 (P/S) x $4.00 (SPS) * (1 + 5.5%)

19. Reality Check, Revisited! And as they were in mid-2005 and mid-2006, the price ratio predictions from early-2003 to early-2004 were far away from the actual price The price of Intel in early-2004 was around $33 to $34 Higher than any of the three estimates! The exact opposite of the actual mid-2006 prices which were far lower than the mid-2005 predicted prices

20. Dividend Discount Models Shares of stock are valued on the basis of the future dividend streams the stock is projected to produce a.k.a. DDMs, Dividend Valuation Models (DVMs), Discounted Cash Flows Models Recall: The value of a stock is based on the present value of its future cash flows Therefore, dividend discount models should be extremely popular

21. Dividend Discount Model (Purest incarnation) Value of stock = present value of all expected future dividend payments Example: Page 165 (Page 178, 3rd edition) Three annual dividends of $100 per share Required rate of return = 15% ($100/1.15)+($100/1.152)+($100/1.153) = $228.32 Dividend Discount Models

22. What is �Present Value?� Present Value The value today of a lump sum (or series of payments) to be received at some future date It is the opposite of future value! (a.k.a. the inverse) Remember the optional future value calculations? Future value of $10,000 in 10 years at 8% $10,000 * 2.1589 = $21,589 (1 + 8%) 10 years Present value of $21,589 in 10 years at 8% $21,589 * 0.4632 = $10,000 1 1 $10,000 * 2.1589 = $21,589 (1 + 8%) 10 years

23. Did the formula for the DDM scare you? This formula has the present value calc built into it We mortals simply use the Present Value tables Just as we used the Future Value tables in Chapter 1 The formula becomes: Present Value & DDM

24. Example: Page 165 using Present Value Multipliers (Page 178, 3rd edition) Three annual dividends of $100 per share Required rate of return = 15% Value = ($100*0.870) + ($100*0.756) + ($100*0.658) = $87.00 + $75.60 + $65.80 = $228.40 ? $228.32 (from page 165) Present Value & DDM

25. Dividend Discount Models Zero Growth Model (Not covered in our book) Assume dividends will continue at a fixed rate indefinitely into the future Value of stock = --------------- Example: Annual dividend = $3.00 per share Required rate of return = 6% $3.00 / 6% = $50.00 per share

26. Dividend Discount Models Zero Growth Model (Not covered in our book) Assume dividends will continue at a fixed rate indefinitely into the future Value of stock = --------------- Dividend Yield = ---------------

27. Dividend Discount Models Zero Growth Model (Real-life Example) Consolidated Edison � ED (Utility income stock) Current market price is $55.12 per share (9 Sep 2011) Currently paying $2.40 per year in annual dividends The question is, �What is our required rate of return?� Let�s first use 8% Value = $2.40 / 8% = $30 The stock is overpriced if our required rate of return is 8% What about 5%? Value = $2.40 / 5% = $48 The stock is still too expensive if our required return is 5%

28. Dividend Discount Models Constant Perpetual Growth Model Assume dividends will continue to grow at a specified rate perpetually into the future Value of stock = ------------------- Example: Page 167 (Page 180, 3rd edition) Annual dividend = $10 per share (Next year�s=$10.40) Annual dividend growth rate = 4% per year Required rate of return = 9% ($10 * 1.04) / (9% - 4%) = $10.40 / 5% = $208 The stock should be worth $208 per share

29. Dividend Discount Models Constant Perpetual Growth Model (Real-life Example) Johnson & Johnson (blue chip) Current market price is $64.14 (19 Sep 2011) Currently paying $2.28 annual dividends Assume dividends growing around 8% per year Our required rate of return is 13% ($2.28 * 1.08) / (13% - 8%) = $2.4624 / 5% ? $49.25 Not a great buy if we require 13%, huh? What if our required rate of return were only 10%? ($2.28 * 1.08) / (10% - 8%) = $2.4624 / 2% ? $123.12 What a deal! Note: The model is very sensitive to our choice of our required rate of return

