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Chapter 8 Stock Valuation. Valuing a Company and Its 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
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Chapter 8 Stock Valuation
Valuing a Company and Its 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 • Information used for forecasting: • Past price, volume • Financial reports (income statement, balance sheet, cash flow statement) • Macroeconomic series
Valuing a Company and Its Future • Forecasts normally involves (an overview): • Sales and sales growth • Profit margin: converts sales into earnings • Returns (ROE): converts equity into earnings • Payout ratio: converts earnings into dividends. • ROE & payout ratio are also used to project future growth rates. High return and low payout leads to higher growth in the future. • Price to earning/book ratios: If these ratios are stable, one can use forecasted earnings/book to predict future prices. • Book value refers to the accounting value of the firm recorded on the balance sheet.
Table 8.1 Comparative Dollar-Based and Common-Size Income Statements Universal Office Furnishings, Inc. 2010 Income Statements
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
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
Step 1: Forecast Future Sales and Profits (cont’d) • 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%.
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:
Step 2: Forecast Future EPS (cont’d) • 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%.
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
Step 2: Forecast Future Dividends (cont’d) • 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%.
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 economic conditions, general stock market outlook in near term, or anticipated changes in company’s operating results
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
Step 3: Forecast Future Stock Price • Example: Assume estimated EPS are $3.25 and the estimated P/E ratio is 17.5 times. • To estimate the stock price in three years, extend the EPS figure for two more years and repeat the calculations.
Table 8.3Summary Forecast Statistics, Universal Office Furnishings
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 priceundervalued current price = estimated pricefairly valued current price > estimated price overvalued
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 determine what a stock ought to be worth • If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment candidate • If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment candidate • There is no assurance that actual outcome will match expected outcome
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
Required Rate of Return (cont’d) • 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?
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
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
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
Growth rate forecast • Based on historical sales/EPS growth • Based on earnings power (ROE) and how much is reinvested: • Expected growth = ROE*(1- PayoutRatio) • ROE (return on equity) = Net Income/Total Equity
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
Dividends-and-Earnings Approach • Very similar to variable-growth dividend-valuation model • 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
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
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
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
Price-to-Book-Value (P/BV) Approach • Similar to P/E approach, but substitutes book value for earnings