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McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter Seven

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Valuation of the Individual FirmValuation of the Individual Firm

22

Basic Valuation ConceptsBasic Valuation Concepts

Based on:Based on: Dividend valuation modelsDividend valuation models

(sum of the present value of dividends (sum of the present value of dividends expected to be received in the future) expected to be received in the future)

Earnings valuation modelEarnings valuation model

(price-earnings ratio, or multiplier of (price-earnings ratio, or multiplier of earnings) earnings)

Value (price of a share/stock)Value (price of a share/stock)

33

Basic Valuation Concepts Basic Valuation Concepts cont.cont. Long-run historical relationships betweenLong-run historical relationships between

“ “market price” of the stock and market price” of the stock and

• Sales (or revenues) Sales (or revenues)

• Book valueBook value

• Market value of assetsMarket value of assets CashCash Liquid assetsLiquid assets Replacement value of plant & Replacement value of plant & equipmentequipment Hidden assets (undervalued holdings)Hidden assets (undervalued holdings)

44

Review ofReview of Risk & Required Return ConceptsRisk & Required Return Concepts

Required rate of return: Required rate of return:

Required rate of return on the various Required rate of return on the various

RISK CLASSES of assetsRISK CLASSES of assets

rate at which future cash flows arerate at which future cash flows are

discounted to reach a valuationdiscounted to reach a valuation

the higher the risk, the higher the risk,

the higher the required rate of returnthe higher the required rate of return

55

Risk & Required Return Concepts Risk & Required Return Concepts cont.cont.

RRFF (Risk free rate) (Risk free rate)

= (1+ Real rate)(1 + Expected rate of inflation) – 1= (1+ Real rate)(1 + Expected rate of inflation) – 1

66

Risk & Required Return ConceptsRisk & Required Return Concepts cont.cont.

Adding a “risk” component to the risk free Adding a “risk” component to the risk free raterate

KKee = R = RFF + b(K + b(KMM - R- RFF))

KKe e = Required rate of return= Required rate of return

RRF F = Risk free rate= Risk free rate

b = Beta coefficientb = Beta coefficient

KKM M = = Expected return for common stocks in the marketExpected return for common stocks in the market

((KKMM - R - RFF ) = Equity risk premium (ERP) ) = Equity risk premium (ERP)

Equity riskEquity risk premiumpremium

betabetarisk free risk free raterate

77

Beta (Beta (ββ) b) b

Individual company riskIndividual company risk Compare with market risk (e.g. S&P 500)Compare with market risk (e.g. S&P 500) b > 1 more risk than the marketb > 1 more risk than the market b < 1 less risk than the marketb < 1 less risk than the market b = 1 same risk as the marketb = 1 same risk as the market

88

Dividend Valuation ModelsDividend Valuation Models

General Dividend Model General Dividend Model Constant Growth ModelConstant Growth Model A Nonconstant Growth ModelA Nonconstant Growth Model

General Dividend ModelGeneral Dividend Model

P0 = 1

1

)1( eK

D 2

2

)1( eK

D

33

)1( eK

D…+

where:P0 = Present value of the stock priceDt = Dividend for each year, e.g.1, 2, 3,..∞Ke = Required rate of return (discount rate)

)1( eK

D

Constant Growth ModelConstant Growth Model

P0 =

1

10

)1(

)1(

eK

gD

2

20

)1(

)1(

eK

gD

3

30

)1(

)1(

eK

gD

where:P0 = Present value of the stock priceDt = Dividend for each year, for example, 1, 2, 3,..∞Ke = Required rate of return (discount rate)

D0(1+g)1 = Dividends in the initial yearD0(1+g)2 = Dividends in year 2, and so on g = Constant growth rate in the dividend

)1(

)1(... 0

eK

gD

1111

Constant Growth Model Constant Growth Model cont.cont.

If the following two conditions are metIf the following two conditions are met

1.1. Constant growth rate gConstant growth rate g

2.2. Required rate of return KRequired rate of return Kee > growth rate g > growth rate g

Then constant growth model formula becomesThen constant growth model formula becomes

PP00 = D = D11/(/(KKee – g) – g)

1212

Numerical Example

Assume,

g = 8% (a constant number)

Ke= 12%

D1= $3.38

Substituting the values in the equationSubstituting the values in the equation

PP00 = D = D11/(K/(Kee – g) – g)

PP00 = $3.38/(0.12 – 0.08) = $3.38/(0.12 – 0.08)

= $3.38/0.04= $3.38/0.04

= $84.50= $84.50

1313

A Nonconstant Growth Model A Nonconstant Growth Model

Combination of different growth ratesCombination of different growth ratesExample: Constant growth in dividends Example: Constant growth in dividends 20% per year for the first 10 years, and20% per year for the first 10 years, and8% perpetual growth rate after that 8% perpetual growth rate after that

