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(BQ) Part 2 book Fundamentals of investing has contents: Stock valuation, market efficiency and behavioral finance, bond valuation, mutual funds and exchange traded funds, mutual funds and exchange traded funds, futures markets and securities, investing in preferred stocks.
8 Find more at www.downloadslide.com Stock Valuation W LEARNING GOAlS After studying this chapter, you should be able to: Explain the role that a company’s future plays in the stock valuation process Develop a forecast of a stock’s expected cash flow, starting with corporate sales and earnings, and then moving to expected dividends and share price Discuss the concepts of intrinsic value and required rates of return, and note how they are used Determine the underlying value of a stock using the zero-growth, constant-growth, and variable-growth dividend valuation models hat drives a stock’s value? Many factors come into play, including how much profit the company earns, how its new products fare in the marketplace, and the overall state of the economy But what matters most is what investors believe about the company’s future Nothing illustrates this principle better than the stock of the oil driller, Helmerich & Payne (ticker symbol HP) The company announced its financial results for the first quarter of its fiscal year on January 29, 2015, reporting earnings per share of $1.85 with total revenue of $1.06 billion Wall Street stock analysts had been expecting the company to earn just $1.55 per share with $977 million in total revenue, so the company’s performance was much better than expected Even so, HP’s stock price slid nearly 5% in response to the earnings news Why would investors drive down the stock price of a company that was outperforming expectations? The answer had to with the company’s future rather than its past earnings In its earnings report, HP warned investors that its earnings for the rest of 2015 would likely be hit by falling oil prices Indeed, in early 2015 oil prices were lower than they had been in six years, and many analysts believed that the market had not yet hit bottom Stock analysts who followed HP acknowledged that the company had experienced solid revenue growth and used a reasonable amount of debt Nevertheless, these analysts advised investors who did not already own HP to stay away from the stock because of the company’s poor return on equity and lackluster growth in earnings per share How investors determine a stock’s true value? This chapter explains how to determine a stock’s intrinsic value by using dividends, free cash flow, price/earnings, and other valuation models Use other types of present value–based models to derive the value of a stock, as well as alternative pricerelative procedures Understand the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks (Source: Richard Saintvilus, “Helmerich & Payne Stock Falls on Outlook Despite Earnings Beat,” http://www.thestreet.com/story/13027986/1/ helmerich-payne-stock-falls-on-outlook-despite-earnings-beat.html, accessed on May 27, 2015.) 327 M09_SMAR3988_13_GE_C08.indd 327 12/05/16 5:14 PM Find more at www.downloadslide.com I 328 Part three Investing in Common Stocks Valuation: Obtaining a Standard of Performance Obtaining an estimate of a stock’s intrinsic value that investors can use to judge the merits of a share of stock is the underlying purpose of stock valuation Investors attempt to resolve the question of whether and to what extent a stock is under- or overvalued by comparing its current market price to its intrinsic value At any given time, the price of a share of stock depends on investors’ expectations about the future performance of the company When the outlook for the company improves, its stock price will probably go up If investors’ expectations become less rosy, the price of the stock will probably go down Valuing a Company Based on Its Future Performance Thus far we have examined several aspects of security analysis including macroeconomic factors, industry factors, and company-specific factors But as we’ve said, for stock valuation the future matters more than the past The primary reason for looking at past performance is to gain insight about the firm’s future direction Although past performance provides no guarantees about what the future holds, it can give us a good idea of a company’s strengths and weaknesses For example, history can tell us how well the company’s products have done in the marketplace, how the company’s fiscal health shapes up, and how management tends to respond to difficult situations In short, the past can reveal how well the company is positioned to take advantage of the things that may occur in the future Because the value of a share of stock depends on the company’s future performance, an investor’s task is to use historical data to project key financial variables into the future In this way, he or she can judge whether a stock’s market price aligns well with the company’s prospects AN ADVISOR’S PERSPECTIVE Forecasted Sales and Profits The key to the forecast is, of course, the company’s future performance, and the most important aspects to consider in this regard are the outlook for sales and profits One way to develop a sales forecast is to assume that the company will continue to perform as it has in the past and simply extend the historical trend For example, if a firm’s sales have been growing at a rate of 10% per year, then investors “The best way to