Chapter 10 Charles P. Jones, Investments: Analysis and Management, Ninth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University.

Chapter 10Chapter 10Charles P. Jones, Investments: Analysis and Charles P. Jones, Investments: Analysis and

Management,Management,Ninth Edition, John Wiley & SonsNinth Edition, John Wiley & Sons

Prepared byPrepared byG.D. Koppenhaver, Iowa State UniversityG.D. Koppenhaver, Iowa State University

Common Stock Common Stock ValuationValuation

10-10-11

10-10-22

Fundamental AnalysisFundamental Analysis

Present value approachPresent value approach– Capitalization of expected incomeCapitalization of expected income– Intrinsic value based on the discounted Intrinsic value based on the discounted

value of the expected stream of cash value of the expected stream of cash flowsflows

Multiple of earnings approachMultiple of earnings approach– Valuation relative to a financial Valuation relative to a financial

performance measureperformance measure– Justified P/E ratioJustified P/E ratio

10-10-33

Intrinsic value of a security isIntrinsic value of a security is

Estimated intrinsic value compared Estimated intrinsic value compared to the current market priceto the current market price– What if market price is different than What if market price is different than

estimated intrinsic value?estimated intrinsic value?

n

tt k) (

Cash Flows urity secValue of

1 1

Present Value ApproachPresent Value Approach

10-10-44

Required InputsRequired Inputs

Discount rateDiscount rate– Required rate of return: minimum Required rate of return: minimum

expected rate to induce purchaseexpected rate to induce purchase– The opportunity cost of dollars used for The opportunity cost of dollars used for

investmentinvestment Expected cash flowsExpected cash flows

– Stream of dividends or other cash Stream of dividends or other cash payouts over the life of the investmentpayouts over the life of the investment

10-10-55

Required InputsRequired Inputs

Expected cash flows Expected cash flows – Dividends paid out of earningsDividends paid out of earnings

Earnings important in valuing stocksEarnings important in valuing stocks

– Retained earnings enhance future Retained earnings enhance future earnings and ultimately dividendsearnings and ultimately dividends Retained earnings imply growth and future Retained earnings imply growth and future

dividendsdividends Produces similar results as current dividends Produces similar results as current dividends

in valuation of common sharesin valuation of common shares

10-10-66

Current value of a share of stock is Current value of a share of stock is the discounted value of all future the discounted value of all future dividendsdividends

1

22

11

1

111

tt

cs

t

cscscscs

)k(

D

)k(

D ...

)k(

D

)k(

D P

Dividend Discount ModelDividend Discount Model

10-10-77

Dividend Discount ModelDividend Discount Model

Problems:Problems:– Need infinite stream of dividendsNeed infinite stream of dividends– Dividend stream is uncertainDividend stream is uncertain

Must estimate future dividendsMust estimate future dividends

– Dividends may be expected to grow Dividends may be expected to grow over timeover time Must model expected growth rate of Must model expected growth rate of

dividends and need not be constantdividends and need not be constant

10-10-88

Assume no growth in dividendsAssume no growth in dividends– Fixed dollar amount of dividends Fixed dollar amount of dividends

reduces the security to a perpetuityreduces the security to a perpetuity

– Similar to preferred stock because Similar to preferred stock because dividend remains unchangeddividend remains unchanged

cskD

P 00

Dividend Discount ModelDividend Discount Model

10-10-99

Assume a constant growth in Assume a constant growth in dividendsdividends– Dividends expected to grow at a Dividends expected to grow at a

constant rate, g, over timeconstant rate, g, over time

– DD11 is the expected dividend at end of the is the expected dividend at end of the first periodfirst period

– D1 =D0 (1+g)

gkD

P

10

Dividend Discount ModelDividend Discount Model

10-10-1010

Dividend Discount ModelDividend Discount Model

Implications of constant growthImplications of constant growth– Stock Stock pricesprices grow at the same rate as the grow at the same rate as the

dividendsdividends– Stock Stock total returnstotal returns grow at the required grow at the required

rate of returnrate of return Growth rate in price plus growth rate in Growth rate in price plus growth rate in

dividends equals k, the required rate of returndividends equals k, the required rate of return

– A lower required return or a higher A lower required return or a higher expected growth in dividends raises pricesexpected growth in dividends raises prices

10-10-1111

nt

t

k)(k-g)g(D

k)(

)g(D P cn

n

t

1

11

1

1

1

100

Dividend Discount ModelDividend Discount Model

Multiple growth rates: two or more Multiple growth rates: two or more expected growth rates in dividendsexpected growth rates in dividends– Ultimately, growth rate must equal that Ultimately, growth rate must equal that

of the economy as a wholeof the economy as a whole– Assume growth at a rapid rate for n Assume growth at a rapid rate for n

periods followed by steady growthperiods followed by steady growth

10-10-1212

Dividend Discount ModelDividend Discount Model

Multiple growth ratesMultiple growth rates– First present value covers the period of First present value covers the period of

super-normal (or sub-normal) growthsuper-normal (or sub-normal) growth– Second present value covers the period Second present value covers the period

of stable growthof stable growth Expected price uses constant-growth model Expected price uses constant-growth model

as of the end of super- (sub-) normal periodas of the end of super- (sub-) normal period Value at n must be discounted to time Value at n must be discounted to time

period zero period zero

0 k=16% 1 2 3 4

g = 30% g = 30% g = 30% g = 6%

D0 = 4.00 5.20 6.76 8.788 9.315 4.48 5.02 5.6359.68 P3 = 9.31574.81 = P0 .10

Example: Valuing equity with growth Example: Valuing equity with growth ofof

30% for 3 years, then a long-run 30% for 3 years, then a long-run constant growth of 6%constant growth of 6%

10-10-1414

What About Capital Gains?What About Capital Gains?

