Chapter 8 Stock Valuation and Investment Decisions

1
Chapter 8 Stock Valuation and Investment
Decisions
2
Valuation Obtaining a Standard of Performance

• Valuing a Company and Its Future
• Stock Valuation. The process by which the
  underlying value of a stock is established on the
  basis of its forecasted risk and return
  performance.
• Its not the past performance of a stock that
  matters but its future performance.
• Because the value of a stock is a function of its
  future returns the investors task is to use the
  available historical data to project key
  financial variables.
• Forecasted Sales and Profits
• The key to our forecast is of course the future
  behavior of the company.
• The most important aspects to consider are the
  sales projections and the trend in the net profit
  margin (See Equation 8.1).

3
Valuation Obtaining a Standard of Performance

• Valuing a Company and Its Future (continued)
• Forecasted Dividend and Prices. Given the
  corporate earnings forecast we need three
  additional items of information to determine
  forecasted stock returns
• An estimate of the dividend payout ratio (use
  past data to forecast the future)
• The number of common shares that will be
  outstanding over the forecast period (use past
  data to forecast the future).
• A future price/earnings (P/E) ratio. While the
  first two variables are not terribly difficult to
  forecast the future P/E ratio is.
• The P/E ratio is a function of several variables
  including
• The growth rate in earnings (higher P/Es can be
  expected with higher growth).
• The general state of the market (higher P/Es
  expected with optimistic market).

4
Valuation Obtaining a Standard of Performance

• Valuing a Company and Its Future (continued)
• Forecasted Dividend and Prices (continued).
• The P/E ratio is a function of several variables
  including (continued)
• The amount of debt in the companys capital
  structure (lower debt lower financial risk
  higher P/Es).
• The current and projected rate of inflation
  (generally though not always higher inflation
  results in higher required returns and lower
  stock prices and P/Es).
• The level of dividends (although seemingly
  contradictory high dividend payouts usually
  correspond to low P/E ratios).
• Average Market Multiple. A useful starting point
  for evaluating the P/E it is simply the average
  P/E ratio of stocks in the marketplace because it
  indicates the general state of the market (See
  Table 8.1).

5
Valuation Obtaining a Standard of Performance

• Valuing a Company and Its Future (continued)
• Forecasted Dividend and Prices (continued).
• Relative P/E Multiple. The relative P/E multiple
  is a measure of how a stocks P/E behaves
  relative to the average market multiple.
• High relative P/Es indicate how aggressively a
  stock has been priced relative to the market.
• Other things equal a higher relative P/E is
  desirable. But be cautious of the higher
  volatility.
• Estimating EPS (See Equation 8.2 or Equation 8.3)
• Estimating Dividends Per Share (See Equation 8.4)
• Estimating Share Price (See Equation 8.5)
• Putting it all Together.

6
Valuation Obtaining a Standard of Performance

• Developing an Estimate of Future Behavior.
• Universal Office Furnishings Case
• Selected Historical Financial Data (See Table
  8.2)
• Summary Forecast Statistics (See Table 8.3)
• The Valuation Process
• Valuation is a process by which an investor uses
  risk and return concepts to determine the worth
  of a security.
• Stock Valuation Models determine either an
  expected rate of return or the intrinsic worth of
  a stock.
• We would consider investing in a stock if (a) its
  computed expected return equals or exceeds our
  required return or if (b) its intrinsic value or
  worth equals or exceeds the current market price.

7
Valuation Obtaining a Standard of Performance

• The Valuation Process (continued)
• No Guarantee! Remember that there is absolutely
  no assurance that the actual outcome will be even
  remotely similar to the forecasted behavior.
• Required Rate of Return
• Using CAPM (See Equation 8.6)
• Beta can be easily obtained from Value Line
  Quicken.com or a variety of other print or
  online sources.
• The Risk-Free Rate can be estimated from the
  average return from Treasury Bills during the
  last year or so.
• The Market Return can be estimated from the
  average stock returns over the past 10 to 15
  years (or more) or so (See Table 6.1).
• Using a Subjective Approach

