1 MT 483 Investments Unit 5: Ch 8 and 9

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-2 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-3 Step 1: Forecast Future Sales and Profits 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%.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-4 Step 2: Forecast Future EPS 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%.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-5 Step 2: Forecast Future Dividends 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%.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-6 Step 3: Forecast P/E Ratio 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-7 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.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-8 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 priceundervalued current price=estimated pricefairly valued current price>estimated priceovervalued

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-9 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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?

Copyright © 2011 Pearson Prentice Hall. All rights reserved Other Stock Valuation Methods Dividend Valuation Model –Zero growth –Constant growth –Variable growth Dividend and Earnings Approach Price/Earnings Approach Other Price-Relative Approaches –Price-to-cash-flow ratio –Price-to-sales ratio –Price-to-book-value ratio

Copyright © 2011 Pearson Prentice Hall. All rights reserved Dividend Valuation Models Zero Growth Constant Growth Variable Growth

Copyright © 2011 Pearson Prentice Hall. All rights reserved Price/Earnings (P/E) Approach 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Efficient Market Hypothesis Efficient Market Hypothesis (EMH): information is reflected in prices—not only the type and source of information, but also the quality and speed with which it is reflected in prices. The more information that is incorporated into prices, the more efficient the market becomes. Levels of the EMH –Weak Form EMH –Semi-strong Form EMH –Strong Form EMH

Copyright © 2011 Pearson Prentice Hall. All rights reserved Levels of EMH Weak Form EMH –Past data on stock prices are of no use in predicting future stock price changes –Everything is random –Should simply use a “buy-and-hold” strategy Semi-strong Form EMH –Abnormally large profits cannot be consistently earned using public information –Any price anomalies are quickly found out and the stock market adjusts Strong Form EMH –There is no information, public or private, that allows investors to consistently earn abnormally high returns

Copyright © 2011 Pearson Prentice Hall. All rights reserved Technical vs. Fundamental: So Who is Right? There is growing consensus that markets may not be perfectly efficient, but they may be at least reasonably efficient Individual investor must determine which approach has merits for their investing decisions

Copyright © 2011 Pearson Prentice Hall. All rights reserved Investor Behavior and Security Prices Overconfidence Biased Self-Attribution Loss Aversion Representativeness Narrow Framing Belief Perseverance

Copyright © 2011 Pearson Prentice Hall. All rights reserved Big Picture Technical Indicators The Dow Theory –Market’s performance is based upon long-term price trend (primary trend) in overall market Trading Action –Looks at minor trading characteristics in market over long periods of time –Assumes the market moves in cycles and these cycles repeat themselves Confidence Index –Looks at ratio between yields on high-grade corporate bonds compared to low-grade corporate bonds

Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Technical Indicators Market Volume –Pure supply and demand analysis for common stocks Breadth of the Market –Looks at number of stock prices that go up (advances) versus number of stock prices that go down (declines) Short Interest –Looks at number of stocks that have been sold short at any given time Contrary Opinion and Odd-Lot Trading –Measures the volume of small traders

Copyright © 2011 Pearson Prentice Hall. All rights reserved Trading Rules and Measures Advance-Decline Line –Measures the difference between stocks closing higher and stocks closing lower than previous day The Arms Index or Trading Index (TRIN) –Combines advance-decline line with trading volume –Used as signal to buy or sell stocks Mutual Fund Cash Ratio (MFCR) –Tracks cash position of mutual funds