analyze a stock is to might assume sales will continue at that rate Of course, if there is some determine what you expect its sales evidence about the economy, industry, or company that hints at a faster or numbers to be.” slower rate of growth, investors would want to adjust the forecast accordMyFinanceLab ingly Often, this “naive” approach will be about as effective as more complex techniques Once they have produced a sales forecast, investors shift their attention to the net profit margin We want to know what profit the firm will earn on the sales that it achieves One of the best ways of doing that is to use what is known as a commonsize income statement Basically, a common-size statement takes every entry found on an ordinary income statement or balance sheet and converts it to a percentage To create a common-size income statement, divide every item on the statement by sales—which, in effect, is the common denominator An example of this appears in Table 8.1, which shows the 2016 dollar-based and common-size income statements for Universal Office Furnishings (This is the same income statement that we first saw in Table 7.4.) Rod Holloway Equity Portfolio Manager, CFCI M09_SMAR3988_13_GE_C08.indd 328 12/05/16 5:14 PM Find more at www.downloadslide.com I 329 Chapter 8 Stock Valuation Excel@Investing Table 8.1 Comparative Dollar-Based and Common-Size Income Statement Universal Office Furnishings, Inc 2016 Income Statement ($ millions) (Common-Size)* Net Sales $1,938.0 100.0% Cost of goods sold $1,128.5 58.2% Gross operating Profit $ 809.5 41.8% Selling, general, & administrative expenses Depreciation & amortization Other expenses $ 496.7 $ 77.1 $ 0.5 25.6% 4.0% 0.0% Total operating expenses $ 574.3 29.6% Earnings before interest & taxes (EBIT) $ 235.2 12.1% Interest Expense $ 13.4 0.7% Income taxes $ 82.1 4.2% Net profit after taxes $ 139.7 7.2% *Common-size figures are found by using ‘Net Sales” as the common denominator, and then dividing all entries by net sales For example, cost of goods sold = $1,128.5 ÷ $1,938.0 = 58.2%; EBIT = $235.2 , $1,938.0 = 12.1% To understand how to construct these statements, let’s use the gross profit margin (41.8%) as an illustration In this case, divide the gross operating profit of $809.5 million by sales of $1,938.0 million: $809 , $1,938 = 4177 = 41 8, Example Use the same procedure for every other entry on the income statement Note that a common-size statement adds up, just like its dollar-based counterpart For example, sales of 100.0% minus costs of goods sold of 58.2% equals a gross profit margin of 41.8% (You can also work up common-size balance sheets, using total assets as the common denominator.) Securities analysts and investors use common-size income statements to compare operating results from one year to the next The common-size format helps investors identify changes in profit margins and highlights possible causes of those changes For example, a common-size income statement can quickly reveal whether a decline in a firm’s net profit margin is caused by a reduction in the gross profit margin or a rise in other expenses That information also helps analysts make projections of future profits For example, analysts might use the most recent common-size statement (or perhaps an average of the statements that have prevailed for the past few years) combined with a sales forecast to create a forecasted income statement a year or two ahead Analysts can make adjustments to specific line items to sharpen their projections For example, if analysts know that a firm has accumulated an unusually large amount of inventory this year, it is likely that the firm will cut prices next year to reduce its inventory holdings, and that will put downward pressure on profit margins Adjustments like these (hopefully) improve the accuracy of forecasts of profits Given a satisfactory sales forecast and estimate of the future net profit margin, we can combine these two pieces of information to arrive at future earnings (i.e., profits) Equation 8.1 M09_SMAR3988_13_GE_C08.indd 329 Future after@tax earnings in year t = Estimated sales in year t * Net profit margin expected in year t 12/05/16 5:14 PM Find more at www.downloadslide.com 330 I Part three Investing in Common Stocks The year t notation in this equation simply denotes a future calendar or fiscal year Suppose that in the year just completed, a company reported sales of $100 million Based on the company’s past growth rate and on industry trends, you estimate that revenues will grow at an 8% annual rate, and you think that the net profit margin will be about 6% Thus, the forecast for next year’s sales is $108 million (i.e., $100 million *1.08), and next year’s profits will be $6.5 million: Future after@tax = $108 million * 0.06 = $6.5 million earnings next year Using this same process, investors could estimate sales and earnings for other years in the forecast period Forecasted Dividends and Prices At this point the forecast provides some insights into the company’s future earnings The next step is to evaluate how these results will influence the company’s stock price Given a corporate earnings forecast, investors need three additional pieces of information: • An estimate of future dividend payout ratios • The number of common shares that will be outstanding over the forecast period • A future price-to-earnings (P/E) ratio For the first two pieces of information, lacking evidence to the contrary, investors can simply project the firm’s