Slides_Fundamentals of Investments - Chapter 6 ppt

6
6
C h a p t e r
Common Stock ValuationCommon Stock Valuation
second edition
Fundamentals
of
Investments
Valuation & Management
Charles J. Corrado Bradford D.Jordan
McGraw Hill / Irwin Slides by Yee-Tien

(Ted) Fu
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw Hill / Irwin
6 - 2
Common Stock Valuation
Our goal in this chapter is to examine
the methods commonly used by
financial analysts to assess the
economic value of common stocks.
Goal
 These methods are grouped into two
categories:
c dividend discount models
d price ratio models
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw Hill / Irwin
6 - 3
Security Analysis: Be Careful Out There
 The basic idea is to identify “undervalued”

stocks to buy and “overvalued” stocks to sell.
 In practice however, such stocks may in fact
be correctly priced for reasons not immediately
apparent to the analyst.
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.
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6 - 4
The Dividend Discount Model
where V(0) = the present value of the future dividend
stream
D(t) = the dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate
Dividend discount model (DDM)
Method of estimating the value of a share of
stock as the present value of all expected
future dividend payments.
()
()() ()
T
k
TD
k
D
k
D

k
D
V
+
++
+
+
+
+
+
=
1
)(
1
)3(
1
)2(
1
)1(
)0(
32
"
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw Hill / Irwin
6 - 5
The Dividend Discount Model
 Assuming that the dividends will grow at a
constant growth rate g,
()
() ( )

() ()
kgDTV
kg
k
g
gk
gD
V
T
=×=
≠
⎥
⎥
⎦
⎤
⎢
⎢
⎣
⎡
⎟
⎠
⎞
⎜
⎝
⎛
+
+
−
−
+×

=


00
1
1
1
10
0
(
)
(
)( )
gtDtD
+
×
=
+
11
 Then
 This is the constant growth rate model.
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McGraw Hill / Irwin
6 - 6
The Dividend Discount Model
Example: Constant Growth Rate Model
 Suppose the dividend growth rate is 10%, the
discount rate is 8%, there are 20 years of dividends to
be paid, and the current dividend is $10. What is the
value of the stock based on the constant growth rate

model?

()
()
86.243$
08.1
10.1
1
10.08.
10.110$
0
20
=
⎥
⎥
⎦
⎤
⎢
⎢
⎣
⎡
⎟
⎠
⎞
⎜
⎝
⎛
−
−
×

=V
 Thus the price of the stock should be $243.86.
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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6 - 7
The Dividend Discount Model
 Assuming that the dividends will grow forever
at a constant growth rate g,
()
(
)
(
)
(
)
kg
gk
D
gk
gD
V <
−
=
−
+
×
=
110
0
 This is the constant perpetual growth model.

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6 - 8
The Dividend Discount Model
Example: Constant Perpetual Growth Model
 Consider the electric utility industry. In late 2000, the
utility company Detroit Edison (DTE) paid a $2.06
dividend. Using D(0)=$2.06, k =8%, and g=2%,
calculate a present value estimate for DTE. Compare
this with the late-2000 DTE stock price of $36.13.

()
(
)
02.35$
02.08.
02.106.2$
0 =
−
×
=V
 Our estimated price is a little lower than the $36.13
stock price.
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6 - 9
The Dividend Discount Model
 The growth rate in dividends (g) can be
estimated in a number of ways.
c Using the company’s historical average growth

rate.
d Using an industry median or average growth rate.
e Using the sustainable growth rate.
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6 - 10
The Dividend Discount Model
Sustainable
= ROE ×

Retention ratio
growth rate
Return on equity (ROE) = Net income / Equity
Retention ratio = 1 – Payout ratio
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6 - 11
The Dividend Discount Model
Example: The Sustainable Growth Rate
 DTE has a ROE of 12.5%, earnings per share (EPS)
of $3.34, and a per share dividend (D(0)) of $2.06.
Assuming k = 8%, what is the value of DTE’s stock?
 Payout ratio = $2.06/$3.34 = .617
So, retention ratio = 1 – .617 = .383 or 38.3%
 Sustainable growth rate = 12.5% × .383 = 4.79%