8
Stock Valuation Models

• Types of Investors
• Value Investors. Investors who search for value
  in a companys financials by keying in on such
  factors as book value debt load return on
  equity and cash flow.
• Growth Investors. Investors who concentrate
  solely on growth in projected earnings by
  keying in on such factors as large future
  earnings and high P/Es.
• Dividend Valuation Models
• Zero Growth (See Equation 8.7)
• Constant Growth (See Equation 8.8 and 8.8a)
• Variable Growth (See Equation 8.9 and 8.9a and
  Table 8.4)
• Defining the Expected Growth Rate (See Equation
  8.10)

9
Stock Valuation Models

• An Alternative to the DVM
• A Dividends-and-Earnings Approach. The DE
  approach uses projected dividends EPS and P/E
  multiples to value a share of stock (See
  Equations 8.11 and 8.11a).
• The DE method differs from the variable growth
  model is that it doesnt rely on dividends as the
  principle player in the valuation process.
• Therefore it works just as well with companies
  that pay little or no dividends as those that pay
  high dividends.
• Also whereas the variable growth model uses
  future dividends to price the stock the DE
  method employs projected EPS and estimated P/E
  multiples.
• Using a market or industry P/E as a benchmark
  you should try to establish a P/E multiple that
  you feel the stock will trade at in the future.
• See the example at the top of page 334.

10
Stock Valuation Models

• Determining Expected Return
• Many investors find it easier and more convenient
  to understand returns rather than present values.
• The IRR can be computed using the same projected
  cash flows in addition to the current market
  price.
• Compare the IRR with the CAPM required return.
• Use Table 8.3 data and see the equation at the
  top of page 335.
• The Price/Earnings (P/E) Approach
• The P/E Approach first tries to find the P/E
  ratio thats most appropriate for the stock.
• This ratio along with estimated (forecasted) EPS
  is used to determine a reasonable stock price
  (See Equation 8.12).

11
Stock Valuation Models

• Putting a Value on Tech Stocks (See Table 8.5)
• Defined
• Broadly defined tech stocks are those in which
  the companys core business contains a
  significant technology component.
• Tech companies are those which are providing the
  technology not just using it.
• Tiers of Tech Stocks
• Top-Tier tech stocks are well-established market
  leaders with solid track records. Most can be
  valued like any other stock
• Mid-Tier tech stocks are smaller and less
  well-known but have been around a while and have
  substantial revenues and solid profits year after
  year. Many have very high P/Es so cannot be
  valued using traditional models.
• Lower-Tier tech stocks have yet to generate any
  earnings and sometimes little in the way of
  revenues. Valuation of these firms is very
  difficult and often amounts to no more than
  hunches.

12
Stock Valuation Models

• Putting a Value on Tech Stocks (continued)
• Tech-Stock Valuation Methods
• Discounted Cash Flow (DCF) Analysis
• One problem with applying the DVM or the DE
  models to tech stocks is that few tech stocks pay
  any dividends.
• Therefore the method we apply here assume all
  dividends are zero and find the PV of the future
  price of the firms stock using a future
  projection of the firms earnings and its P/E
  ratio the future price of the firms stock.
• Unfortunately even future earnings and P/Es are
  difficult to project rendering the DCF model
  difficult to apply.
• Price-Multiple Methods
• With this method investors identify firms that
  are comparable to the one being valued determine
  their average (or typical) multiples and use
  them to value the firm under consideration.
• Commonly used multiples include those based on
  earnings (P/E) book value (price/book value)
  and sales (price/sales).

13
Stock Valuation Models

• Putting a Value on Tech Stocks (continued)
• Tech-Stock Valuation Methods (continued)
• Price-Multiple Methods (continued)
• Given an appropriate multiple we simply multiply
  the corresponding variable to obtain price.
• Unfortunately the P/E and price/book ratios may
  not be useful because many tech firms have no
  earnings (or losses!) and value may bear little
  relationship to book value thus price/ sales
  (P/S) ratio is the multiple of choice when
  valuing tech stocks.
• As with the P/E method the P/S multiple can be
  calculated on a trailing or a forward basis.
• In any case the P/S ratio also has its
  shortcomings
• Even though sales may be positive while earnings
  are negative many analysts argue that the focus
  should be on the bottom line.
• The multiple itself can be highly volatile due to
  the volatility in the underlying average
  tech-company stock price.