recent experience into the future Except during economic downturns, payout ratios are usually fairly stable, so recent experience is a fairly good indicator of what the future will bring Similarly, the number of shares outstanding does not usually change a great deal from one year to the next, so using the current number in a forecast will usually not lead to significant errors Even when shares outstanding change, companies usually announce their intentions to issue new shares or repurchase outstanding shares, so investors can incorporate this information into their forecasts Getting a Handle on the P/E Ratio The most difficult issue in this process is coming up with an estimate of the future P/E ratio—a figure that has considerable bearing on the stock’s future price behavior Generally speaking, the P/E ratio (also called the P/E multiple) is a function of several variables, including the following: An Advisor’s Perspective Rod Holloway Equity Portfolio Manager, CFCI “The P/E ratio by itself is a great gauge as to whether a stock is a good buy.” MyFinanceLab What Is a P/E Ratio? M09_SMAR3988_13_GE_C08.indd 330 • The growth rate in earnings • The general state of the market • The amount of debt in a company’s capital structure • The current and projected rate of inflation • The level of dividends As a rule, higher P/E ratios are associated with higher rates of growth in earnings, an optimistic market outlook, and lower debt levels (less debt means less financial risk) The link between the inflation rate and P/E multiples, however, is a bit more complex Generally speaking, as inflation rates rise, so the interest rates offered by bonds As returns on bonds increase, investors demand higher returns on stocks because they are riskier than bonds Future returns on stocks can increase if companies earn higher profits and pay higher dividends, but if earnings and profits remain fixed, investors will only earn higher future returns if stock prices are lower today Thus, inflation often puts downward pressure on stock prices and P/E multiples On the other hand, declining 12/05/16 5:14 PM Find more at www.downloadslide.com I Chapter 8╇ ╇ Stock Valuation 331 inflation (and interest) rates normally have a positive effect on the economy, and that translates into higher P/E ratios and stock prices Holding all other factors constant, a higher dividend payout ratio leads to a higher P/E ratio In practice, however, most companies with high P/E ratios have low dividend payouts because firms that have the opportunity to grow rapidly tend to reinvest most of their earnings In that case, the prospect of earnings growth drives up the P/E, more than offsetting the low dividend payout ratio A Relative Price-to-Earnings Multiple╇ A useful starting point for evaluating the P/E ratio is the average market multiple This is simply the average P/E ratio of all the stocks in a given market index, like the S&P 500 or the DJIA The average market multiple indicates the general state of the market It gives us an idea of how aggressively the market, in general, is pricing stocks Other things being equal, the higher the P/E ratio, the more optimistic the market, though there are exceptions to that general rule Figure 8.1 plots the S&P 500 price-to-earnings multiple from 1901 to 2015 This figure calculates the market P/E ratio by dividing prices at the beginning of the year by earnings over the previous 12 months The figure shows that market multiples move over a fairly wide range For example, in 2009, the market P/E ratio was at an all-time high of more than 70, but just one year later the ratio had fallen to just under 21 It is worth noting that the extremely high P/E ratio in 2009 was not primarily the result of stock prices hitting all-time highs Instead, the P/E ratio at the time was high because earnings over the preceding 12 months had been extraordinarily low due to a severe recession This illustrates that you must be cautious when interpreting P/E ratios as a sign of the health of individual stocks or of the overall market Figure 8.1 Average P/E Ratio of S&P 500 Stocks The average price-to-earnings ratio for stocks in the S&P 500 Index fluctuated around a mean of 13 from 1940 to 1990 before starting an upward climb Increases in the P/E ratio not necessarily indicate a bull market The P/E ratio spiked in 2009 not because prices were high, but because earnings were very low due to the recession (Source: Data from http://www.multpl.com.) 75 70 P/e ratio of S&P 500 Stock Index 65 60 55 50 45 40 35 30 25 20 15 10 1901 1907 1913 1919 1925 1931 1937 1943 1949 1955 1961 1967 1973 1979 1985 1991 1997 2003 2009 2015 M09_SMAR3988_13_GE_C08.indd 331 12/05/16 5:14 PM Find more at www.downloadslide.com 332 I Part three Investing in Common Stocks Famous P/E Ratios Can Be Misleading Failures level The reason is that with the deep recession of IN Finance The most recent spike in the S&P 2008, corporate earnings declined even more sharply 500 P/E ratio cannot be explained by a booming economy or a rising stock market Recall that in 2008 stock prices fell dramatically, with the overall market declining by more than 30% Yet, as 2009 began the average P/E ratio stood at an extraordinarily high than stock prices did So, in the market P/E ratio, the denominator (last year’s earnings) declined more rapidly than the numerator (prices), and the overall P/E ratio jumped In fact, in mid-2009 the average S&P 500 P/E ratio reached an all-time high of 144! Looking