1. 6 6 C h a p t e r Common Stock Valuation second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu

2.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 3 Security Analysis: Be Careful Out There  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.  Numbers such as a company’s earnings per share, cash flow, book equity value, and sales are often called fundamentals because they describe, on a basic level, a specific firm’s operations and profits (or lack of profits).  Information, regarding such things as management quality, products, and product markets is often examined as well. 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.

4.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 4 The Dividend Discount Model  A fundamental principle of finance holds that the economic value of a security is properly measured by the sum of its future cash flows, where the cash flows are adjusted for risk and the time value of money.  For example, suppose a risky security will pay either $100 or $200 with equal  probability one year from today. The expected future payoff is $150 = ($100 + $200) / 2, and the security's value today is the $150 expected future value discounted for a one-year waiting period.  If the appropriate discount rate for this security is, say, 5 percent, then the present value of the expected future cash flow is $150 / 1.05 = $142.86. If instead the appropriate discount rate is 15 percent, then the present value is $150 / 1.15 = $130.43.  As this example illustrates, the choice of a discount rate can have a substantial impact on an assessment of security value.

5.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 5 The Dividend Discount Model whereV(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 Dividend discount model (DDM) Method of estimating the value of a share of stock as the present value of all expected future dividend payments.

6.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 6 The Dividend Discount Model  Example 6.1 Using the DDM. Suppose again that a stock pays three annual dividends of $100 per year and the discount rate is k = 15 percent. In this case, what is the present value V(0) of the stock?  With a 15 percent discount rate, we have V(0) = $228.32.

7.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 7 The Dividend Discount Model  Example 6.2 More DDM. Suppose instead that the stock pays three annual dividends of $10, $20,and $30 in years 1, 2, and 3, respectively, and the discount rate is k = 10 percent. What is the present value V(0) of the stock?  Check that the answer is V(0) = $48.16.

8.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 8 Constant Dividend Growth Rate Model  For many applications, the dividend discount model is simplified substantially by assuming that dividends will grow at a constant growth rate. This is called a constant growth rate model. Letting a constant growth rate be denoted by g, then successive annual dividends are stated as D(t+1) = D(t)(1+g).  constant growth rate model A version of the dividend discount model that assumes a constant dividend growth rate.

9.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 9 Constant Dividend Growth Rate Model  Assuming that the dividends will grow at a constant growth rate g,  Then  This is the constant growth rate model.

10.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 10 Constant Dividend Growth Rate Model  Actually, when the growth rate is equal to the discount rate, that is, k = g, the effects of growth and discounting cancel exactly, and the present value V(0) is simply the number of payments T times the current dividend D(0):

11.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 11 Constant Dividend Growth Rate 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 $243.86.

12.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 12 Constant Perpetual Growth  Assuming that the dividends will grow forever at a constant growth rate g,  This is the constant perpetual growth model which is :A version of the dividend discount model in which dividends grow forever at a constant rate, and the growth rate is strictly less than the discount rate

13.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 13 Constant Perpetual Growth  The reason is that a perpetual dividend growth rate greater than a discount rate implies an infinite value because the present value of the dividends keeps getting bigger and bigger. Since no security can have infinite value, the requirement that g < k simply makes good economic sense.

14.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 14 Constant Perpetual Growth 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 $36.13 stock price.

15.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 15 Applications of the Constant Perpetual Growth Model  A standard example of an industry for which the constant perpetual growth model can often be usefully applied is the electric utility industry. Consider the first company in the Dow Jones Utilities, American Electric Power, which is traded on the New York Stock Exchange under the ticker symbol AEP. At midyear 1997, AEP's annual dividend was $1.40; thus we set D(0) = $1.40, k= 6.5%, g=1.5 %,

16.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 16 Sustainable Growth Rate  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, Which involves using a company’s earnings to estimate g.  sustainable growth rate A dividend growth rate that can be sustained by a company's earnings.)

17.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 17 Sustainable Growth Rate  As we have discussed, a limitation of the constant perpetual growth model is that it should be applied only to companies with stable dividend and earnings growth. Essentially, a company's earnings can be paid out as dividends to its stockholders or kept as retained earnings within the firm to finance future growth.  (retained earnings Earnings retained within the firm to finance growth.)  (payout ratio Proportion of earnings paid out as dividends.)  (retention ratio Proportion of earnings retained for reinvestment.)

18.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 18 Sustainable Growth Rate Sustainable = ROE  Retention ratio growth rate Return on equity (ROE) = Net income / Equity Retention ratio = 1 – Payout ratio Payout ratio = dividends \net income

19.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 19 Sustainable Growth Rate 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.

20.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 20 The Two-Stage Dividend Growth Model  In the previous section, we examined dividend discount models based on a single growth rate. You may have already thought that a single growth rate is often unrealistic, since companies often experience temporary periods of unusually high or low growth, with growth eventually converging to an industry average or an economy-wide average.  In such cases as these, financial analysts frequently use a two-stage dividend growth model.  (two-stage dividend growth model Dividend model that assumes a firm will temporarily grow at a rate different from its long-term growth rate.)

