MARKETING

190 Part 2 Analysis and Valuation of Equity Securities

ffi suMMARy This-chapter presents severar common stock valuation dends and earnings per share. For the valuation to be earnings and dividends needs to be correct.

free cash flow 1g5 growth companies 775 growth stock 775 hidden assets 189 least squares trend

analysis 185 price-earnings ratio 177

models that rely on divi- accurate, the forecast of

required rate of return 165

retention ratio 174 risk-free rate 165 sustainable growth

model 173 valuation 164

Firms can be varued_in many ways, and, afianalyst may use severar methods tosubstantiate estimates. varuation mojels based pri^"rrty on airia"rrds rook atfuture prol'ections of diviclends and the associated present values of the dividends.Assumptions must be made as to whether the divii""a gro-tn paftern is constant,accelerating. or decreasing. . calculating the p.op"i rare of return for the valuation of a company,s stock isimportant. The capital Asset pricing Model is used

^ u--"thoa'"r.rr."irtr"sreturn. \7e also discuss the problemi with heta and the ;di;y risk premium. Analternate return methocl is presented where the company,s corporate bond yield isused as a baseline for the iequired rate of return. The analysis of a firm's growth rate is a very important part of the valuationprocess' sre discuss the various ways of analyzingg.o*.tn i".riamg the sustainablegrowth model and the.rerationship berween thJ lriving fo.c.s of growth. Thesedriving forces of growth are a function of sales g.o*f,; ire ,,u.io* reration_ships between profit margins, payout ratios, and number of shares outstanding.valuation using the earnings method requires that a price-earnings ratio be usedas a multiplier of Eps. price-earnings ratios are influenc"a ny lrlrrry variables such asgrowth, risk, capital stnrcture, dividend poriry, revel of the market in general, in<lustryfactors, and more. A careful study of eaih situation must be concludecl before choos-ing the appropriate P/E. The price-earnings ratio is a function of two fluctuating vari-ables-earnings and price. The two variab"les combine to form a ratiothat is primarilyfuture oriented' High price-earnings ratios usually indicate positive expectations of thefuture, whereas low price-earning-s ratios connote negative expectations.

To choose ap/Ethat is reasonable, the analyst must have some idea about theexpected grou.th rate in earnings per share.-Investors may find earnings estimates ininvestmenr advisory se.ices, in itatisticar forecasrs t;;;.rge houses, throughtheir own time series statisticar regression anarysis, ", "1y "r;;;h'" income statementmethod' Growth stocks were clisc-ussed more with the view oialerting the student towhat to look for when trying ro identig/ a growth stock or ;o_prrry than with theconcept of valuation' The previously developed methods of valuailon can be used ongrowth stocks as long as care is taken to evaluate the durationu.ra t"r."t of growth.we also presenred some basic ideas about rhe varue ;i;;;;r".s basecl nor ontheir earmngs or dividend stream but on their assets such as cash or natural resources.

ffi KEY woRDs AND coNcEprs beta 165 dividend valuation

models '1,65 earnings valuation

model 165 EBITDA 185 equity risk premium

(ERP) \55

ffi DrscusstoN ouEsrtoNs L' To determine the required rate of return, K", what factor is aclcled to the risk_free rate? (Use FormulaT_2 on page f66.)

[Q Whar does beta represenr? I What does the equiry risk premium (ERp) represent? 4- How is value interpreted under the dividend valuation model?