Chapter 8

1. Chapter 8 Stock Valuation

2. Stock Valuation • Learning Goals • Explain the role that a company’s future plays in stock valuation. • Develop a forecast of a stock’s cash flow, expected dividends and share price. • Discuss the concepts of intrinsic value and RequiredRates of Return. • Calculate the underlying value of a stock using various dividend valuation models.

3. Stock Valuation • Learning Goals • Use other types of present-value-based models to derive the value of a stock as well as alternative price-relative procedures. • Gain a basic understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

4. Valuing a Company and Its Future • The single most important issue in the stock valuation process is what a stock will do in the 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

5. Comparative Dollar Based and Common-Size Income Statements

6. 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

7. 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

8. 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%. So $100M x 8% = $8M Growth  $100+$8 = $108M

9. 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:

10. Step 2: Forecast Future EPS • 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%.

11. 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

12. Step 2: Forecast Future Dividends • 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%.

13. 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 (1) economic conditions, (2) general stock market outlook in near term, or (3) anticipated changes in company’s operating results

14. 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

15. 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.

16. 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

17. 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 to find How Much a stock ought to be worth • If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment. • If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment. • There is no assurance that actual outcome will match expected outcome

18. 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

19. Required Rate of Return • 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?

20. 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

21. 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

22. 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

23. 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

24. Dividends-and-Earnings Approach • Very similar to variable-growth DVM • 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

25. 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

26. 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

27. 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

28. Price-to-Book-Value (P/BV) Approach • Similar to P/E approach, but substitutes book value for earnings

29. Review • Explained the role that a company’s future plays in stock valuation. • Developed a forecast of a stock’s cash flow, expected dividends and share price. • Discussed the concepts of intrinsic value and required rates of return, and noted how they are used. • Calculated the underlying value of a stock using various dividend valuation models.

30. Review • Used other types of present-value-based models to derive the value of a stock as well as alternative price-relative procedures. • Gained a basic Understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

31. T h e E n d !

32. Chapter 8 Additional Chapter Art

33. Average Market P/E Multiples 1977–2006

34. Selected Historical Financial Data, Universal Office Furnishings

35. Using the Variable-Growth DVM to Value Sweatmore Stock