at Figure 8.1, you can see that the market’s P/E ratio has increased in recent years From 1900 to 1990, the market P/E averaged about 13, but since then its average value has been above 24 (or more than 22 if you exclude the peak in 2009) At least during the 1990s, that upward trend could easily be explained by the very favorable state of the economy Business was booming and new technologies were emerging at a rapid pace There were no recessions from 1991 to 2000 If investors believed that the good times would continue indefinitely, then it’s easy to understand why they might be willing to pay higher and higher P/E ratios over time With the market multiple as a benchmark, investors can evaluate a stock’s P/E performance relative to the market That is, investors can calculate a relative P/E multiple by dividing a stock’s P/E by a market multiple For example, if a stock currently has a P/E of 35 and the market multiple for the S&P 500 is, say, 25, the stock’s relative P/E is 35 , 25 = 1.4 Looking at the relative P/E, investors can quickly get a feel for how aggressively the stock has been priced in the market and what kind of relative P/E is normal for the stock Other things being equal, a high relative P/E is desirable—up to a point, at Investor Facts least For just as abnormally high P/Es can spell trouble (i.e., the stock may be How to Spot an Undervalued (or overpriced and headed for a fall), so too can abnormally high relative P/Es Overvalued) Market Just as Given that caveat, it follows that the higher the relative P/E measure, the higher shares of common stock can the stock will be priced in the market But watch out for the downside: High become over- or undervalued, so relative P/E multiples can also mean lots of price volatility, which means that can the market as a whole How both large gains and large losses are possible (Similarly, investors use average can you tell if the market is overvalued? One of the best ways industry multiples to get a feel for the kind of P/E multiples that are standard is to examine the overall market for a given industry They use that information, along with market multiples, P/E ratio relative to its long-term to assess or project the P/E for a particular stock.) average When the market’s P/E The next step is to generate a forecast of the stock’s future P/E over the anticratio is above its long-term ipated investment horizon (the period of time over which an investor expects to average, that is a good sign that the market is overvalued and hold the stock) For example, with the existing P/E multiple as a base, an increase subsequent market returns will be might be justified if investors believe the market multiple will increase (as the lower than average Conversely, market becomes more bullish) even if they not expect the relative P/E to when the market’s P/E ratio is change Of course, if investors believe the stock’s relative P/E will increase as well, unusually low, that is a sign that that would result in an even more bullish forecast the market may be undervalued and future returns will be higher than average Estimating Earnings per Share So far we’ve been able to come up with an estimate for the dividend payout ratio, the number of shares outstanding, and the price-to-earnings multiple Now we are ready to forecast the stock’s future earnings per share (EPS) as follows: Equation 8.2 M09_SMAR3988_13_GE_C08.indd 332 Future after@tax earnings in year t Estimated EPS = in year t Number of shares of common stock outstanding in year t 12/05/16 5:14 PM Find more at www.downloadslide.com I Chapter 8 Stock Valuation 333 Earnings per share is a critical part of the valuation process Investors can combine an EPS forecast with (1) the dividend payout ratio to obtain (future) dividends per share and (2) the price-to-earnings multiple to project the (future) price of the stock Equation 8.2 simply converts total corporate earnings to a per-share basis by dividing forecasted company profits by the expected number of shares outstanding Although this approach works quite effectively, some investors may want to analyze earnings per share from a slightly different perspective One way to this begins by measuring a firm’s ROE For example, rather than using Equation 8.2 to calculate EPS, investors could use Equation 8.3 as follows: Equation 8.3 EPS = After@tax earnings Book value of equity * = ROE * Book value per share Book value of equity Shares outstanding This formula will produce the same results as Equation 8.2 The major advantage of this form of the equation is that it highlights how much a firm earns relative to the book value of its equity As we’ve already seen, earnings divided by book equity is the firm’s ROE Return on equity is a key financial measure because it captures the amount of success the firm is having in managing its assets, operations, and capital structure And as we see here, ROE is not only important in defining overall corporate profitability, but it also plays a crucial role in defining a stock’s EPS To produce an estimated EPS using Equation 8.3, investors would go directly to the two basic components of the formula and try to estimate how those components might change in the future In particular, what kind of growth in the firm’s book value per share is reasonable to expect, and what’s likely to happen to the company’s ROE? In the vast majority of cases, ROE is really the driving force, so it’s important to produce a good estimate of that variable Investors often