30. Dividend Discount Models Constant Perpetual Growth Model (Real-life Example) Proctor & Gamble (blue chip) Current market price is $63.81 (19 Sep 2011) Currently paying $2.10 annual dividends Assume dividends growing around 8% per year Our required rate of return is 13% ($2.10 * 1.08) / (13% - 8%) = $2.268 / 5% ? $45.36 Proctor & Gamble doesn�t quite measure up to our 13% rate What if our required rate of return were only 10%? ($2.10 * 1.08) / (10% - 8%) = $2.268 / 2% ? $113.40 The model says P&G is undervalued if we require only 10%

31. Dividend Discount Models Constant Perpetual Growth Model (Real-life Example) Coca-Cola (blue chip) Current market price is $70.49 (19 Sep 2011) Currently paying $1.88 annual dividends Assume dividends growing around 8% per year Our required rate of return is 13% ($1.88 * 1.08) / (13% - 8%) = $2.0304 / 5% ? $40.61 So much for caramel colored, fizzy sugar water! What if our required rate of return were only 10%? ($1.88 * 1.08) / (10% - 8%) = $2.0304 / 2% ? $101.52 Maybe we ought to spend more time researching KO �

32. Dividend Discount Models Constant Perpetual Growth Model (Real-life Example) GE (blue chip) Current market price is $16.18 (19 Sep 2011) Currently paying $0.60 annual dividends Assume dividends also growing around 8% per year What if our required rate of return is 13% ($0.60 * 1.08) / (13% - 8%) = $0.648 / 5% ? $12.96 Uh, GE does not look so good if we want 13% How about 10%? ($0.60 * 1.08) / (10% - 8%) = $0.648 / 2% ? $32.40 If we are happy with 10%, GE appears to be a great deal

33. Dividend Discount Models Constant Perpetual Growth Model (Real-life Example) Altria (blue chip) Current market price is $26.87 (19 Sep 2011) Currently paying $1.64 annual dividends Assume dividends also growing around 8% per year Same required rate of return of 13% ($1.64 * 1.08) / (13% - 8%) = $1.7712 / 5% ? $35.424 What a buy! Better than a 13% rate of return! If you ignore the potential tobacco related lawsuit damage And that tobacco kills 400,000 Americans each year� Using this model, investors are currently requiring approximately a 14.72% required rate of return ($1.64 * 1.08) / (14.72% - 8%) ? $26.36

34. Dividend Discount Models Constant Perpetual Growth Model (continued) The Constant Perpetual Growth Model is very sensitive to the assumed growth rate of dividends The recent dividend growth rates of Coke, Altria, P&G, and J&J are all currently higher than 8% Coke is 10.4%, Altria is 12.8%, P&G is 13.3%, and J&J is 14.6%! But the model does not work if the required rate of return is equal to or less than the dividend growth rate (Division by zero or negative prices!) Therefore, we should actually raise our expected rates of returns for all of these companies All are actually much better buys than what the model is telling us for our 10% or 13% rates of return

35. Constant Growth Model Assume dividends will continue to grow at a specified rate for a specified number of years Example: Page 166 (Page 179, 3rd edition) Current annual dividend = $10 per share Annual dividend growth rate = 8% per year Required rate of return = 10% Specified number of years = 20 ($10 * 1.08) / ( 10% - 8%) * [1 � (1.08/1.10)20] = = $540 * (1 � 0.6928) = $540 * 0.3072 ? $165.88 Dividend Discount Models

36. Dividend Discount Models Two-Stage Dividend Growth Model a.k.a. Variable Growth Model Assume dividends will continue to grow at a specified rate into the future (presumably the fast-growth stage) and then grow at a second (presumably slower growth once the company matures) Essentially combines Constant Growth and Constant Perpetual Growth Models into one Example: Page 173 (Page 187, 3rd edition) You can do it yourself if you really want to�

37. Dividend Discount Models Observations of the Dividend Discount Models How do you use them for a company that isn�t paying any dividends? The answer is, �You can�t!� Constant perpetual growth is usually an unrealistic assumption (except for a very small number of companies) Dividend growth rates are very difficult to estimate With large cap, well-established companies, historical growth rates may be useful But with fast growing companies in new industries, it is almost impossible