Is the dividend discount model only Is the dividend discount model only capable of handling dividends?capable of handling dividends?– Capital gains are also importantCapital gains are also important

Price received in future reflects Price received in future reflects expectations of dividends from that expectations of dividends from that point forward point forward – Discounting dividends or a combination Discounting dividends or a combination

of dividends and price produces same of dividends and price produces same resultsresults

10-10-1515

Intrinsic ValueIntrinsic Value

““Fair” value based on the Fair” value based on the capitalization of income processcapitalization of income process– The objective of fundamental analysisThe objective of fundamental analysis

If intrinsic value >(<) current market If intrinsic value >(<) current market price, hold or purchase (avoid or sell) price, hold or purchase (avoid or sell) because the asset is undervalued because the asset is undervalued (overvalued)(overvalued)– Decision will always involve estimatesDecision will always involve estimates

10-10-1616

P/E Ratio or P/E Ratio or Earnings Multiplier ApproachEarnings Multiplier Approach

Alternative approach often used by Alternative approach often used by security analystssecurity analysts

P/E ratio is the strength with which P/E ratio is the strength with which investors value earnings as investors value earnings as expressed in stock priceexpressed in stock price– Divide the current market price of the Divide the current market price of the

stock by the latest 12-month earningsstock by the latest 12-month earnings– Price paid for each $1 of earningsPrice paid for each $1 of earnings

10-10-1717

To estimate share valueTo estimate share value

P/E ratio can be derived fromP/E ratio can be derived from

– Indicates the factors that affect the Indicates the factors that affect the estimated P/E ratioestimated P/E ratio

11 /E P Eo P/E rati justified

earnings estimated P

o

o

k - g/ED

/E or Pk - gD

P oo11

11

P/E Ratio ApproachP/E Ratio Approach

10-10-1818

P/E Ratio ApproachP/E Ratio Approach

The higher the payout ratio, the The higher the payout ratio, the higher the justified P/Ehigher the justified P/E– Payout ratio is the proportion of Payout ratio is the proportion of

earnings that are paid out as dividendsearnings that are paid out as dividends The higher the expected growth rate, The higher the expected growth rate,

g, the higher the justified P/Eg, the higher the justified P/E The higher the required rate of The higher the required rate of

return, k, the lower the justified P/Ereturn, k, the lower the justified P/E

10-10-1919

Understanding the P/E RatioUnderstanding the P/E Ratio Can firms increase payout ratio to Can firms increase payout ratio to

increase market price?increase market price?– Will future growth prospects be affected?Will future growth prospects be affected?

Does rapid growth affect the riskiness of Does rapid growth affect the riskiness of earnings?earnings?– Will the required return be affected?Will the required return be affected?– Are some growth factors more desirable than Are some growth factors more desirable than

others?others? P/E ratios reflect expected growth and P/E ratios reflect expected growth and

riskrisk

10-10-2020

P/E Ratios and Interest P/E Ratios and Interest RatesRates

A P/E ratio reflects investor optimism A P/E ratio reflects investor optimism and pessimismand pessimism– Related to the required rate of returnRelated to the required rate of return

As interest rates increase, required As interest rates increase, required rates of return on all securities rates of return on all securities generally increasegenerally increase

P/E ratios and interest rates are P/E ratios and interest rates are indirectly relatedindirectly related

10-10-2121

Which Approach Is Best?Which Approach Is Best?

Best estimate is probably the present Best estimate is probably the present value of the (estimated) dividends value of the (estimated) dividends – Can future dividends be estimated with Can future dividends be estimated with

accuracy?accuracy?– Investors like to focus on capital gains Investors like to focus on capital gains

not dividendsnot dividends P/E multiplier remains popular for its P/E multiplier remains popular for its

ease in use and the objections to the ease in use and the objections to the dividend discount modeldividend discount model

10-10-2222

Which Approach Is Best?Which Approach Is Best?

Complementary approaches?Complementary approaches?– P/E ratio can be derived from the P/E ratio can be derived from the

constant-growth version of the dividend constant-growth version of the dividend discount modeldiscount model

– Dividends are paid out of earningsDividends are paid out of earnings– Using both increases the likelihood of Using both increases the likelihood of

obtaining reasonable resultsobtaining reasonable results Dealing with uncertain future is Dealing with uncertain future is

always subject to erroralways subject to error

10-10-2323

Other MultiplesOther Multiples

Price-to-book value ratioPrice-to-book value ratio– Ratio of share price to stockholder equity Ratio of share price to stockholder equity

as measured on the balance sheetas measured on the balance sheet– Price paid for each $1 of equityPrice paid for each $1 of equity

Price-to-sales ratioPrice-to-sales ratio– Ratio of a company’s total market value Ratio of a company’s total market value

(price times number of shares) divided (price times number of shares) divided by salesby sales

– Market valuation of a firm’s revenuesMarket valuation of a firm’s revenues

10-10-2424

Copyright 2004 John Wiley & Sons, Inc. All rights Copyright 2004 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 beyond that permitted in Section 117 of the 1976 United states Copyright Act without the express United states Copyright Act without the express written permission of the copyright owner is written permission of the copyright owner is unlawful. Request for further information should unlawful. Request for further information should be addressed to the Permissions department, be addressed to the Permissions department, John Wiley & Sons, Inc. The purchaser may make John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or no responsibility for errors, omissions, or damages, caused by the use of these programs or damages, caused by the use of these programs or from the use of the information contained herein.from the use of the information contained herein.