14
Stock Valuation Models

• Putting a Value on Tech Stocks (continued)
• Tech-Stock Valuation Methods (continued)
• The Burn Rate in Tech Stocks. The (cash) burn
  rate is the rate at which the firm is using up
  its supply of cash over time and is determined by
  examining a firms Statement of Cash Flows (See
  Table 8.6).
• Tech Stock Valuation Example (Global Applications
  Software)
• Income Statement (See Table 8.7)
• Comparable Firm Data (See Table 8.8)
• Trailing Sales/share 56.5/30 1.88/share
• Sales/Share x P/S Ratio 1.88 x 3.34
  6.28/share

15
Technical Analysis

• Overview
• Technical Analysis is the study of various forces
  at work in the marketplace and their effect on
  stock prices.
• Technical Analysts believe that much of what is
  done in security analysis is useless because it
  is the market that matters not individual
  companies.
• Principles of Market Analysis
• During the nineteenth and early twentieth
  century little data was available and so
  studying the market was the only method for
  selecting stocks.
• Charts were the earliest tools for carrying out
  market analysis.
• Charts were centered on stock price movements and
  it was believed that these movements possessed
  exploitable patterns.

16
Technical Analysis

• Principles of Market Analysis (continued)
• While it is true that stock price movements
  exhibit patterns it is the supply and demand for
  securities that determine market movements.
• Thus technical analysis today monitors the supply
  and demand forces in the market and detects any
  shifts in the relationship.
• Measuring the Market (See Figure 8.1)
• While charting is still used to measure the
  market many technical analysts today prefer to
  study various market statistics including the
  volume of trading the amount of short selling
  and odd-lot transactions (the buying and selling
  patterns of small investors).
• If an analyst can detect some of the key elements
  driving behavior then they can better assess the
  market and predict its direction.

17
Technical Analysis

• Measuring the Market (continued)
• Important Technical Indicators (also see the RSI
  on page 345)
• Market Volume. Market volume indicates investor
  interest.
• The market is considered strong when volume goes
  up in a rising market or drops off during market
  declines.
• The market is considered weak when volume rises
  during declines or drops during rallies.
• Breadth of the Market. The breadth of the market
  deals with stock advances and declines.
• As long as the number of stocks that advance in
  price on a given day exceeds the number that
  decline the market is considered strong.
• The extent of strength depends on the spread
  between the number of advances and declines.
• Short Interest. The number of stocks sold short
  in the market at any given point in time is known
  as short interest (See Figure 8.2).

18
Technical Analysis

• Measuring the Market (continued)
• Important Technical Indicators
• Short Interest (continued)
• Because all short (borrowed) shares must
  eventually be covered (returned) a short sale
  ensures the future demand for a stock (future
  market optimism).
• Thus the market is viewed optimistically if the
  level of short interest becomes high by
  historical standards because the shares bought
  back to cover short sales will drive up demand
  and prices in the future.
• In addition because more sophisticated investors
  participate in short selling an increase in
  short sales is thought to indicate current market
  pessimism.
• Odd-Lot Trading. The odd-lot trading rule (also
  called the theory of contrary opinion) uses the
  amount and type of odd-lot trading as an
  indicator of the current state of the market and
  pending changes.
• The theory is that small uninformed investors
  more often trade in odd lots.
• When the balance of odd-lot trades increases the
  idea is that the market is about to decline.

19
Technical Analysis

• Using Technical Analysis
• Investors can use the charts and complex ratios
  of technical analysis or more informally use it
  to get a general sense of the market.
• Technical analysis might also be used in
  conjunction with fundamental analysis to
  determine when to add a particular stock to a
  portfolio.
• Charting
• Charting is perhaps the best-known activity of
  the technical analyst.
• Charting is the activity of charting price
  behavior and other market information and then
  using the patterns these charts form to make
  investment decisions (See Figure 8.3).