that by breaking ROE into its component parts— net profit margin, total asset turnover, and the equity multiplier (see Equation 7.15) With a forecast of ROE and book value per share in place, investors can plug these figures into Equation 8.3 to produce estimated EPS The bottom line is that, one way or another (using the approach reflected in Equation 8.2 or that in Equation 8.3), investors have to arrive at a forecasted EPS number that they are comfortable with After that, it’s a simple matter to use the forecasted payout ratio to estimate dividends per share: Equation 8.4 Estimated dividends Estimated EPS Estimated = * per share in year t for year t payout ratio Finally, estimate the future value of the stock by multiplying expected earnings times the expected P/E ratio: Equation 8.5 Estimated share price Estimated EPS Estimated P/E = * at end of year t in year t ratio Pulling It All Together Now, to see how all of these components fit together, let’s continue with the example we started above Using the aggregate sales and earnings approach, if the company had two million shares of common stock outstanding and investors expected that to remain constant, then given the estimated earnings M09_SMAR3988_13_GE_C08.indd 333 12/05/16 5:14 PM Find more at www.downloadslide.com 334 I Part three Investing in Common Stocks of $6.5 million obtained from Equation 8.1, the firm should generate earnings per share next year of Estimated EPS $6.5 million = = $3.25 next year million An investor could obtain the same figure using forecasts of the firm’s ROE and its book value per share For instance, suppose we estimate that the firm will have an ROE of 15% and a book value per share of $21.67 According to Equation 8.3, those conditions would also produce an estimated EPS of $3.25 (i.e., 15 * $21 67) Using this EPS figure, along with an estimated payout ratio of 40%, dividends per share next year should equal Estimated dividends = $3.25 * 40 = $1.30 per share next year Keep in mind that firms don’t always adjust dividends in lockstep with earnings A firm might pay the same dividend for many years if managers are not confident that an increase in earnings can be sustained over time In a case like this, when a firm has a history of adjusting dividends slowly if at all, it may be that past dividends are a better guide to future dividends than projected earnings are Finally, if it has been estimated that the stock should sell at 17.5 times earnings, then a share of stock in this company should be trading at $56.88 by the end of next year Estimated share price = $3.25 * 17.5 = $56.88 at the end of next year Actually, an investor would be most interested in the price of the stock at the end of the anticipated investment horizon Thus, the $56.88 figure would be appropriate for an investor who had a one-year horizon However, for an investor with a three-year holding period, extending the EPS figure for two more years and repeating these Investor Facts calculations with the new data would be a better approach The bottom line is Target Prices A target price is that the estimated share price is important because it has embedded in it the the price an analyst expects a capital gains portion of the stock’s total return stock to reach within a certain period of time (usually a year) Target prices are normally based on an analyst’s forecast of a company’s sales, earnings, and other criteria, some of which are highly subjective One common practice is to assume that a stock should trade at a certain price-toearnings multiple—say, on par with the average P/E multiples of similar stocks—and arrive at a target price by multiplying that P/E ratio by an estimate of what the EPS will be one year from now Use target prices with care, however, because analysts will often raise their targets simply because a stock has reached the targeted price much sooner than expected M09_SMAR3988_13_GE_C08.indd 334 Developing a Forecast of Universal’s Financial Performance Using information obtained from Universal Office Furnishings (UVRS), we can illustrate the forecasting procedures we discussed above Recall that our earlier assessment of the economy and the office equipment industry was positive and that the company’s operating results and financial condition looked strong, both historically and relative to industry standards Because everything looks favorable for Universal, we decide to take a look at the future prospects of the company and its stock Let’s assume that an investor considering Universal common stock has a three-year investment horizon Perhaps the investor believes (based on earlier studies of economic and industry factors) that the economy and the market for office equipment stocks will start running out of steam near the end of 2019 or early 2020 Or perhaps the investor plans to sell any Universal common stock purchased today to finance a major expenditure in three years Regardless of the reason behind the investor’s three-year horizon, we will focus on estimating Universal’s performance for 2017, 2018, and 2019 12/05/16 5:14 PM Find more at www.downloadslide.com I 335 Chapter 8 Stock Valuation Table 8.2 SELECTED HISTORICAL FINANCIAL DATA, UNIVERSAL OFFICE FURNISHINGS 2012 2013 2014 2015 $554.20 $ 694.90 $ 755.60 $ 761.50 $ 941.20 1.72 1.85 1.98 2.32 2.06 Sales revenue (millions) $953.20 $1,283.90 $1,495.90 $1,766.20 $1,938.00 Annual rate of growth in sales* −1.07% 34.69% 16.51% 18.07% 9.73% Net profit margin 4.20% 6.60% 7.50% 8.00% 7.20% Payout