1. Investment and portfolio management MGT 531

2. Investment and portfolio management Lecture # 21

3. References The course assumes little prior applied knowledge in the area of finance. References Kristina Levišauskait (2010) ‘Investment Analysis and Portfolio Management’,

4. SUMMARY OF LAST LECTURE Financial ratios by category Market value ratios Stock valuation

5. Contents of today's lecture Stock valuation process fundamental and speculative value of stock

6. stock market prices reflect the fundamental value. The distinction between fundamental and speculative value of stock is very important one. Fundamental value here we understand the value of an equity investment, that is held over the long term, as opposed to the value, speculative trading that can be realized by short term, speculative trading. Stock valuation

8. Stock valuation process: 1. Forecasting of future cash flows for the stock. 2. Forecasting of the stock price. 3. Calculation of Present value of these cash flows. This result is intrinsic (investment) value of stock. Stock valuation process:

10. 4. Comparison of intrinsic value of stock and current market price of the stock and decision making: to buy or to sell the stock. Valuation methods: 1. Method of income capitalization. 2. Discounted dividend models. 3. Valuation using multiples. Valuation methods:

12. This method is based on the use of Present and Future value concept well known in finance. The value of any investment could be estimated as present value of future cash flows generated by this investment, using formula: V = CF1 / (1 + k) + CF2/ (1 + k)2 + … + CFn / (1 + k)ⁿ = = ΣCFt/ (1 + k)t Method of income capitalization

14. here CF - expected cash flows from the investment during period t; k - discount rate (capitalization rate or required rate of return for the investor, which include the expected level of risk). Discounted dividend models The discounted dividends models (DDM) is based on the method of income capitalization and considers the stock price as the discounted value of future dividends, at the risk adjusted required return of equity, for dividend paying firms. Discounted dividend models

16. Important assumption behind the DDM: the only way a corporation can transfer wealth to its stockholders is through the payment of dividend, because dividends are the only source of cash payment to a common stock investor. Common stock value using DDM: V = D1 /(1 + k) + D2 / (1 + k)2 + … + Dn/(1 + k)ⁿ = Σ Dt / (1 + k)t Discounted dividend models

18. here D1,2 …,t is stock dividend for the period t. The forecasted dividends during long-term valuation period of dividends are the key factor influencing the stock value. Expected growth rate in dividends (g) is calculated by formula: g = (Dt - Dt-1)/ Dt-1 Discounted dividend models

20. Various types of DDM, depending upon the assumptions about the expected growth rate in dividends (g): “Zero” growth DDM Constant growth DDM Multistage growth DDM Discounted dividend models

22. “Zero” growth DDM Assumption: D1 = D2 = D3 =... = D∞, that means Dt = Dt-1 and g = 0. The basic DDM formula for stock valuation using “zero” growth model becomes as follows: V = D1/ k or D0 / k0 Discounted dividend models

23. Constant growth DDM Assumption: if last year (t0) firm was paying D0 dividends, then in period t=1 its dividends will grow at growth rate g: D1 = D0 (1 + g) or Dt = Dt-1 (1 + g) = D0(1 + g) The basic DDM formula for stock valuation using constant growth model becomes as follows: ∞ V = Σ D0 (1 + g)/ (1 + k)t (continuing series) ( Discounted dividend models

24. V = D1/ (k - g) (Gordon formula) Observed Price Earning Ratio (PER):. Prices of stock and earnings measures, from which observed PERs are derived, are publicly available. Earnings per share are observed or estimates of analysts. The observed PERs for a firm, a group of firms, an industry, of the index derives directly from such data. What should be the PER, according to analysts, might differ from observed PER. It is important to make a distinction between observed PER with normative PER*, or what the PER should be. Price Earning Ratio (PER):

25. PER* = V / EPS0, (4.11) here: PER* - normative PER V - intrinsic value of the stock; EPS0 - earnings per share for the last period. Investor might consider that the PER* that should apply to the firm, of which stock value has to be estimated, should be in line with peer firms selected or the industry average. Price Earning Ratio (PER):

26. Decision making for investment in stocks, using PER: If PER* > PER - decision to buy or to keep the stock, because it is under valuated; If PER* < PER - decision to sell the stock, because it is over valuated; If PER* = PER - stock is valuated at the same range as in the market. In this case the decision depends on the additional observations of investor. There are remarkable variations of PERs across firms, industries, etc. Decision making for investment in stocks PER: