6 6 C h a p t e r Common Stock ValuationCommon Stock Valuation second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 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: c dividend discount models d price ratio models © 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. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 6 - 4 The Dividend Discount Model where V(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. () ()() () T k TD k D k D k D V + ++ + + + + + = 1 )( 1 )3( 1 )2( 1 )1( )0( 32 " © 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, () () ( ) () () kgDTV kg k g gk gD V T =×= ≠ ⎥ ⎥ ⎦ ⎤ ⎢ ⎢ ⎣ ⎡ ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ + + − − +× = 00 1 1 1 10 0 ( ) ( )( ) gtDtD + × = + 11 Then This is the constant growth rate model. © 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 $10. What is the value of the stock based on the constant growth rate model? () () 86.243$ 08.1 10.1 1 10.08. 10.110$ 0 20 = ⎥ ⎥ ⎦ ⎤ ⎢ ⎢ ⎣ ⎡ ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ − − × =V Thus the price of the stock should be $243.86. © 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, () ( ) ( ) ( ) kg gk D gk gD V < − = − + × = 110 0 This is the constant perpetual growth model. © 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 $36.13. () ( ) 02.35$ 02.08. 02.106.2$ 0 = − × =V Our estimated price is a little lower than the $36.13 stock price. © 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. c Using the company’s historical average growth rate. d Using an industry median or average growth rate. e Using the sustainable growth rate. © 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 [...]... reserved 6 - 22 An Analysis of the McGraw-Hill Company McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved An Analysis of the McGraw-Hill Company 6 - 24 An Analysis of the McGraw-Hill Company Getting the Most from the Value Line Page 6 - 25 An Analysis of the McGraw-Hill Company @2002 by the McGraw- Hill Companies Inc.All rights reserved 6 - 26 Getting the Most from the... McGraw-Hill Companies, Inc All rights reserved 6 - 21 Price Ratio Analysis Intel Corp (INTC) - Sales (P/S) Analysis Current SPS $4. 56 5-year average P/S ratio 6. 7 SPS growth rate 13.3% expected = historical × projected SPS stock price P/S ratio = 6. 7 × ($4. 56 1.133) = $34 .62 * Late-2000 stock price = $89.88 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 6 - 22 An.. .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 = 61 7 So, retention ratio = 1 – 61 7 = 383 or 38.3% Sustainable growth rate = 12.5% × 383 = 4.79% $2. 06 × (1.0479 ) V (0 ) = = $67 .25 >> $ 36. 13 08... An Analysis of the McGraw-Hill Company McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved 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 = 62 9 × 25.5% = 16. 04% Since g > k, the constant growth rate model cannot be used McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies,... rights reserved 6 - 28 An Analysis of the McGraw-Hill Company Quick calculations used: P/CF = P/E × EPS/CFPS P/S = P/E × EPS/SPS McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 6 - 29 An Analysis of the McGraw-Hill Company McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 6 - 30 Work the Web Check out: New York Society of Security Analysts... 2002 by The McGraw-Hill Companies, Inc All rights reserved 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc... ($1.35×1. 165 ) = $47.81 * Late-2000 stock price = $89.88 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 6 - 20 Price Ratio Analysis Intel Corp (INTC) - Cash Flow (P/CF) Analysis Current CFPS $1.97 5-year average P/CF ratio 21 .6 CFPS growth rate 15.3% expected = historical × projected CFPS stock price P/CF ratio = 21 .6 × ($1.97×1.153) = $49. 06 * Late-2000 stock price = $89.88... 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 6 - 17 Price Ratio Analysis Price-cash... reserved 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 6 - 16. .. McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 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 . value of DTE’s stock? Payout ratio = $2. 06/ $3.34 = .61 7 So, retention ratio = 1 – .61 7 = .383 or 38.3% Sustainable growth rate = 12.5% × .383 = 4.79% () ( ) 13. 36$ 25 .67 $ 0479.08. 0479.1 06. 2$ 0. 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. () ( ) 02.35$ 02.08. 02.1 06. 2$ 0. 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