Slides_Fundamentals of Investments - Chapter 6 ppt

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