J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Valuation of Common Stock Corporate Finance: March 26 (LA) and March 20 (OCC)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Valuation of Stocks u Stock analysts as discussed first week - buy side, sell side focus on stock research u Strategy departments of corporations and others value companies in close parallel to stock analysis except for control issues and integrating strategic changes into intrinsic value calculations u Problem is always to estimate future cash flows and choose risk-adjusted discount rate

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Fundamental vs. Technical Analysis of Stocks u Fundamental analysis depends on thorough analysis of a firm’s business and prospects u This approach is associated with Graham and Dodd, Warren Buffett, and Copeland et al u Technical analysis depends on patterns in prices over time u Academic research supports the use of fundamental analysis

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Fundamental Analysis u Approach used by Value Line Investment Survey is one example of fundamental analysis u Fundamental analysis requires research and analysis of a firm’s past performance and estimates of future performance u Can find examples in the Wall Street Transcript, brokerage reports summarized in Zack’s Earnings Forecast

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Stocks and Stock Indices u Stocks values reflect specific firm (or idiosyncratic) and general economic factors u Stock indices reflect factors general to a class of stocks u Stock indices and related statistics (e.g. PE ratio or dividend yield) provide benchmarks u Stocks are often classified as blue chip, growth, value, small caps, or cyclical stocks, and others, by market observers

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Stock Market Indices u Dow-Jones Industrials (30 blue chips) u S&P larger than average companies u NYSE Index - mainly larger than average u NASDAQ Index - includes smaller companies but also Intel, Apple, Microsoft u Wilshire in dollars u Industry and other indices u “Beating the market” - what does it mean?

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Investment Strategies u Value Investors - Low P-Es, low Market/Book, Current Assets/Market Value -- typical of Graham and Dodd u Growth Stocks - High P-Es, high growth, often have momentum u Market Timers - Switch between stocks in different industries and/or fixed incomes u Sector Balance - Switch between cyclical and trend stocks

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Simple patterns in cash flows from stocks u All cash flows from stocks can be considered dividends u May include regular dividends, special dividends, or liquidating dividends u Other cash flows are from distribution of securities or rights or cash sales u Using (5.4) we have:

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Preferred Stock u Preferred stock is a hybrid security with a fixed commitment to pay but counts as equity u Preferred often arises out of financial distress or special situations u Valuation of perpetual preferred is easy:

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Common Stock u Payments to common shareholders are not contractual u Common stock represents a residual claim on the cash flows and assets of the firm u Dividends to common stock must be declared by the board of directors u Many other claimants (bondholders and preferred shareholders) may restrict payment to common

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Simple Price-Earnings Multiples Come from Simple Dividends u If dividends grow forever at g and the firm pays out a constant proportion d of earnings and dividends, we have (P. 148) u The Price-Earnings multiple (P-E) is

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 What Determines Growth (g)? u Future sales and costs must be supported by investment in fixed and working capital u If a firm is projected to have a constant return on investment (ROI) then dividend growth depends on amount of investment u If investment is financed by retained earnings (or a constant proportion by equity in form of retained earnings), g = (1-d)*ROI

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 P-E Multiples From other Simple Dividend Patterns u Constant growth (as above) u No growth (perpetuity) u Fast growth then no growth (consisting of areas in diagram of A+B+C+D u Explore values of different growth periods and discount rates to assess determinants of real stock P-Es u Current vs. forecasted P-Es

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Differential Growth (g 1 and g 2 ) u Many analysts use two growth rates (see Fig. 5.3), an early rate (presumably high) and a long-run rate (presumably close to average): u No company can grow faster than the discount rate forever but can for a few years

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Examples of Differential Growth

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Non-Dividend Paying Stocks u Value for all assets comes from future cash flows for consumption u Non-dividend paying stocks must promise future cash flows at some point in the future u Value of stock may increase while no dividends paid because of growth of expected future dividends u Remember by dividends we mean any cash flow, including sale of company for cash

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Stock Value can be Interpreted as Value of Current and Future Cash u Value of a firm can be conceptually thought of as value of current cash plus present value of future cash from retained earnings u Although it looks different, this is the same as the dividend growth model (see pp. 144ff)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 For Next Class u Review the “Financial Statement Analysis and Assumptions for Valuation u Start thinking about Part 2 of PVFIRM05 u Be sure that each member of the team understand how Part 1 of PVFIRM05 works and review those estimates for plausibility