Chapter 8
Stock Valuation
1
Stock Valuation
 Learning Goals
1.
Explain the role that a company’s future plays in
stock valuation.
2.
Develop a forecast of a stock’s cash flow, expected
dividends and share price.
3.
Discuss the concepts of intrinsic value and Required
Rates of Return.
4.
Calculate the underlying value of a stock using
various dividend valuation models.
2
Stock Valuation
 Learning Goals
5.
Use other types of present-value-based models to
derive the value of a stock as well as alternative pricerelative procedures.
6.
Gain a basic understanding of the procedures
used to value different types of stocks, from
traditional dividend-paying shares to more growthoriented stocks.
3
Valuing a Company and Its Future
 The single most important issue in the stock
valuation process is what a stock will do in
the future
 Value of a stock depends upon its future returns
from dividends and capital gains/losses
 We use historical data to gain insight into the future
direction of a company and its profitability
 Past results are not a guarantee of future results
4
Comparative Dollar Based and CommonSize Income Statements
5
Steps in Valuing a Company
 Three steps are necessary to project key
financial variables into the future:

Step 1: Forecast future sales & profits

Step 2: Forecast future EPS and dividends

Step 3: Forecast future stock price
6
Step 1: Forecast Future
Sales and Profits
 Forecasted Future Sales based upon:


“Naïve” approach based upon continued historical
trends, or
Historical trends adjusted for anticipated changes
in operations or environment
 Forecasted Net Profit Margin based upon:



“Naïve” approach based upon continued historical
trends, or
Historical trends adjusted for anticipated changes
in operations or environment, or
Earnings forecasts from brokerage houses, Value
Line, Forbes, or other sources
7
Step 1: Forecast Future
Sales and Profits (cont’d)
Future after-tax
earnings in year t
Estim ated sales

for year t

N et profit m argin
expected in year t
 Example: Assume last year’s sales were $100
million, revenue growth is estimated at 8% and the
net profit margin is expected to be 6%.
So $100M x 8% = $8M Growth  $100+$8 = $108M
Future after-tax
earnings next year

$108 m illion  0.06  $6.5 m illion
8
Step 2: Forecast Future EPS
 Forecasted outstanding shares of common stock
based upon:


“Naïve” approach based upon continued historical
tends, or
Historical trends adjusted for anticipated changes in
operations or environment
 Forecasted Earnings Per Share (EPS) based upon:
E stim ated E PS
in y ear t

Fu ture after-tax
earnings in year t
N u m ber of sh ares o f com m o n stock
outstan ding in year t
9
Step 2: Forecast Future EPS
 Example: Assume estimated profits are $6.5
million, 2 million shares of common stock are
outstanding, and the dividend payout ratio is
estimated at 40%.
E stim ated E PS
next year

$6.5 m illion
2 m illion
 $3.25
10
Step 2: Forecast Future Dividends
 Forecasted Dividend Payout ratio
based upon:

“Naïve” approach based upon continued
historical trends, or

Historical trends adjusted for anticipated
changes in operations or environment
E stim ated dividends
per share in year t

E stim ated E PS
in year t

E stim ated
payout ratio
11
Step 2: Forecast Future Dividends
 Example: Assume estimated profits are $6.5
million, 2 million shares of common stock are
outstanding, and the dividend payout ratio is
estimated at 40%.
E stim ated dividends
per share next year

$3.25  .40  $1.30
12
Step 3: Forecast P/E Ratio
 Estimated P/E ratio based upon:

“Average market multiple” of all stocks in the
marketplace, or

“Relative P/E multiple” of individual stocks

Adjust up or down based upon expectations
of (1) economic conditions, (2) general stock
market outlook in near term, or (3) anticipated
changes in company’s operating results
13
Step 3: Forecast P/E Ratio
 Estimated P/E ratio is function of several variables,
including:

Growth rate in earnings

General state of the market

Amount of debt in a company’s capital structure

Current and projected rate of inflation

Level of dividends
14
Step 3: Forecast Future Stock Price
E stim ated share price
at end of year t

E stim ated E PS
in year t

E stim ated P/E
ratio
 Example: Assume estimated EPS are $3.25 and the
estimated P/E ratio is 17.5 times.
Estim ated share price
at the end of next year

$3.25  17.5  $56.88
 To estimate the stock price in three years, extend the
EPS figure for two more years and repeat the
calculations.
15
Using Stock Valuation
 Once we have an estimated future stock price, we
can compare it to the current market price to see if it
may be a good investment candidate:
current price
<
estimated price
undervalued
current price
=
estimated price
fairly valued
current price
>
estimated price
overvalued
16
The Valuation Process
 Valuation is a process by which an investor uses risk and
return concepts to determine the worth of a security.