Application Example – Application Example – Please click on the ExcelPlease click on the Excelto see calculations for JAYCARto see calculations for JAYCARAlso, Figure 7-1 on page 174 in the textbookAlso, Figure 7-1 on page 174 in the textbook

1414

Earnings Valuation ModelEarnings Valuation Model

The Combined Earnings and Dividend ModelThe Combined Earnings and Dividend Model More comprehensive, using bothMore comprehensive, using both EPS (earnings per share) &EPS (earnings per share) &

P/E (earnings multiplier, or P/E Ratio)P/E (earnings multiplier, or P/E Ratio) Combined with a Combined with a Finite dividend modelFinite dividend model

Application Example – Application Example – Please click on the ExcelPlease click on the Excelto see calculations for J&Jto see calculations for J&J

I.I.

II.II.

1515

EVA: Economic Value AddedEVA: Economic Value AddedThe Real World of InvestingThe Real World of Investing

New valuation conceptNew valuation concept Considered by Considered by

• Coca ColaCoca Cola• Eli LillyEli Lilly• Merrill LynchMerrill Lynch• MonsantoMonsanto

Emphasize maximizing EVAEmphasize maximizing EVA Less interested at generating EPSLess interested at generating EPS

ContinuedContinued

1616

EVAEVA

(Capital) Investment decision made (Capital) Investment decision made

or projects acceptedor projects accepted ONLY IFONLY IF

>>Net operating profit after taxes Net operating profit after taxes

Capital costs to finance the investmentCapital costs to finance the investment

Founders of EVA Founders of EVA www.sternstewart.com

contcont..

1717

The Price-Earning RatioThe Price-Earning Ratio

The P/E Ratio for Individual StocksThe P/E Ratio for Individual Stocks The Pure, Short-Term Earnings ModelThe Pure, Short-Term Earnings Model Relating an Individual Stock’s P/E Ratio to the Relating an Individual Stock’s P/E Ratio to the

MarketMarket

1818

The Price-Earning RatioThe Price-Earning Ratio

MathematicallyMathematically

P/E ratioP/E ratio = = Price per sharePrice per share

Earnings per shareEarnings per share

Ultimately P/E ratio is set by investorsUltimately P/E ratio is set by investors Bid price up or down in relation to earningsBid price up or down in relation to earnings

(1) Today’s price(1) Today’s price(2) Latest 12-month earnings per share(2) Latest 12-month earnings per share

(1)(1)

(2)(2)

1919

Factors Affecting P/E RatioFactors Affecting P/E Ratio

Investors’ expectation of EPSInvestors’ expectation of EPS Expected growth in EPSExpected growth in EPS Historical analysisHistorical analysis Overall conditions in the stock marketOverall conditions in the stock market Growth prospects in the economyGrowth prospects in the economy Inflation inversely related to P/E ratioInflation inversely related to P/E ratio

• CPI goes down P/E ratio goes upCPI goes down P/E ratio goes up• CPI goes up P/E ratio goes downCPI goes up P/E ratio goes down

2020

The P/E Ratio for Individual StocksThe P/E Ratio for Individual Stocks

1. Growth prospect1. Growth prospect

2. Risk associated with future performance2. Risk associated with future performance

3. Debt to equity ratio3. Debt to equity ratio ContinuedContinued

The higher the expected growth rate The higher the expected growth rate

The higher the P/E ratioThe higher the P/E ratio

Firm with less debt Higher value in Firm with less debt Higher value in marketplacemarketplace

2121

The P/E Ratio for Individual Stocks The P/E Ratio for Individual Stocks cont.cont.

4. Dividend policy4. Dividend policy

5. Quality of management5. Quality of management

6. Technology and research6. Technology and research

7. Fads7. Fads

8. Government policy and politics8. Government policy and politics

9. 9. Can you think of any other factors that Can you think of any other factors that could affect the P/E ratio of an individual could affect the P/E ratio of an individual stock?stock?

2222

The P/E Ratio for Individual Stocks The P/E Ratio for Individual Stocks cont.cont.