ratio Total assets (millions) Total asset turnover 2016 6.80% 5.20% 5.50% 6.00% 6.60% Price/earnings ratio 13.5 16.2 13.9 15.8 18.4 Number of common shares outstanding (millions) 77.7 78.0 72.8 65.3 61.8 * To find the annual rate of growth in sales divide sales in one year by sales in the previous year and then subtract one For example, the annual rate of growth in sales for 2016 = ($1,938.00 - $1,766.20) , $1,766.20 - = 9.73% Table 8.2 provides selected historical financial data for the company, covering a fiveyear period (ending with the latest fiscal year) and provides the basis for much of our forecast The data reveal that, with one or two exceptions, the company has performed at a fairly steady pace and has been able to maintain a very attractive rate of growth Our previous economic analysis suggested that the economy is about to pick up, and our research indicated that the industry and company are well situated to take advantage of the upswing Therefore, we conclude that the rate of growth in sales should pick up from the 9.7% rate in 2016, attaining a growth rate of over 20% in 2017—a little higher than the firm’s five-year average After a modest amount of pent-up demand is worked off, the rate of growth in sales should drop to about 19% in 2018 and to 15% in 2019 The essential elements of the financial forecast for 2017 through 2019 appear in Table 8.3 Highlights of the key assumptions and the reasoning behind them are as follows: • Net profit margin Various published industry and company reports suggest a comfortable improvement in earnings, so we decide to use a profit margin of 8.0% in 2017 (up a bit from the latest margin of 7.2% recorded in 2016) We’re projecting even better profit margins (8.5%) in 2018 and 2019, as Universal implements some cost improvements • Common shares outstanding We believe the company will continue to pursue its share buyback program, but at a substantially slower pace than in the 2013–2016 period From a current level of 61.8 million shares, we project that the number of shares outstanding will drop to 61.5 million in 2017, to 60.5 million in 2018, and to 59.0 million in 2019 • Payout ratio We assume that the dividend payout ratio will hold at a steady 6% of earnings • P/E ratio Primarily on the basis of expectations for improved growth in revenues and earnings, we are projecting a P/E multiple that will rise from its present level of 18.4 times earnings to roughly 20 times earnings in 2017 Although this is a fairly conservative increase in the P/E, when it is coupled with the hefty growth in EPS, the net effect will be a big jump in the projected price of Universal stock M09_SMAR3988_13_GE_C08.indd 335 12/05/16 5:14 PM Find more at www.downloadslide.com 336 Table 8.3 I Part three Investing in Common Stocks Summary Forecast Statistics, Universal Office Furnishings Latest Actual Figure (Fiscal 2016) Annual rate of growth in sales Net sales (millions) 9.7% $1,938.0 * Net profit margin = Net after-tax earnings (millions) , Common shares outstanding (millions) = Earnings per share 7.2% $ 139.7 61.8 $ * Payout ratio 2.26 6.6% = Dividends per share $ 0.15 Earnings per share $ 2.26 $ 41.58 * P/E ratio = Share price at year end 18.4 Forecasted Figures** Weighted Average in Recent Years (2012–2016) 2017 15.0% N/A* 22.0% $2,364.4 5.6% N/A 6.2% $0.08 N/A 8.5% $ 275.0 60.5 $ 6.0% 3.95 59.0 $ 6.0% 4.66 6.0% $ 0.18 $ 0.24 $ 0.28 $ 3.08 $ 3.95 $ 4.66 $ 61.51 $ 79.06 $ 93.23 16.8 N/A 3.08 15.0% $3,235.6 8.5% $ 239.2 61.5 $ 2019 19.0% $2,813.6 8.0% $ 189.1 71.1 N/A 2018 20.0 20.0 20.0 *N/A: Not applicable **Forecasted sales figures: Sales from preceding year * (1 + growth rate in sales) = forecasted sales For example, for 2017: $1,938.0 * (1 + 0.22) = $2,364.4 Excel@Investing Table 8.3 also shows the sequence involved in arriving at forecasted dividends and share price behavior; that is: The company dimensions of the forecast are handled first These include sales and revenue estimates, net profit margins, net earnings, and the number of shares of common stock outstanding Next we estimate earnings per share by dividing expected earnings by shares outstanding The bottom line of the forecast is, of course, the returns in the form of dividends and capital gains expected from a share of Universal stock, given that the assumptions about sales, profit margins, earnings per share, and so forth hold up We see in Table 8.3 that dividends should go up to 28 cents per share, which is a big jump from where they are now (15 cents per share) Even with a big dividend increase, it’s clear that dividends still won’t account for much of the stock’s return In fact, our projections indicate that the dividend yield in 2019 will fall to just 0.3% (divide the expected $0.28 dividend by the anticipated $93.23 price to get a yield of just 0.3%) Clearly, our forecast implies that the returns from this stock are going to come from capital gains, not dividends That’s obvious when we look at year-end share prices, which we expect to more than double over the next three years That is, if our projections are valid, the price of a share of stock should rise from around $41.50 to more than $93.00 by year-end 2019 We now have an idea of what the future cash flows of the investment are likely to be We can now use that information to establish an intrinsic value for Universal Office Furnishings stock M09_SMAR3988_13_GE_C08.indd 336 12/05/16 5:14 PM Find more at www.downloadslide.com 18-28 I Web Chapter 18 Real Estate