21.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 21 The Two-Stage Dividend Growth Model  A two-stage dividend growth model assumes that a firm will initially grow at a rate g 1 for T years, and thereafter grow at a rate g 2 < k during a perpetual second stage of growth. The first term on the right-hand side measures the present value of the first T dividends and is the same expression we used earlier for the constant growth model. The second term then measures the present value of all subsequent dividends.

22.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 22 The Two-Stage Dividend Growth Model  Example 6.9 Using the Two-Stage Model Suppose a firm has a current dividend of D(0) = $5, which is expected to “shrink” at the rate g1 = -10 percent for T = 5 years, and thereafter grow at the rate g2 = 4 percent. With a discount rate of k = 10 percent, what is the value of the stock?  Using the two-stage model, present value, V(0), is calculated as:  The total present value of $46.03 is the sum of a $14.25 present value of the first five dividends plus a $31.78 present value of all subsequent dividends.

23.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 23 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

24.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 24 Discount Rates for Dividend Discount Models  A stock’s beta is a measure of a single stock’s risk relative to an average stock, and we discuss beta at length in a later chapter. For now, it suffices to know that the market average beta is 1.0.  A beta of 1.5 indicates that a stock has 50 percent more risk than average, so its risk premium is 50 percent higher.  A beta of.50 indicates that a stock is 50 percent less sensitive than average to market volatility, and has a smaller risk premium  (beta Measure of a stock’s risk relative to the stock market average.)

25.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 25 Discount Rates for Dividend Discount Models  Example 6.13 Stride-Rite’s Beta Look back at Example 6.12. What beta did we use to determine the appropriate discount rate for Stride-Rite? How do you interpret this beta?  Again assuming a T-bill rate of 5 percent and stock market risk premium of 8.6 percent, we have  13.9% = 5% + Stock beta × 8.6%  Thus Stock beta = (13.9% - 5%) / 8.6% = 1.035  Since Stride-Rite’s beta is greater than 1.0, it had greater risk than an average stock — specifically, 3.5 percent more.

26.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 26 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.

27.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 27 Observations on Dividend Discount Models Two-Stage Dividend Growth Model More realistic in that it accounts for two stages of growth. ( it accounts for low, high, or zero growth in the first stage, followed by constant long-term) 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.

28.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 28 Price Ratio Analysis  Price-earnings ratio (P/E ratio)  The most popular price ratio used to assess the value of common stock  Current stock price divided by annual earnings per share (EPS).  Earnings yield  Inverse of the P/E ratio: earnings divided by price (E/P).  annual earnings per share can be calculated either as the most recent quarterly earnings per share times four or the sum of the last four quarterly earnings per share figures.  High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as value stocks.

29.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 29 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.

30.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 30 Price Ratio Analysis  Most analysts agree that cash flow can be more informative than net income in examining a company's financial performance. To see why, consider the hypothetical example ?

31.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 31 Price Ratio Analysis  Twiddle-Dee Co. chooses straight-line depreciation and Twiddle-Dum Co. chooses accelerated depreciation. These two depreciation schedules are tabulated below:

32.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 32 Price Ratio Analysis  Now, let's look at the resulting annual cash flows and net income figures for the two companies, recalling that in each year, Cash flow = Net income + Depreciation:

33.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 33 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.  A ratio smaller than 1.0 indicates that the company is actually worth less than it cost.  because of varied and changing accounting standards, book values are difficult to interpret

34.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 34 Price Ratio Analysis Intel Corp (INTC) - Earnings (P/E) Analysis Current EPS$1.35 5-year average P/E ratio30.4 EPS growth rate16.5% expected = historical  projected EPS stock price P/E ratio = 30.4  ($1.35  1.165) = $47.81 * Late-2000 stock price = $89.88

35.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 35 Price Ratio Analysis Intel Corp (INTC) - Cash Flow (P/CF) Analysis Current CFPS$1.97 5-year average P/CF ratio21.6 CFPS growth rate15.3% expected = historical  projected CFPS stock price P/CF ratio = 21.6  ($1.97  1.153) = $49.06 * Late-2000 stock price = $89.88

36.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 36 Price Ratio Analysis Intel Corp (INTC) - Sales (P/S) Analysis Current SPS$4.56 5-year average P/S ratio6.7 SPS growth rate13.3% expected = historical  projected SPS stock price P/S ratio = 6.7  ($4.56  1.133) = $34.62 * Late-2000 stock price = $89.88

37.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 37 An Analysis of the McGraw-Hill Company

39. 6 - 39

40. An Analysis of the McGraw-Hill Company Getting the Most from the Value Line Page 6 - 40 @2002 by the McGraw- Hill Companies Inc.All rights reserved.

41. An Analysis of the McGraw-Hill Company Getting the Most from the Value Line Page 6 - 41 @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

42.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 42 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.

43.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 43 An Analysis of the McGraw-Hill Company Quick calculations used:P/CF= P/E  EPS/CFPS P/S= P/E  EPS/SPS

44.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 44 An Analysis of the McGraw-Hill Company

45.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 45 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

46.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 46 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

47.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 47 Chapter Review  An Analysis of the McGraw-Hill Company