c.s Valuation

8/13/2019 c.s Valuation

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10-2

Fundamental Analysis

Present value approach

Capitalization of expected income

Intrinsic value based on the discounted valueof the expected stream of cash flows

Multiple of earnings approach

Valuation relative to a financial performance

measure

P/E ratio


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10-3

Intrinsic value of a security is

Estimated intrinsic value compared to thecurrent market price

What if current market price is different thanestimated intrinsic value?

n

t tk)(

Cash Flowsuri tysecValue o f

1 1

Present Value Approach


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10-4

Required Inputs

Discount rate

Required rate of return: minimum expectedrate to induce purchase

The opportunity cost of dollars used forinvestment

Expected cash flows

Stream of dividends or other cash payoutsover the life of the investment


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10-5

Required Inputs

Expected cash flows

Dividends paid out of earnings

Earnings important in valuing stocks

Retained earnings enhance future earningsand ultimately dividends

Retained earnings imply growth and futuredividends


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10-6

Current value of a share of stock is thediscounted value of all future dividends

1

2

2

1

1

1

111

tt

cs

t

cscscs

cs

)k(

D

)k(

D...

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D

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DP

Dividend Discount Model


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10-8

Assume no growth in dividendsFixed dollar amount of dividends reduces the

security to a perpetuity

Similar to preferred stock because dividendremains unchanged

csk

DP 00



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10-9

Assume a constant growth in dividendsDividends expected to grow at a constant

rate, g, over time

D1 is the expected dividend at end of the first

periodD1=D0 1+g)

gk

DP

10



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10-10


Implications of constant growth

Stock prices grow at the same rate as thedividends

Stock total returns grow at the required rate ofreturn

Growth rate in price plus growth rate in dividendsequals k, the required rate of return

A lower required return or a higher expectedgrowth in dividends raises prices


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10-11

nt

t

k)(k-g

)g(D

k)(

)g(DP cn

n

t

111

1

1

1

100


Multiple growth rates two or moreexpected growth rates in dividends

Assume growth at a rapid rate for n periods

followed by steady growth


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Multiple growth rates

First present value covers the period of super-normal (or sub-normal) growth

Second present value covers the period ofstable growth

Expected price uses constant-growth model as ofthe end of super- (sub-) normal period

Value at n must be discounted to time period zero


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0 k=16% 1 2 3 4

g = 30% g = 30% g = 30% g = 6%

D0 = 4.00 5.20 6.76 8.788 9.315

4.48

5.025.63

59.68 P3= 9.315

74.81 = P0 .10

Example Valuing equity with growth of30% for 3 years, then a long-run constant

growth of 6%


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10-14

What About Capital Gains?

Is the dividend discount model onlycapable of handling dividends?

Capital gains are also important

Price received in future reflectsexpectations of dividends from that pointforward

Discounting dividends or a combination ofdividends and price produces same results


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10-15

Intrinsic Value

Fair value based on the capitalization ofincome process

The objective of fundamental analysis

If intrinsic value >(


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10-16

P/E Ratio orEarnings Multiplier Approach

Alternative approach often used bysecurity analysts

P/E ratio is the strength with whichinvestors value earnings as expressed instock price

Divide the current market price of the stock by

the latest 12-month earningsPrice paid for each $1 of earnings


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10-17

To estimate share value

P/E ratio can be derived from

11/EPEP/E ratioearningsestimatedP oo

k - g

/ED/Eor P

k - g

DP oo

111

1

P/E Ratio Approach


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10-18

P/E Ratio Approach

The higher the payout ratio, the higher theP/E ratio

Payout ratio is the proportion of earnings that

are paid out as dividends

The higher the expected growth rate, g,the higher the P/E

The higher the required rate of return, k,the lower the P/E


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10-19

P/E Ratios and Interest Rates

IR Related to the required rate of return

As interest rates increase, required rates

of return on all securities generallyincrease

P/E ratios and interest rates are indirectly

related


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10-20

Which Approach Is Best?

Best estimate is probably the presentvalue of the (estimated) dividends

Can future dividends be estimated with

accuracy?

P/E multiplier remains popular for its easein use and the objections to the dividend

discount model


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10-21

Which Approach Is Best?

Complementary approaches?

P/E ratio can be derived from the constant-growth version of the dividend discount model

Dividends are paid out of earnings

Using both increases the likelihood ofobtaining reasonable results

Dealing with uncertain future is alwayssubject to error


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Other Multiples

Price-to-book value ratio

Ratio of share price to stockholder equity asmeasured on the balance sheet

Price paid for each $1 of equity

Price-to-sales ratio

Ratio of a companys total market value (price

times number of shares) divided by sales Market valuation of a firms revenues


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10-23

Preferred Stock Valuation


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Preferred Stock

Preferred stock is superior to commonstock in the event of liquidation. Typically,preferred stock pays a fixed dividend

periodically and the preferred stockholdersare usually not entitled to vote as are thecommon shareholders.

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Preferred stock is very much like common

stock, except that the dividends areconstant (i.e., the growth rate is 0%)

Therefore, we can use the DDM with a 0%

growth rate to find the value:

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V Dk

D

kP

CS CS

0 1 0

0


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Preferred Stock: An Example

Suppose that you are interested inpurchasing shares of a preferred stockwhich pays a $5 dividend every year. Ifyour required return is 7%, what is theintrinsic value of this stock?

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Preferred Stock: An Example

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c.s Valuation

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