and Other Tangible Investments a piece of fine art, and know what separates the good gems, rare coins, or artwork from the rest In the material that follows, we look at tangibles strictly as investment vehicles Gold and Other Precious Metals Precious metals are tangibles that concentrate a great deal of value in a small amount of weight and volume In other words, just a small piece of a precious metal is worth a lot of money Three kinds of precious metals command the most investor attention: gold, silver, and platinum Of these silver (at about $15.34 per ounce in August 2015) is the cheapest It is far less expensive than either gold (about $1,118 per ounce) or platinum (about $1,001 per ounce), which were also priced in August 2015 Gold is by far the most popular, so we’ll use gold here to discuss precious metals For thousands of years, people have been fascinated with gold Records from the age of the pharaohs in Egypt show a desire to own gold Today, ownership of gold is still regarded as a necessity by many investors, and its price has increased considerably Actually, Americans are relatively recent gold investors because of the legal prohibition on gold ownership, except in jewelry form, that existed from the mid-1930s until January 1, 1975 Like other forms of precious metals, gold is a highly speculative investment whose price has fluctuated widely over the past 45 years (see Figure 18.2) Figure 18.2 The Annual Closing Price of Gold, 1970 through 2014 The price of gold is highly volatile and can pave the way to big returns or, just as easily, subject the investor to large losses (Source: http://onlygold.com/Info/Historical-Gold-Prices.asp) 1,800 1,600 Price per Ounce ($) 1,400 1,200 1,000 800 600 400 200 1970 M19_SMAR3988_13_GE_C18.indd 28 1975 1980 1985 1990 1995 Year 2000 2005 2010 13/05/16 9:46 AM Find more at www.downloadslide.com Web Chapter 18 I Real Estate and Other Tangible Investments 18-29 Many investors hold at least a part—and at times, a substantial part—of their portfolios in gold as a hedge against inflation or a world economic or political disaster Gold can be purchased as coins, bullion, or jewelry (all of which can be physically held); it can also be purchased through gold-mining stocks and mutual funds, gold futures (and futures options), and gold certificates Here’s a brief rundown of the ways gold can be held as a form of investing: • Gold bullion coins. Gold bullion coins have little or no collector value; rather, their value is determined primarily by the quality and amount of gold in the coins Popular gold coins include the American Eagle, the Canadian Maple Leaf, the Mexican 50-Peso, and the Chinese Panda (Numismatic coins, however, are valued for rarity and beauty beyond the intrinsic value of their gold content.) • Gold bullion. Gold bullion is gold in its basic ingot (bar) form Bullion ranges in weight from 5- to 400-gram bars; the kilo bar (which weighs 32.15 troy ounces) is probably the most popular size • Gold jewelry. Jewelry is a popular way to own gold, but it’s not a very good way to invest in gold because gold jewelry usually sells for a substantial premium over its underlying gold value (to reflect artisan costs, retail markups, and other factors) Moreover, most jewelry is not pure 24-carat gold but a 14- or 18-carat blend of gold and other, nonprecious metals • Gold stocks, mutual funds, and exchange-traded funds (ETFs). Many investors prefer to purchase shares of gold-mining companies, mutual funds, or ETFs that invest in gold stocks The prices of gold-mining stocks tend to move in direct relationship to the price of gold Thus, when gold rises in value, these stocks usually move up, too It is also possible to purchase shares in mutual funds that invest primarily in gold-mining stocks Gold funds offer professional management and a much higher level of portfolio diversification; the shares of gold-oriented mutual funds also tend to fluctuate along with the price of gold Additionally, beginning in 2004, a number of exchange-traded funds linked to gold prices became available • Gold futures. A popular way of investing in the short-term price volatility of gold is through futures contracts or futures options • Gold certificates. A convenient and safe way to own gold is to purchase a gold certificate through a bank or broker The certificate represents ownership of a specific quantity of gold that is stored in a bank vault In this way, you not have to be concerned about the safety that taking physical possession of gold entails; also, by purchasing gold certificates, you can avoid state sales taxes (which may be imposed on coin or bullion purchases) Like gold, silver and platinum can be bought in a variety of forms Silver can be purchased as bags of silver coins, bars or ingots, silver-mining stocks, futures contracts, or futures options Similarly, platinum can be bought in the form of coins, plates and ingots, platinum-mining stocks, or futures contracts Transaction costs in precious metals vary widely, depending on the investment form chosen At one extreme, an investor buying one Canadian Maple Leaf coin might pay 5% commission, 7% dealer markup, and 4% gross excise tax (sales tax) In contrast, the purchase of a gold certificate would entail only a 2% total commission and markup, with no sales tax Storage costs vary as well Gold coins and bars M19_SMAR3988_13_GE_C18.indd 29 13/05/16 9:46 AM Find more at www.downloadslide.com 18-30 I Web Chapter 18 Real Estate and Other