STOCK ANALYSIS AND INVESTMENT pptx

CHAPTER EIGHT: STOCK ANALYSIS AND INVESTMENT 06/08/2011 1 06/08/2011 2 INVESTMENT PROCESS What is Value? • In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller • Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset 06/08/2011 3 Several Kinds of “Value” • There are several types of value, of which we are concerned with four: – Book Value – The carrying value on the balance sheet of the firm’s equity (Total Assets less Total Liabilities) – Tangible Book Value – Book value minus intangible assets (goodwill, patents, etc) – Market Value - The price of an asset as determined in a competitive marketplace – Intrinsic Value - The present value of the expected future cash flows discounted at the decision maker’s required rate of return 06/08/2011 4 Determinants of Intrinsic Value • There are two primary determinants of the intrinsic value of an asset to an individual: – The size and timing of the expected future cash flows. – The individual’s required rate of return (this is determined by a number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.). • Note that the intrinsic value of an asset can be, and often is, different for each individual (that’s what makes markets work). 06/08/2011 5 Common Stock • A share of common stock represents an ownership position in the firm. Typically, the owners are entitled to vote on important matters regarding the firm, to vote on the membership of the board of directors, and (often) to receive dividends. • In the event of liquidation of the firm, the common shareholders will receive a pro-rata share of the assets remaining after the creditors (including employees) and preferred stockholders have been paid off. If the liquidation is bankruptcy related, the common shareholders typically receive nothing, though it is possible that they may receive some small amount. 06/08/2011 6 Common Stock Valuation • As with any other security, the first step in valuing common stocks is to determine the expected future cash flows. • Finding the present values of these cash flows and adding them together will give us the value: • For a stock, there are two cash flows: – Future dividend payments – The future selling price        1 1 t t t CS k CF V 06/08/2011 7 Common Stock Valuation: An Example • Assume that you are considering the purchase of a stock which will pay dividends of $2 (D 1 ) next year, and $2.16 (D 2 ) the following year. After receiving the second dividend, you plan on selling the stock for $33.33. What is the intrinsic value of this stock if your required return is 15%?     V CS       2 00 1 15 216 3333 1 15 2857 1 2 . . . . . . 2.00 2.16 33.33 ? 06/08/2011 8 Some Notes About Common Stock • In valuing the common stock, we have made two assumptions: – We know the dividends that will be paid in the future. – We know how much you will be able to sell the stock for in the future. • Both of these assumptions are unrealistic, especially knowledge of the future selling price. • Furthermore, suppose that you intend on holding on to the stock for twenty years, the calculations would be very tedious! 06/08/2011 9 Common Stock: Some Assumptions • We cannot value common stock without making some simplifying assumptions. These assumptions will define the path of the future cash flows so that we can derive a present value formula to value the cash flows. • If we make the following assumptions, we can derive a simple model for common stock valuation: – Your holding period is infinite (i.e., you will never sell the stock so you don’t have to worry about forecasting a future selling price). – The dividends will grow at a constant rate forever. • Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend and the growth rate. 06/08/2011 10 [...]... value of its equity, we subtract the value of the firm’s debt and the value of its preferred stock: VCS  FCF0 1  g   VNonOps  VD  VP kg • Since this is the total value of its equity, we divide by the number of shares outstanding to get the per share value of the stock 06/08/2011 29 Relative Value Models • Professional analysts often value stocks relative to one another • For example, an analyst... estimate: VCS  P  Sales1 S 06/08/2011 32 Technical Analysis 06/08/2011 33 Introduction • Technical analysis is the attempt to forecast stock prices on the basis of market-derived data • Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time • They are looking for trends and patterns in the data that indicate future price... per year What’s the value of the stock now? (Recall that D0 = 1.85) 2.1275 0 2.4466 2.8136 3.0387 1 2 3 4 g = 15% 06/08/2011 … g = 8% 17 What if Growth Isn’t Constant? (cont.) • First, note that we can calculate the value of the stock at the end of period 3 (using D4): V3  3.0387  43.41 15  08 • Now, find the present values of the future selling price and D1, D2, and D3: V0  2.1275 2.4466 2.8136... (1964 to 1984) Strategy Buy and Hold Avoid Bear Markets Long and Short Major Swings Long and Short Every 5% Swing 06/08/2011 Avg Annual Gain 11.46% 21.48% 27.99% 93.18% $10,000 Grows To $ 87,500 $ 489,700 $ 1,391,200 $ 5,240,000,000 35 The Potential Rewards • This chart, from Barron’s, shows the benefit of being smart enough to miss the worst 5 days of the year between Feb 1966 and Oct 2001 Source: “The... components: – Current earnings, which are assumed to be repeated forever with no growth and 100% payout – Growth of earnings which derives from future investments • If the current earnings are a perpetuity with 100% payout, then they are worth: VCE 06/08/2011 EPS1  k 23 The Earnings Model (cont.) • VCE is the value of the stock if the company does not grow, but if it does grow in the future its value must... the company if it doesn’t grow and the value of the future growth: VCS r  RE1   1 EPS1 NPV1 EPS1 k      k kg k kg • Where RE1 is the retained earnings in period 1, r is the return on equity, k is the required return, and g is the growth rate 06/08/2011 26 The Free Cash Flow Model • Free cash flow is the cash flow that’s left over after making all required investments in operating assets:... will eventually be constant, then we can modify the DDM • Recall that the intrinsic value of the stock is the present value of its future cash flows Further, we can use the DDM to determine the value of the stock at some future period when growth is constant If we calculate the present value of that price and the present value of the dividends up to that point, we will have the present value of all of... justified • To calculate the value of the stock, we merely multiply its next years’ earnings by this justified P/E: VCS  P  EPS1 E 06/08/2011 31 The P/S Approach • In some cases, companies aren’t currently earning any money and this makes the P/E approach impossible to use (because there are no earnings) • In these cases, analysts often estimate the value of the stock as some multiple of sales (Price/Sales... example, we might want to calculate the price that a stock should sell for in two years • To do this, we can simply generalize the DDM: D N 1  g D N 1 VN   k CS  g k CS  g • For example, to value a stock at year 2, we simply use the dividend for year 3 (D3) 06/08/2011 14 The DDM Example (cont.) • In the earlier example, how did we know that the stock would be selling for $33.33 in two years? •... 2.8136  43.41    34.09 2 3 1.15 1.15 1.15 • So, the value of the stock is $34.09 and we didn’t even have to assume a constant growth rate Note also that the value is higher than the original value because the average growth rate is higher 06/08/2011 18 Two-Stage DDM Valuation Model • The previous example showed one way to value a stock with two (or more) growth rates Typically, such a company can . STOCK ANALYSIS AND INVESTMENT 06/08/2011 1 06/08/2011 2 INVESTMENT PROCESS What is Value? • In general, the value of an asset is the price that a willing and able buyer pays to a willing and. value of the stock at the end of period 3 (using D 4 ): • Now, find the present values of the future selling price and D 1 , D 2 , and D 3 : • So, the value of the stock is $34.09 and we didn’t. the purchase of a stock which will pay dividends of $2 (D 1 ) next year, and $2.16 (D 2 ) the following year. After receiving the second dividend, you plan on selling the stock for $33.33.