1. Fundamentals of Investments6
C h a p t e r
Common Stock Valuation
Fundamentals of Investments
Valuation & Management
second edition
Charles J. Corrado Bradford D. Jordan
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu

2. Common Stock Valuation
Our goal in this chapter is to examine the methods commonly used by financial analysts to assess the economic value of common stocks.
Goal
These methods are grouped into two categories:
dividend discount models
price ratio models

3. Security Analysis: Be Careful Out There
Fundamental analysis
Examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock.
The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell.
In practice however, such stocks may in fact be correctly priced for reasons not immediately apparent to the analyst.

4. The Dividend Discount Model
Dividend discount model (DDM)
Method of estimating the value of a share of stock as the present value of all expected future dividend payments.
where V(0) = the present value of the future dividend stream
D(t) = the dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate

5. The Dividend Discount Model
Assuming that the dividends will grow at a constant growth rate g,
Then
This is the constant growth rate model.

6. The Dividend Discount Model
Example: Constant Growth Rate Model
Suppose the dividend growth rate is 10%, the discount rate is 8%, there are 20 years of dividends to be paid, and the current dividend is $10. What is the value of the stock based on the constant growth rate model?
Thus the price of the stock should be $

7. The Dividend Discount Model
Assuming that the dividends will grow forever at a constant growth rate g,
This is the constant perpetual growth model.

8. The Dividend Discount Model
Example: Constant Perpetual Growth Model
Consider the electric utility industry. In late 2000, the utility company Detroit Edison (DTE) paid a $2.06 dividend. Using D(0)=$2.06, k =8%, and g=2%, calculate a present value estimate for DTE. Compare this with the late-2000 DTE stock price of $36.13.
Our estimated price is a little lower than the $ stock price.

9. The Dividend Discount Model
The growth rate in dividends (g) can be estimated in a number of ways.
Using the company’s historical average growth rate.
Using an industry median or average growth rate.
Using the sustainable growth rate.

10. The Dividend Discount Model
Sustainable = ROE  Retention ratio
growth rate
Return on equity (ROE) = Net income / Equity
Retention ratio = 1 – Payout ratio

11. The Dividend Discount Model
Example: The Sustainable Growth Rate
DTE has a ROE of 12.5%, earnings per share (EPS) of $3.34, and a per share dividend (D(0)) of $2.06. Assuming k = 8%, what is the value of DTE’s stock?
Payout ratio = $2.06/$3.34 = .617
So, retention ratio = 1 – .617 = .383 or 38.3%
Sustainable growth rate = 12.5%  .383 = 4.79%
DTE’s stock is perhaps undervalued, or more likely, its growth rate has been overestimated.

12. The Two-Stage Dividend Growth Model
A two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T years, and thereafter grow at a rate g2 < k during a perpetual second stage of growth.

13. Discount Rates for Dividend Discount Models
The discount rate for a stock can be estimated using the capital asset pricing model (CAPM ).
Discount = time value risk
rate of money premium
= T-bill + ( stock  stock market )
rate beta risk premium
T-bill rate = return on 90-day U.S. T-bills
stock beta = risk relative to an average stock
stock market = risk premium for an average stock
risk premium

14. Observations on Dividend Discount Models
Constant Perpetual Growth Model
Simple to compute.
Not usable for firms that do not pay dividends.
Not usable when g > k.
Is sensitive to the choice of g and k.
k and g may be difficult to estimate accurately.
Constant perpetual growth is often an unrealistic assumption.

15. Observations on Dividend Discount Models
Two-Stage Dividend Growth Model
More realistic in that it accounts for two stages of growth.
Usable when g > k in the first stage.
Not usable for firms that do not pay dividends.
Is sensitive to the choice of g and k.
k and g may be difficult to estimate accurately.

16. Price Ratio Analysis Price-earnings ratio (P/E ratio) Earnings yield
Current stock price divided by annual earnings per share (EPS).
Earnings yield
Inverse of the P/E ratio: earnings divided by price (E/P).
High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as value stocks.

17. Price Ratio Analysis Price-cash flow ratio (P/CF ratio)
Current stock price divided by current cash flow per share.
In this context, cash flow is usually taken to be net income plus depreciation.
Most analysts agree that in examining a company’s financial performance, cash flow can be more informative than net income.
Earnings and cash flows that are far from each other may be a signal of poor quality earnings.

18. Price Ratio Analysis Price-sales ratio (P/S ratio)
Current stock price divided by annual sales per share.
A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales growth.
Price-book ratio (P/B ratio)
Market value of a company’s common stock divided by its book (accounting) value of equity.
A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders.

19. Price Ratio Analysis Intel Corp (INTC) - Earnings (P/E) Analysis
Current EPS $1.35
5-year average P/E ratio 30.4
EPS growth rate 16.5%
expected = historical  projected EPS
stock price P/E ratio
=  ($1.351.165)
= $47.81
* Late-2000 stock price = $89.88

20. Price Ratio Analysis Intel Corp (INTC) - Cash Flow (P/CF) Analysis
Current CFPS $1.97
5-year average P/CF ratio 21.6
CFPS growth rate 15.3%
expected = historical  projected CFPS
stock price P/CF ratio
=  ($1.971.153)
= $49.06
* Late-2000 stock price = $89.88

21. Price Ratio Analysis Intel Corp (INTC) - Sales (P/S) Analysis
Current SPS $4.56
5-year average P/S ratio 6.7
SPS growth rate 13.3%
expected = historical  projected SPS
stock price P/S ratio
=  ($4.561.133)
= $34.62
* Late-2000 stock price = $89.88

22. An Analysis of the McGraw-Hill Company
6 - 22
An Analysis of the McGraw-Hill Company
McGraw Hill / Irwin
 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23. An Analysis of the McGraw-Hill Company

24. An Analysis of the McGraw-Hill Company
6 - 24
An Analysis of the McGraw-Hill Company

25. An Analysis of the McGraw-Hill Company
6 - 25
Getting the Most from the Value Line Page
An Analysis of the McGraw-Hill Company
@2002 by the McGraw- Hill Companies Inc.All rights reserved.

26. An Analysis of the McGraw-Hill Company
6 - 26
Getting the Most from the Value Line Page
An Analysis of the McGraw-Hill Company
McGraw Hill / Irwin
@2002 by the McGraw- Hill Companies Inc.All rights reserved.

27. An Analysis of the McGraw-Hill Company
Based on the CAPM,
k = 6% + (.85  9%) = 13.65%
Retention ratio = 1 – $1.02/$2.75 = 62.9%
sustainable g = .629  25.5% = 16.04%
Since g > k, the constant growth rate model cannot be used.

28. An Analysis of the McGraw-Hill Company
Quick calculations used: P/CF = P/E  EPS/CFPS
P/S = P/E  EPS/SPS

29. An Analysis of the McGraw-Hill Company

30. Work the Web Check out: New York Society of Security Analysts
American Association of Individual Investors
Association for Investment Management and Research

31. Chapter Review Security Analysis: Be Careful Out There
The Dividend Discount Model
Constant Dividend Growth Rate Model
Constant Perpetual Growth
Applications of the Constant Perpetual Growth Model
The Sustainable Growth Rate

32. Chapter Review The Two-Stage Dividend Growth Model
Discount Rates for Dividend Discount Models
Observations on Dividend Discount Models
Price Ratio Analysis
Price-Earnings Ratios
Price-Cash Flow Ratios
Price-Sales Ratios
Price-Book Ratios
Applications of Price Ratio Analysis