()
(
)
13.36$25.67$

0479.08.
0479.106.2$
0 >>=
−
×
=V
 DTE’s stock is perhaps undervalued, or more likely,
its growth rate has been overestimated.
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6 - 12
The Two-Stage Dividend Growth Model
 A two-stage dividend growth model assumes
that a firm will initially grow at a rate g
1
for T
years, and thereafter grow at a rate g
2
< k
during a perpetual second stage of growth.
()
()( )
()( )
2
211
1
1
10
1
1

1
1
1
10
0
gk
gD
k
g
k
g
gk
gD
V
TT
−
+
⎟
⎠
⎞
⎜
⎝
⎛
+
+
+
⎥
⎥
⎦
⎤

⎢
⎢
⎣
⎡
⎟
⎠
⎞
⎜
⎝
⎛
+
+
−
−
+
=
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6 - 13
Discount Rates for Dividend Discount Models
 The discount rate for a stock can be estimated using
the capital asset pricing model (CAPM ).
 Discount
=
time value
+
risk
rate of money premium
=
T-bill

+
(
stock
×

stock market
)
rate beta risk premium
T-bill rate = return on 90-day U.S. T-bills
stock beta = risk relative to an average stock
stock market
=
risk premium for an average stock
risk premium
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Observations on Dividend Discount Models
Constant Perpetual Growth Model
9 Simple to compute.
8 Not usable for firms that do not pay dividends.
8 Not usable when g > k.
8 Is sensitive to the choice of g and k.
8 k and g may be difficult to estimate accurately.
8 Constant perpetual growth is often an
unrealistic assumption.
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Observations on Dividend Discount Models

Two-Stage Dividend Growth Model
9 More realistic in that it accounts for two stages
of growth.
9 Usable when g > k in the first stage.
8 Not usable for firms that do not pay dividends.
8 Is sensitive to the choice of g and k.
8 k and g may be difficult to estimate accurately.
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6 - 16
Price Ratio Analysis
 Price-earnings ratio (P/E ratio)
Î Current stock price divided by annual earnings per
share (EPS).
 Earnings yield
Î Inverse of the P/E ratio: earnings divided by price
(E/P).
 High-P/E stocks are often referred to as growth
stocks, while low-P/E stocks are often referred
to as value stocks.
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6 - 17
Price Ratio Analysis
 Price-cash flow ratio (P/CF ratio)
Î Current stock price divided by current cash flow
per share.
Î In this context, cash flow is usually taken to be net
income plus depreciation.
 Most analysts agree that in examining a

company’s financial performance, cash flow
can be more informative than net income.
 Earnings and cash flows that are far from each
other may be a signal of poor quality earnings.
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Price Ratio Analysis
 Price-sales ratio (P/S ratio)
Î Current stock price divided by annual sales per
share.
Î A high P/S ratio suggests high sales growth, while
a low P/S ratio suggests sluggish sales growth.
 Price-book ratio (P/B ratio)
Î Market value of a company’s common stock
divided by its book (accounting) value of equity.
Î A ratio bigger than 1.0 indicates that the firm is
creating value for its stockholders.
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Price Ratio Analysis
Intel Corp (INTC) - Earnings (P/E) Analysis
Current EPS $1.35
5-year average P/E ratio 30.4
EPS growth rate 16.5%
expected
=
historical
×

projected EPS
stock price P/E ratio
= 30.4 ×

($1.35×1.165)
= $47.81
* Late-2000 stock price = $89.88
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Price Ratio Analysis
Intel Corp (INTC) - Cash Flow (P/CF) Analysis
Current CFPS $1.97
5-year average P/CF ratio 21.6
CFPS growth rate 15.3%
expected
=
historical
×

projected CFPS
stock price P/CF ratio
= 21.6 ×

($1.97×1.153)
= $49.06
* Late-2000 stock price = $89.88
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6 - 21
Price Ratio Analysis
Intel Corp (INTC) - Sales (P/S) Analysis
Current SPS $4.56
5-year average P/S ratio 6.7
SPS growth rate 13.3%
expected
=
historical
×

projected SPS
stock price P/S ratio
= 6.7 ×

($4.56×1.133)
= $34.62
* Late-2000 stock price = $89.88
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw Hill / Irwin
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An Analysis of the
McGraw-Hill Company
An Analysis of the McGraw-Hill Company
An Analysis of the McGraw-Hill Company
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24
An Analysis of the McGraw-Hill Company
Getting the Most from the Value Line Page
6 -

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