Valuation models help to find How Much a stock ought to be
worth

If expected rate of return equals or exceeds our target
yield, the stock could be a worthwhile investment.

If the intrinsic worth equals or exceeds the current market
value, the stock could be a worthwhile investment.

There is no assurance that actual outcome will match
expected outcome
17
Required Rate of Return
 Required Rate of Return is the return
necessary to compensate an investor for the
risk involved in an investment.

Used as a target return to compare forecasted
returns on potential investment candidates
R equired
rate of return

R isk-free
rate

 Stock's
 beta

R isk-free  
 M arket



 return
rate  
18
Required Rate of Return
 Example: Assume a company has a beta of
1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?
R eq u ired retu rn  5 .5 %  1 .3 0  1 5 .0 %  5 .5 %    1 7 .8 5 %
19
Other Stock Valuation Methods
 Dividend Valuation Model



Zero growth
Constant growth
Variable growth
 Dividend and Earnings Approach
 Price/Earnings Approach
 Other Price-Relative Approaches



Price-to-cash-flow ratio
Price-to-sales ratio
Price-to-book-value ratio
20
Dividend Valuation Model:
Zero Growth
 Uses present value to value stock
 Assumes stock value is capitalized value of
its annual dividends
 Potential capital gains are really based upon
future dividends to be received
 Assumes dividends will not grow over time
Value of a
share of stock

A nnual dividends
R equired rate of return
21
Dividend Valuation Model:
Constant Growth
 Uses present value to value stock
 Assumes stock value is capitalized value of its annual
dividends
 Assumes dividends will grow at a constant rate over
time
 Works best with established companies with history
of steady dividend payments
V alue of a
share of stock

N ext year's dividends
R equired rate
of return

C onstant rate of
grow th in dividends
22
Dividend Valuation Model:
Variable Growth
 Uses present value to value stock
 Assume stock value is capitalized value of its annual
dividends
 Allows for variable growth in dividend
growth rate
 Most difficult aspect is specifying the appropriate
growth rate over an extended period of time
Present value of
V alue of a share
of stock

future dividends
during the initial
variable-grow th period

Present value of the price
of the stock at the end of
the variable-grow th period
23
Dividends-and-Earnings Approach
 Very similar to variable-growth DVM
 Uses present value to value stock
 Assumes stock value is capitalized value of its annual
dividends and future sale price
 Works well with companies who pay little or
no dividends
Present value of
a share of stock

Present value of
future dividends

Present value of
the price of the stock
at date of sale
24
Price/Earnings (P/E) Approach
 Future price is based upon the appropriate
P/E ratio and forecasted EPS
 Simple to use and easy to understand
 Widely used in stock valuation
Stock price  EPS  P/E ratio
25
Price-to-Cash-Flow (P/CF) Approach
 Similar to P/E approach, but substitutes
projected cash flow for earnings
 Widely used by investors
 Many consider cash flow to be more accurate
than profits to evaluate a stock
P/C F ratio 
M arket price of com m on stock
C ash flow per share
26
Price-to-Sales (P/S) Approach
 Similar to P/E approach, but substitutes
projected sales for earnings
 Useful for companies with no earnings or
erratic earnings
P/S ratio 
M arket price of com m on stock
Sales per share
27
Price-to-Book-Value
(P/BV) Approach
 Similar to P/E approach, but substitutes book
value for earnings
P/B V 
M arket price of com m on stock
B ook value per share
28
Review
1.
Explained the role that a company’s future plays in
stock valuation.
2.
Developed a forecast of a stock’s cash flow,
expected dividends and share price.
3.
Discussed the concepts of intrinsic value and
required rates of return, and noted how they are used.
4.
Calculated the underlying value of a stock using
various dividend valuation models.
29
Review
5.
Used other types of present-value-based models to
derive the value of a stock as well as alternative pricerelative procedures.
6.
Gained a basic Understanding of the procedures
used to value different types of stocks, from traditional
dividend-paying shares to more growth-oriented
stocks.
30
T h e
E n d !
31
Chapter 8
Additional
Chapter Art
32
Average Market P/E Multiples 1977–
2006
33
Selected Historical Financial Data,
Universal Office Furnishings
34
Using the Variable-Growth DVM to Value
Sweatmore Stock
35