Chapter 6 Stock Valuation Model

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Chapter 6

Stock Valuation Model

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Stock Valuation

Learning Goals

Explain the role that a company’s future plays in the stock valuation process.

Develop a forecast of a stock’s expected cash flow, starting with corporate sales and earnings, and then moving to expected dividends and share price.

Discuss the concepts of intrinsic value and required rates of return, and note how they are used.

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Stock Valuation

Learning Goals (cont’d)

Determine the underlying value of a stock using the zero-growth, constant-growth, and variable-growth dividend valuation models.

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 appreciation of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

P/E

MODEL

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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

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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

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Step 1: Forecast Future Sales and Profits

Forecasted Future Sales based upon:
“Naive” approach based upon continued historical trends, OR
Historical trends adjusted for anticipated changes in operations or environment.
For example if a firm’s sales have been growing at a rate of 10% per year, then the investors might assume sales will continue at that rate.

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

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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%.

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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:

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Step 2: Forecast Future EPS (cont’d)

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%.

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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

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Step 2: Forecast Future Dividends (cont’d)

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%.

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Step 3: Forecast P/E Ratio

The most difficult issue in this process.
Estimated P/E ratio based upon:
“Average market multiple” of all stocks in the marketplace (average P/E ratio of all the stocks in a given market index eg: S&P 500)
“Relative P/E multiple@ratio ” of individual stocks
Adjust up or down based upon expectations of economic conditions, general stock market outlook in near term, or anticipated changes in company’s operating results

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Step 3: Forecast P/E Ratio (cont’)

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

*higher P/E ratio - higher rate of growth in earnings – optimistic market outlook – lower debts level-less financial risk

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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.

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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 price undervalued

current price = estimated price fairly valued

current price > estimated price overvalued

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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 determine what a stock ought to be worthwhile investment candidate in 2 conditions:

i) If expected rate of return equals or exceeds our

target yield,

ii) If the justified price (intrinsic) worth equals or

exceeds the current market value.

- There is no assurance that actual outcome will match the
expected outcome.

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1. 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
The greater the perceived risk, the more investors should expect to earn.
This notion is behind the capital asset pricing model (CAPM)

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Required Rate of Return (cont’d)

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?

*Beta = A measure of diversifiable risk

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2. Price/Earnings (P/E) Approach

P/E ratio is the price an investor is paying for $1 of a company's earnings or profit.
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

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Price/Earnings (P/E) Approach

Eg : If a company is reporting basic or diluted earnings per share of $2 and the stock is selling for $20 per share, therefore the P/E ratio is 10.

$20 = 2 X P/E ratio

P/E ratio = 10

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3. Price-to-Cash-Flow (P/CF) Approach

The price-to-cash flow (P/CF) ratio is a stock valuation indicator or multiple that measures the value of a stock's price relative to its operating cash flow per share.
Widely used by investors
Many consider cash flow to be more accurate than profits to evaluate a stock

= EBITDA

number of common share outstanding

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Price-to-Cash-Flow (P/CF) Approach

Assume a company currently is generating EBITDA of $325 million, which expected to increase by some 12% this year. Suppose the company has 56 million share of stock outstanding.

Cash Flow per share = $325 million x 1.12

56 million

= $6.50 per share

If the company expected that the stock can be trade by 8 times of its projected cash flow, therefore it should be valued by $6.50 X8 = $52 per share.

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4. 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

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5. Price-to-Book-Value (P/BV) Approach

Similar to P/E approach, but substitutes book value for earnings

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Price-to-Book-Value (P/BV) Approach (continued)

Let say the market price of the stock of ABC Co is $41.50, while the book value per share is $4.76, therefore the P/BV is :

= $41.50 / $4.76 = $8.72

Most stock have a price-to-book value ratio is >1 which simply indicate that the stock is selling more than its book value. In this case, the price-to-book ratio is 8.7 times definitely on the high sides, either the stock is already fully priced or perhaps overpriced.