20
Technical Analysis

• Charting (continued)
• Charts are popular because they provide a visual
  summary of activity over time.
• Chartists believe price patterns evolve into
  chart formations that provide signals about the
  future course of the market or stock.
• Types of Charts
• Bar Charts (See Figure 8.4 on the next).
  Bar chars are the simplest kind of chart on which
  share price is plotted on the vertical axis and
  time on the horizontal axis stock prices are
  recorded as vertical bars showing high low and
  closing prices.
• Point-and-Figure Charts (See Figure 8.5 two
  s hence). Point-and-figure charts are used
  to keep track of emerging price patterns by
  plotting significant price changes with Xs and Os
  but with no time dimension used.
• Chart Formations (See Figure 8.6 threes
  hence).

21
Figure 8.4 A Bar Chart
22
Figure 8.5 A Point-and-Figure Chart
23
Figure 8.6 Some Popular Chart Formations
24
Random Walks and Efficient Markets

• Brief Historical Overview
• Random Walk Hypothesis. The theory that stock
  price movements are predictable so theres no
  way to know where prices are headed.
• To describe stock prices as a random walk
  suggests that price movements cannot be expected
  to follow any type of pattern.
• Thorough examinations of the randomness of stock
  prices did not begin until 1959.
• Efficient Markets. A market in which securities
  reflect all possible information quickly and
  accurately.
• Because information itself comes to the market
  randomly efficient markets would explain the
  random nature of stock price movements.
• Because of keen competition among investors when
  new information becomes known the price of the
  security adjusts quickly.

25
Random Walks and Efficient Markets

• Why Should Markets Be Efficient
• The Efficient Markets Hypothesis is a basic
  theory describing the behavior of efficient
  markets and is based on the following tenets
• There are a large number of knowledgeable
  investors who actively analyze value and trade
  securities no individual trader can affect the
  price of any security.
• Information is widely available to all investors
  at approximately the same time and this
  information is free or nearly so.
• Information on events such as labor strikes
  industrial accidents and changes in demand
  tends to occur randomly.
• Investors react quickly and accurately to new
  information causing prices to adjust quickly
  and on average accurately.
• For the most part markets do in fact exhibit
  these characteristics.

26
Random Walks and Efficient Markets

• Levels of Market Efficiency. The efficient
  markets hypotheses is concerned with the source
  quality and speed with which information is
  disseminated among investors.
• Weak Form. The weak form EMH holds that past
  data on stock prices are of no use in predicting
  future changes.
• Semi-Strong Form. The semi-strong form EMH holds
  that abnormally large profits cannot be
  consistently earned using publicly available
  information.
• Strong Form. The strong form EMH holds that
  there is no information public or private that
  allows investors to consistently earn abnormal
  profits.

27
Random Walks and Efficient Markets

• Possible Implications
• General Implications
• Even in an efficient market all sorts of return
  opportunities are available
• But to proponents of efficient markets the only
  way to increase returns is to invest in a
  portfolio of higher-risk securities.
• Implications for Technical Analysis
• If price fluctuations are purely random charts
  of past prices are unlikely to produce
  significant trading profits.
• Technical indicators simply measure
  after-the-fact events with no implications for
  the future.
• Implications for Fundamental Analysis
• In an efficient market it is argued prices
  react so quickly to new information that not even
  security analysis will enable investors to
  realize consistently superior returns.

28
Random Walks and Efficient Markets

• Possible Implications (continued)
• Implications for Fundamental Analysis
  (continued)
• The problem is not that fundamental analysis is
  poorly done on the contrary it is done too
  well!
• So Who is Right
• Some type of fundamental analysis probably has a
  role in the stock selection process.
• Even in an efficient market there is no question
  that stock process reflect a companys
  performance.
• Although markets are not perfectly efficient
  they are reasonably efficient.
• In the final analysis individual investors must
  decide on the merits of fundamental and technical
  analysis.