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Chapter 6

Chapter 6. Stock Valuation. Learning Goals. What is stock valuation model. How to value good and bad stock. Introduction.

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Chapter 6

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  1. Chapter 6 Stock Valuation

  2. Learning Goals • What is stock valuation model. • How to value good and bad stock

  3. Introduction • Purpose – to obtain a standard of performance that can be used to judge the investment merits of a share. It is called stock intrinsic value. It indicates the future risk and return performance of a security. • To look at whether a stock is under or over valued are by comparing its intrinsic value and its current market price. • Price of a share depends on investor’s expectations about the future behavior of the security. If the outlook for the company and its stock is good, the price will probably be bid up. If the condition is deteriorating, the price of the stock will probably go down.

  4. Value of stock can be determined based on: • Par Value - refers to the stated or face value, value of the stock. • Book Value - represents the amount of stockholders’ equity in the firm. • Market Value / Market Capitalization is simply the prevailing market price of an issue traded in stock exchange. • Investment value is determined based on expectations of the return and risk behavior of a stock.

  5. Stock Valuation Model • Market Value Approach The company’s capitalization / = number of shares x price per share total market value outstanding • Book Value Approach BV per share = Total shareholder’s equity - Preferred shares Common shares outstanding. • Asset Value Approach AV = Residual Value_____ Common Stock Outstanding

  6. Price Earning Ratio (P/E) Approach Market Value per Share = Forecasted P/E x Expected EPS • Net Tangible Assets (NTA) Approach NTA = total assets of a company Number of share outstanding

  7. Dividend Valuation Model • The value of a share is a function of all future dividends it is expected to provide over an infinite time horizon. • 3 versions of the dividend valuation model: • The zero-growth model - assume that dividends will not grow over time • The constant-growth model – assumes that dividends will grow by a fixed/constant rate over time • The variables-growth model – which assumes that the rate of growth in dividends varies over time.

  8. Zero Growth Value of a share of stock = Annual dividends Required rate of return P0 = D1 k • For example, if a stock paid a (constant) dividend of RM 3 a share and you wanted to earn 10% on your investment, the value of the stock would be RM 30 a share (RM 3/0.10 = RM 30) • If the capitalization rate goes up to, say 15%, the price of the stock will fall to RM20 (3/0.15)

  9. Constant Growth P0 = D0 x (1 + g )1_ + D0 x (1 + g )2 + … + D0 x (1 + g )n_ (1+k s ) 1 (1+k s ) 2 (1+k s ) n P0 = (D0 x PVIF1) + (D1 x PVIF2) + ……… + (Dn x PVIFn) P0 = D1 = D0 (1+g) k-g k-g A stock currently pays an annual dividend of RM1.75 a share. Growing at a rate of 8% a year, and you expect they will continue to do so into the future. In addition, you feel that because of the risks involved, the investment should carry a required rate of return of 12%. Given this information:  Value of a share of stock = D0 (1+g) k-g = RM1.75 (1.08) 0.12 – 0.08 = RM 47.25

  10. Variable Growth Step 1: D1 = D0 x (1 + g1 ) 1 D2 = D1 x (1 + g1) D3 = D2 x (1 + g1) ….. Dn = Dn-1 x (1 + g1) Step 2: P0 = D1 _ + D2_ + … …+ Dn__ (1+k s ) 1 (1+k s ) 2 (1+k s ) n P0 = (D1 x PVIF1,k ) + (D2 x PVIF2,k) + ……… + (Dn x PVIFn,k)

  11. Step 3: MP = Dn x (1 + g2 )n_ x 1__ (k s - g2 ) (1+k s ) n Dn x (1 + g2 )n_ x PVIFn,k (k s - g2 ) Step 4: Po = Po in step 2 + MP in step 3

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