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. 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 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.

5.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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 $243.86.

7.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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 $36.13 stock price.

9.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 10 The Dividend Discount Model Sustainable = ROE  Retention ratio growth rate Return on equity (ROE) = Net income / Equity Retention ratio = 1 – Payout ratio

11.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 12 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.

13.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 16 Price Ratio Analysis  Price-earnings ratio (P/E ratio)  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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 19 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

20.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 20 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

21.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 21 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

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

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

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

27.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 28 An Analysis of the McGraw-Hill Company Quick calculations used:P/CF= P/E  EPS/CFPS P/S= P/E  EPS/SPS

29.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 29 An Analysis of the McGraw-Hill Company

30.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 30 Work the Web  Check out:  New York Society of Security Analysts http://www.nyssa.comwww.nyssa.com  American Association of Individual Investors http://www.aaii.com  Association for Investment Management and Research http://www.aimr.com

31.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 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

33.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 33 Chapter Review  An Analysis of the McGraw-Hill Company