PresidentPresident PolicyPolicy Result on stocks Result on stocks

Jimmy CarterJimmy Carter Environmental Environmental controlcontrol

Pollution controlPollution control

stocks stocks

Ronald ReganRonald Regan Military strengthMilitary strength Defense stocksDefense stocks

Bill ClintonBill Clinton Health care Health care proposalsproposals

PharmaceuticalsPharmaceuticals

George W. BushGeorge W. Bush Tobacco Tobacco

DefenseDefense

2323

The Pure, Short-Term Earnings ModelThe Pure, Short-Term Earnings Model

Investors/speculators Investors/speculators • Short term viewShort term view

• Ignore present value analysis ofIgnore present value analysis of Dividends &Dividends & Earnings per shareEarnings per share

InsteadInsteadUse: Use:

EPS &EPS &

Multiplier (P/E ratio)Multiplier (P/E ratio)

ComputeComputeestimated valueestimated value

of stockof stock

2424

Relating an Individual Stock’s Relating an Individual Stock’s P/E Ratio to the MarketP/E Ratio to the Market

Sales per share (SPS)Sales per share (SPS) Dividends per share (DPS)Dividends per share (DPS) Cash Flow per share (CFPS)Cash Flow per share (CFPS) Book Value per share (BVPS)Book Value per share (BVPS)

Continued Continued

2525

Relating an Individual Stock’s Relating an Individual Stock’s P/E Ratio to the Market P/E Ratio to the Market cont.cont.

Stock PriceStock Price P/E Ratio of a stock (JNJP/E Ratio of a stock (JNJ P/E Ratio of S&P 500P/E Ratio of S&P 500 Relative P/E RatiosRelative P/E Ratios

Relative P/E Ratio =Relative P/E Ratio =

See Table 7-4 on page 183See Table 7-4 on page 183

Look at Look at annualannual

high/low high/low rangesranges

Company P/ECompany P/E

S&P 500 P/ES&P 500 P/E

2626

Other Valuation Models Using Average Other Valuation Models Using Average Price Ratios and 10-Year AveragesPrice Ratios and 10-Year Averages

A. Avg. Price/Avg. Sales per share (SPS)A. Avg. Price/Avg. Sales per share (SPS)

Example:Example:

Price-to-SPS Ratio = $36.79/$9.61 = 3.83Price-to-SPS Ratio = $36.79/$9.61 = 3.83

Price-to-SPS Ratio x Est. SPS = Projected Price Price-to-SPS Ratio x Est. SPS = Projected Price

3.83 x $15.12 = $57.913.83 x $15.12 = $57.91Please refer to Table 7-5 on page 185Please refer to Table 7-5 on page 185

2727

Other Valuation Models Using Average Other Valuation Models Using Average Price Ratios and 10-Year Averages Price Ratios and 10-Year Averages cont.cont.

Similar calculations as shown on the Similar calculations as shown on the previous slide for:previous slide for:

B. Price to dividends per Share (DPS)B. Price to dividends per Share (DPS)

C. Price to cash flow per share (CFPS)C. Price to cash flow per share (CFPS)

D. Price to book value per share (BVPS)D. Price to book value per share (BVPS)

2828

Forecasting Earnings per ShareForecasting Earnings per ShareInvestors get earnings forecasts from:Investors get earnings forecasts from: Brokerage house researchBrokerage house research Investment advisory firmsInvestment advisory firms

• Value LineValue Line• Standard & Poor’sStandard & Poor’s

Financial magazinesFinancial magazines• ForbesForbes• Business WeekBusiness Week• WorthWorth• MoneyMoney

Do it themselvesDo it themselves

2929

Forecasting Earnings per ShareForecasting Earnings per Share

Least Squares Trendline Least Squares Trendline The Income Statement MethodThe Income Statement Method

3030

Least Squares TrendlineLeast Squares TrendlineFor Forecasting EPS For Forecasting EPS

Least squares trend analysis, most popularLeast squares trend analysis, most popular Statistical methodStatistical method Trendline fitted to a time series of historical Trendline fitted to a time series of historical

earnings (observations)earnings (observations) A straight line that minimizes the distance A straight line that minimizes the distance

of the individual observations from the lineof the individual observations from the line

3131

The Income Statement MethodThe Income Statement Method

Start with sales forecastStart with sales forecast Create standardized set of financial statementsCreate standardized set of financial statements Based on historical relationshipsBased on historical relationships Sales forecast must be accurate to give a Sales forecast must be accurate to give a

meaningful EPSmeaningful EPS Important factorsImportant factors

• ProfitabilityProfitability• Fluctuations in profit marginsFluctuations in profit margins

Before tax

After tax

3232

Growth StocksGrowth Stocks

In assessing the worth of an investment, the In assessing the worth of an investment, the term term growth stockgrowth stock is used by is used by • StockholdersStockholders• AnalystsAnalysts• InvestorsInvestors

Common stock of a company growing faster Common stock of a company growing faster than the economy or market normthan the economy or market norm

Predictable earnings growthPredictable earnings growth

Definition

3333

Growth CompaniesGrowth Companies

Companies that exhibit rising returns on Companies that exhibit rising returns on assets each yearassets each year

Sales growing at an increasing rate Sales growing at an increasing rate

(growth phase of the life cycle curve)(growth phase of the life cycle curve) Usually, not as well-known as Usually, not as well-known as growth stocksgrowth stocks

ContinuedContinued

Definition

3434

Growth CompaniesGrowth Companies

Example of industries:Example of industries:• Computer networkingComputer networking• Cable televisionCable television• Cellular telephonesCellular telephones• BiotechnologyBiotechnology• Medical electronicsMedical electronics• Can you suggest any more industries?Can you suggest any more industries?

contcont..