38. Dividends and Earnings Model Uses present value of expected dividends and expected future price to value a share of stock Does not really use earnings� But then again, French toast is not French and it is not toast Value of stock = present value of future dividends + present value of price of stock when you plan to sell Must use present value multipliers 1 / (1+required rate of return)years Not covered in our text Pity. I think it is probably the best variation of DDM

39. Dividends and Earnings Model Example 1: Assume it is January 1, 2011. Pretzels Unlimited is currently selling for $22 per share and will pay $2.00 per share in dividends in 2011. PU expects to increase their dividends to $2.20 in 2012, $2.30 in 2013, and $2.30 in 2014. We will be selling the stock at the end of 2014 and we expect the price to be $27 per share at that time. Our required rate of return is 12%. Value of stock = present value of future dividends + present value of price of stock when you plan to sell Value = ($2.00*0.893)+(2.20*0.797)+(2.30*0.712)+(2.30*0.636) + ($27.00*0.636) = = [ $1.786 + $1.7534 + $1.6376 + $1.4628 ] + $17.172 = = $6.6398 + $17.172 = $23.8118 ? $23.81

40. Dividends and Earnings Model Example 1: Pretzels Unlimited in Table Format

41. Dividends and Earnings Model Example 1 (Simplified): Pretzels Unlimited in a More Simplified Table Format

42. Internal Rate of Return (a.k.a. IRR) The Internal Rate of Return is a measure of what rate of return we expect to get from a series of cash flows, including positive and negative flows Someday, when you take an upper-level or graduate finance or investment class, you will learn how to manually compute Internal Rate of Return Hopefully, you will not have a sadistic professor who will make you do it more than once manually We are simply going to enter the numbers into a spreadsheet formula and press [Enter], okay? Dividends and Earnings Model

43. Internal Rate of Return (a.k.a. IRR), continued The spreadsheet formula is: =IRR(values,approximate-rate-of-return) where values is the block of cells containing the cash flows, both positive and negative, and approximate-rate-of-return is our guess as to what the internal rate of return will be Dividends and Earnings Model

44. Dividends and Earnings Model Example 2: Genes �R� Us (symbol GRUS) is currently selling for $21 per share. It pays no dividend. We believe that GRUS will sell for around $50 per share in five years. Our required rate of return is 13%. How can we determine if this is a good investment? With no dividends, which model can we use? The Dividends & Earnings Model can still be useful Value of stock = present value of future dividends + present value of price of stock when you plan to sell Value = $0.00 (from dividends) + ($50.00*0.543) = $27.13

45. Residual Income Model Another method that is a cousin of the DDMs is the Residual Income Model As with the Dividends & Earnings model, it allows us to value a company that is not paying dividends Instead of using dividends, the model uses earnings We will skip it for now and maybe come back to it later I think you have enough on your plate as it is �

46. Okay, Paiano, this is great, but just where are we supposed to get all this historical information, anyway? And just who decides what next year�s earnings per share, dividends per share, sales per share, cash flow per share, etc. are going to be? Before the Internet (BI?), this information was not readily available Normally, you would ask your broker for it Or you would use one of the securities industry�s trusted information sources The most respected source traditionally was � Sources of Information

47. Still one of the most respected and trusted sources of data and analysis Traditionally, it was often the only source many investors used Expensive ($600 per year), but can be gotten for free at any decent library The Value Line

48. Can you find� The Value Line indicators? The future price projections? The historical data? The cash assets, receivables, inventory, and other assets? The description and analysis of the business? The historical annual rates? The insider and institutional buying & selling? The amount of debt and number of shares outstanding? The company�s financial strength, stability, price growth, and earnings predictability ratings? The Value Line

49. The Value Line

50. The Value Line

51. The Value Line Let�s put The Value Line to the test Their price prediction for late 2009 was in the range from around $66 to around $82 Aye! McGraw-Hill�s price was hovering around $24 in late 2009 What happened? It reached $70 in mid-2007 and started falling as the credit markets started reacting to the home mortgage loan crisis McGraw-Hill owns Standard & Poors It then plummeted as the home mortgage loan crisis spread to the entire financial sector in 2008 & 2009

52. The Value Line

53. The Value Line

54. CHAPTER 6 � REVIEW