Investments: Analysis and Management, Second Canadian … · INVESTMENTS: Analysis and Management...
Transcript of Investments: Analysis and Management, Second Canadian … · INVESTMENTS: Analysis and Management...
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INVESTMENTS: Analysis and Management
Second Canadian Edition
W. Sean Cleary
Charles P. Jones
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Chapter 13
Common Stock Valuation
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• Name two approaches to the valuation of
common stocks used in fundamental security
analysis.
• Explain the present value approach.
• Use the dividend discount model to estimate
stock prices.
• Explain the P/E ratio approach.
• Outline other relative valuation approaches.
Learning Objectives
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• Present value approach
Capitalization of expected income
Intrinsic value based on the discounted value
of the expected stream of future cash flows
• Multiple of earnings approach
Valuation relative to a financial performance
measure
Justified P/E ratio
Fundamental Analysis
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• Estimated intrinsic value compared to the
current market price
What if market price is different than estimated
intrinsic value?
n
1ttk) (1
Flows Cash security of Value
• Intrinsic value of a security is
Present Value Approach
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• Discount rate
Required rate of return: minimum expected rate
to induce purchase
The opportunity cost of dollars used for
investment
• Expected cash flows
Stream of dividends or other cash payouts over
the life of the investment
Required Inputs
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• Expected cash flows
Dividends paid out of earnings
• Earnings important in valuing stocks
Retained earnings enhance future earnings and
ultimately dividends
• Retained earnings imply growth and future
dividends
• Produces similar results as current dividends in
valuation of common shares
Required Inputs
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• Current value of a share of stock is the
discounted value of all future dividends
1tt
cs
t
cs2
cs
21
cs
1cs
)k(1
D
)k1(
D ...
)k1(
D
)k1(
D P
Dividend Discount Model
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• Problems:
Need infinite stream of dividends
Dividend stream is uncertain
• Must estimate future dividends
Dividends may be expected to grow over time
• Must model expected growth rate of dividends
and need not be constant
Dividend Discount Model
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• Assume no growth in dividends
Fixed dollar amount of dividends reduces the
security to a perpetuity
cs
00
k
DP
Similar to preferred stock because dividend
remains unchanged
Dividend Discount Model
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• Assume constant growth rate in dividends
Dividends expected to grow at a constant rate,
g, over time
gk
D P 1
0
Dividend Discount Model
D1 is the expected dividend at end of the first
period
D1 = D0 x (1+g)
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• Implications of constant growth
Stock prices grow at the same rate as the
dividends
Stock total returns grow at the required rate of
return
• Growth rate in price plus growth rate in
dividends equals k, the required rate of return
A lower required return or a higher expected
growth in dividends raises prices
Dividend Discount Model
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• Multiple growth rates: two or more expected
growth rates in dividends
Ultimately, growth rate must equal that of the
economy as a whole
Assume growth at a rapid rate for n periods,
followed by steady growth
nt
t
)k1(
1
g-k
)g(1D
k)(1
)g(1D P cn
n
1t
100
Dividend Discount Model
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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 of
stable growth
• Expected price uses constant-growth model as of
the end of super- (sub-) normal period
• Value at n must be discounted to time period zero
Dividend Discount Model
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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
5.02
5.63
59.68 P3 = 9.315
74.81 = P0 .10
Valuing equity with growth of 30% for 3 years, then a
long-run constant growth of 6%
Example
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• Is the dividend discount model only capable
of handling dividends?
Capital gains are also important
• Price received in future reflects expectations
of dividends from that point forward
Discounting dividends or a combination of
dividends and price produces same results
What About Capital Gains?
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• “Fair” value based on the capitalization of
income process
The objective of fundamental analysis
• If intrinsic value >(<) current market price, hold
or purchase (avoid or sell) because the asset is
undervalued (overvalued)
Decision will always involve estimates
• If intrinsic value = current market price, an
equilibrium because the asset is correctly
valued
Intrinsic Value
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• Alternative approach often used by security
analysts
• P/E ratio is the strength with which investors
value earnings as expressed in stock price
Divide the current market price of the stock by
the latest 12-month earnings
Price paid for each $1 of earnings
P/E Ratio or Earnings Multiplier
Approach
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• To estimate share value
1o1
o
/EP E ratio P/E justified
earnings estimatedP
• P/E ratio can be derived from
g - k
/ED/EP or
g - k
DP 11
1o1
o
Indicates the factors that affect the estimated
P/E ratio
P/E Ratio Approach
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• The higher the payout ratio, the higher the
justified P/E
Payout ratio is the proportion of earnings that
are paid out as dividends
• The higher the expected growth rate, g, the
higher the justified P/E
• The higher the required rate of return, k, the
lower the justified P/E
P/E Ratio Approach
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• Can firms increase payout ratio to increase
market price?
Will future growth prospects be affected?
• Does rapid growth affect the riskiness of
earnings?
Will the required return be affected?
Are some growth factors more desirable than
others?
• P/E ratios reflect expected growth and risk
Understanding the P/E Ratio
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• A P/E ratio reflects investor optimism and
pessimism
Related to the required rate of return
• As interest rates increase, required rates of
return on all securities generally increase
• P/E ratios and interest rates are inversely
related
P/E Ratios and Interest Rates
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• Market-to-book ratio (M/B)
Ratio of share price to per share shareholder’s
equity as measured on the balance sheet
Price paid for each $1 of equity
• Price-to-sales ratio (P/S)
Ratio of company’s market value (price times
number of shares) divided by sales
Market valuation of a firm’s revenues
Other Valuation Techniques
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• Best estimate is probably the present value of
the (estimated) dividends
Can future dividends be estimated with
accuracy?
Investors like to focus on capital gains not
dividends
• P/E multiplier remains popular for its ease of
use and the objections to the dividend discount
model
Which Approach Is Best?
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• 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 of
obtaining reasonable results
• Dealing with uncertain future is always
subject to error
Which Approach Is Best?
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Appendix 13-A Analysis and
Valuation of Preferred Stocks
• Described as a perpetuity, and it will pay the
indicated dividend forever
• Dividends are fixed when the stock is issued;
these dividends are specified as an annul
dollar amount or as a percentage of par value
• Less risky because the dividend is specified
and must be paid before a common stock
dividend can be paid
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