Dividend Valuation Model (DVM)

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Dividend Valuation Model

When an investor sells a stock, what he is really selling is the right to all future dividends.
The future price of the stock will rise or fall as the outlook for dividends changes.
There are three versions of dividend valuation model, each based on different assumptions about the future rate of growth in dividends:

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Dividend Valuation Model:
i) Zero Growth

Assume the stock has a fixed stream of dividends, that not grow over time.

Dividends stay the same year in and year out.

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Dividend Valuation Model:
Zero Growth

Eg: Suppose a stock pays a dividend $3 per share each year, and you don’t expect the dividend to change. If you want a 10% return on your investment, how much should you willing to pay for the stock?

Value of stock= $ 3 / 0.10 = $30

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Dividend Valuation Model:
ii) Constant Growth

Uses present value to value stock
Assumes dividends will grow at a constant rate over time
Works best with established companies with history of steady dividend payments

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Dividend Valuation Model:
Constant Growth

Eg : In 25 years between 1990, the food company ABC company increased it dividend payments about 7% per year. In April 2015 ABC Co was paying annual dividend at $1.76 per share, so 2016 investor were expecting increase in the dividends over the coming year to $1.88 per share [$1.88 / (0.10-0.07)] in 2015. If the required return on the ABC Co stock is 10%, then how much the investors been willing to pay for the stock?

$62.67= $ 1.88 / (0.10 – 0.07)

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Dividend Valuation Model: Constant Growth(Cont)

Example 2 : The Power Fin Corp. paid $1.40 per year from 2008 to 2014. If the investor required 8% return on stock, then under the assumption of constant dividend, the stock would be sell at :

= 1.40 / 0.08 = $17.50 per share

If let say, the stock traded $30 per share in Dec 2014. Therefore, the investor can assume that either required rate of return was lower than 8% or they can expected dividends to rise.

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Dividend Valuation Model:
iii) 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

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Dividend Valuation Model:
Variable Growth

Also known as The Gordon Growth Model / Dividend Discounted Model (DDM)

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Dividend Valuation Model: Variable Growth (Cont)

Let's assume that during the next few years XYZ Company's dividends will increase rapidly and then grow at a stable rate. Next year's dividend is still expected to be $1 per share, but dividends will increase annually by 7%, then 10%, then 12%, and then steadily increase by 5% after that. By using elements of the stable model, but analyzing each year of unusual dividend growth separately, we can calculate the current fair value of XYZ Company stock.

Here are the inputs:

D1 = $1.00 , k = 10%

g1 (dividend growth rate, year 1) = 7%
g2 (dividend growth rate, year 2) = 10%
g3 (dividend growth rate, year 3) = 12%
gn (dividend growth rate thereafter) = 5%

Since we have estimated the dividend growth rate, we can calculate the actual dividends for those years:

D1 = $1.00
D2 = $1.00 * 1.07 = $1.07
D3 = $1.07 * 1.10 = $1.18
D4 = $1.18 * 1.12 = $1.32

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Dividend Valuation Model: Variable Growth (Cont)

We then calculate the present value of each dividend during the unusual growth period:
$1.00 / (1.10) = $0.91
$1.07 / (1.10)2 = $0.88
$1.18 / (1.10)3 = $0.89
$1.32 / (1.10)4 = $0.90

Then, we value the dividends occurring in the stable growth period, starting by calculating the fifth year's dividend:
D5 = $1.32*(1.05) = $1.39

We then apply the stable-growth Gordon Growth Model formula to these dividends to determine their value in the fifth year:
$1.39 / (0.10-0.05) = $27.80

The present value of these stable growth period dividends are then calculated:
$27.80 / (1.10)5 = $17.26

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Dividend Valuation Model: Variable Growth (Cont)

Finally, we can add the present values of Company XYZ's future dividends to arrive at the current intrinsic value of Company XYZ stock:

$0.91+$0.88+$0.89+$0.90+$17.26 = $20.84

The multistage growth model also indicates that Company XYZ stock is undervalued (a $20.84 intrinsic value, compared with a $10 trading price).

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