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Valuation of Common Stock: Essential Concepts and Techniques

Learn how to determine the intrinsic value of a stock and explore alternative valuation methods, including price-earnings ratios, price to book value, and cash flow analysis. Understand the Efficient Market Hypothesis and its implications for stock investing.

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Valuation of Common Stock: Essential Concepts and Techniques

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  1. Chapter 9 The Valuation of Common Stock

  2. Investing in Stock • Acquiring ownership in a corporation

  3. Corporations • Formed by a state • Certificate of incorporation • Charter - specifies the relation with the state • Bylaws - specifies the relationship with stockholders

  4. Rights of Stockholders • Voting authority to elect a board of directors • Cumulative voting • Preemptive rights

  5. Source of Return • Dividends • Capital gains

  6. Sources of Return • Difference in short and long-term capital gains taxation favor capital gains • Transaction costs (e.g., commissions) favor dividend income

  7. Valuation • The determination of what a stock is worth; the stock's intrinsic value • If the price exceeds the valuation, buy the stock • If the price is less than the valuation, short the stock

  8. If the Dividend Is Fixed Valuation is • V=D/k

  9. If the Dividend Grows at a Constant Rate Valuation is • V=D0 (1+g)/(k - g)

  10. The Dividend Growth Model • Value depends on the • the required return • the dividend • the growth in the dividend

  11. The Required Return (k) • Depends on • the risk-free rate (rf) • the return on the market (rm) • the stock's beta

  12. Risk and Required Rate of Return

  13. Alternative Valuation Techniques • A price-earnings multiple times earnings • P=(m)(EPS)

  14. Weakness in the Use of P/E Ratios • Different definitions of earnings • Differences in estimated earnings • Question of the appropriate multiple

  15. Price to Book Value and Price to Sales • Conceptually the same as using P/E ratios • Same weaknesses apply

  16. The PEG Ratio • Standardizes the P/E ratio for growth P/EEarnings growth • Low PEG ratios (below 1.0) suggest undervaluation

  17. Substitution of Cash Flow for Earnings and Dividends • Emphasis on firm’s ability to generate cash • May be applied when firm does not pay a dividend

  18. Substitution of Cash Flow for Earnings and Dividends • May be applied if firm operates at a loss • Value investing employs all of the alternative methods

  19. The Efficient Market Hypothesis • Hard to beat the market on a risk-adjusted basis consistently • Earning a higher return is not necessarily outperforming the market • Considering risk is also important

  20. Assumptions Concerning Efficient Markets • Large number of competing participants • Information is readily available • Transaction costs are small

  21. Random Walk • Another term for efficient markets • Does not imply security prices are randomly determined • Implies day-to-day price changes are random

  22. Random Walk • Successive prices changes are independent • Today's price does not forecast tomorrow's price • Current price embodies all known information

  23. Random Walk • New information must be randomIF NOT • An opportunity to earn an excess return would exist

  24. Undervaluation drives prices up returns decline Overvaluation drives prices down returns increase Undervaluation and Overvaluation

  25. Undervaluation and Overvaluation

  26. Random Walk • Prices change quickly to new information • By the time most investors know the information the price change has already occurred

  27. Price Adjustments to New Information

  28. Degree of Market Efficiency • The forms of the efficient market hypothesis: • the weak form • the semi-strong form • the strong form

  29. Degree of Market Efficiency • Even if financial markets are efficient, that does not answer the question "How efficient?”

  30. The Weak Form • Studying past price and volume data will not lead to superior investment results • While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior returns

  31. The Semi-Strong Form • Studying economic and accounting data will not lead to superior investment returns • Studying inside information may lend to superior returns

  32. The Strong Form • Using inside information will not lead to superior investment returns

  33. Anomalies • Empirical results generally support • the weak form • the semi-strong form • Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist

  34. Examples of Anomalies • Low P/E stocks • The small firm effect • The January effect • The neglected firm effect

  35. Examples of Anomalies • The day-of-the-week effect • The Value Line effect • The overreaction effect • Drifts in security prices

  36. Anomalies and Returns • Empirical evidence of the existence of an anomaly, however, does not mean the individual can take advantage of the anomaly • The anomaly can still exist and the market be effectively efficient from the individual investor's perspective

  37. Implications of Efficient Markets • Security prices embody known information • The playing field is level • Specifying financial goals may be more important than seeking undervalued stocks

  38. Implications of Efficient Markets • Other markets may not be efficient • Importance of reducing transactions costs: the argument for a buy-and-hold strategy

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