3535

Assets as a Sources of Stock ValueAssets as a Sources of Stock Value

Consider Consider assetsassets as opposed to earnings as opposed to earnings and dividendsand dividends•Cash & marketable securitiesCash & marketable securities•BuildingsBuildings•LandLand•TimberTimber•Old moviesOld movies•Natural resources Natural resources ContinuedContinued

$$$$

$$

3636

Natural ResourcesNatural Resources

Present value of the future income Present value of the future income stream expected from resourcesstream expected from resources

Assets may not be producing any Assets may not be producing any current incomecurrent income

Market value of resources could be Market value of resources could be much higher thanmuch higher than

Book valueBook valueCommon stock prices Common stock prices

3737

Hidden AssetsHidden Assets

Assets not readily apparent to investorsAssets not readily apparent to investors Can add substantial value to firmCan add substantial value to firm Assets do not always show up on the booksAssets do not always show up on the books

Example: Fully depreciated moviesExample: Fully depreciated movies• Sound of MusicSound of Music• 101 Dalmations101 Dalmations• Star WarsStar Wars

Substantial value left in TV or VCR market

3838

WEBSITEWEBSITE COMMENTSCOMMENTS

my.yahoo.commy.yahoo.com

Provides portfolio and stock Provides portfolio and stock tracking and screening – tracking and screening – Requires free registration. Requires free registration.

cbs.marketwatch.comcbs.marketwatch.com Provides stock information, Provides stock information, screening, and evaluation.screening, and evaluation.

www.quicken.comwww.quicken.com Provides stock screening and Provides stock screening and analysis; has intrinsic value analysis; has intrinsic value calculator.calculator.

www.www.valueprovaluepro.net.net Has free intrinsic value Has free intrinsic value calculator—other services fee calculator—other services fee based.based.

www.www.zackszacks.com.comProvides concensus earnings Provides concensus earnings forecastforecast

3939

WEBSITEWEBSITE COMMENTSCOMMENTS

www.morningstar.comwww.morningstar.com Provides stock screening Provides stock screening and detailed evaluation and detailed evaluation with Quick Notes.with Quick Notes.

www.fool.comwww.fool.com Contains stock evaluation Contains stock evaluation and information from and information from Motley Fool. Motley Fool.

www.wsj.comwww.wsj.com

Provides company Provides company information along with information along with news – Most content news – Most content requires subscription to requires subscription to access.access.

www.finportfolio.comwww.finportfolio.com Has portfolio tracker – requires Has portfolio tracker – requires free registrationfree registration. .

4040

WEBSITEWEBSITE COMMENTSCOMMENTS

www.moneycentral.msn.comwww.moneycentral.msn.com Has portfolio tracker, Has portfolio tracker, company information, company information, investment information.investment information.

www.valuengine.comwww.valuengine.com Provides stock analysis and Provides stock analysis and forecasts, mainly fee based – forecasts, mainly fee based – requires free registration.requires free registration.

www.bestsignals.comwww.bestsignals.com Provides stock research; has Provides stock research; has interactive research tools.interactive research tools.

www.pcquote.comwww.pcquote.com Provides stock quotes, portfolio Provides stock quotes, portfolio tracking, and news.tracking, and news.

www.validea.comwww.validea.com Provides fee-based valuation Provides fee-based valuation of stocks.of stocks.

www.stockworm.comwww.stockworm.com Provides stock analysis and Provides stock analysis and screening.screening.

4141

SummarySummary Common stock valuation models, useCommon stock valuation models, use

• Dividends (present value)Dividends (present value)

• EPS and P/E ratiosEPS and P/E ratios GrowthGrowth RiskRisk Capital structureCapital structure Dividend policyDividend policy Level of market in generalLevel of market in general Industry factorsIndustry factors etc. etc. ContinuedContinued

4242

SummarySummary

Hi P/E ratiosHi P/E ratios

Lo P/E ratiosLo P/E ratiosnegative expectationsnegative expectations

of the futureof the future

positive expectationspositive expectations

of the futureof the future

Indicates

Indicates

cont.