Tangible Investments can easily be stored in a safe-deposit box that costs perhaps $50 to $75 per year Gold purchased via gold certificates usually is subject to a storage fee of less than 1% per year Gold coins, bullion, and jewelry can be easily stolen, so it is imperative that these items be stored in a safe-deposit box at a bank or other depository Except for transaction costs, the expenses of buying and holding gold can be avoided when investments are made in gold-mining stocks and mutual funds and in gold futures Gemstones By definition, gemstones consist of diamonds and the so-called colored precious stones (rubies, sapphires, and emeralds) Precious stones offer their owners beauty and are often purchased for aesthetic pleasure However, diamonds and colored stones also serve as a viable form of investing Along with gold, they are among the oldest of investment vehicles, providing a source of real wealth, as well as a hedge against political and economic uncertainties However, diamonds and colored stones are very much a specialist’s domain Generally, standards of value are fully appreciated only by experienced personnel at fine stores, dealers, cutters, and an occasional connoisseur-collector In diamonds, the value depends on the whiteness of the stone and the purity of crystallization A key factor, therefore, is for the purchaser to understand the determinants of quality Precious stones vary enormously in price, depending on how close they come to gem color and purity Investment diamonds and colored stones can be purchased through registered gem dealers Depending on quality and grade, commissions and dealer markups can range from 20% to 100% Because of the difficulty in valuing gemstones, it is imperative to select only dealers with impeccable reputations As investment vehicles, diamonds and colored stones offer no current income, but their prices are highly susceptible to changing market conditions For example, the peak retail price of the best-quality, flawless 1-carat diamond, a popular investment diamond, was about $60,000 in early 1980 By late 1982, this stone was worth only about $20,000—a drop of 67% in just over years By 2015, prices had fallen to less than $10,000 for a 1-carat stone The big difficulty in precious stone investments, aside from the expertise needed in deciding what is in fact gem quality, is the relative illiquidity of the stones As a rule, gemstones should be purchased only by investors who can hold them for at least years; high transaction costs usually mean that profitable resale is not possible after shorter periods Furthermore, gemstones can be difficult to resell, and sellers often wait a month or more for a sale Diamonds and colored stones also require secure storage, and there are no payoffs prior to sale Collectibles Collectibles represent a broad range of items—from coins and stamps to posters and cars—that are desirable for any number of reasons, such as beauty, scarcity, historical significance, or age Collectibles have value because of their attractiveness to collectors During the 1970s, many collectibles shot up in value, but since the early 1980s, most have either fallen in value or have appreciated at a much lower rate than inflation There are some exceptions, of course, but they remain just that—the exception rather than the rule Some examples of collectibles that have done well in recent years are paintings, exotic automobiles and early “muscle cars,” cartoon celluloids, and baseball cards An investment-grade collectible is an item that is relatively scarce as well as historically significant within the context of the collectible genre itself and, preferably, within the larger context of the culture that produced it Further, it should be in excellent condition and attractive to display Although there are almost no bounds M19_SMAR3988_13_GE_C18.indd 30 13/05/16 9:46 AM Find more at www.downloadslide.com Web Chapter 18╇ I ╇ Real Estate and Other Tangible Investments 18-31 to what can be collected (beer cans, fishing tackle, magazines, sheet music), the major categories of collectibles that tend to offer the greatest investment potential include: • Rare coins (numismatics) • Rare stamps (philately) • Artwork (the paintings, prints, sculpture, and crafts of recognized artists) • Antiques (cars, furniture, etc.) • Baseball cards • Books • Games, toys, and comic books • Posters • Movie memorabilia • Historical letters In general, collectibles are not very liquid Their resale markets are poor, and transaction costs can be high Artwork, for example, commonly has a 100% dealer markup, and sales tax is added to the retail price (Works sold on consignment to dealers have much lower costs—generally, a commission of “only” 25%—but they can take months to sell.) In addition, investing in collectibles can be hazardous unless you understand the intricacies of the market In this area of investing, you are well advised to become a knowledgeable collector before even attempting to be a serious investor in collectibles Although certain psychic income may be realized in the form of aesthetic pleasure, the financial return, if any, is realized only when the item is sold On a strictly financial basis, items that have a good market and are likely to appreciate in value are the ones to collect If an item under consideration is expensive, its value and authenticity should always be confirmed by an expert prior to purchase (There are many unscrupulous dealers in collectible items.) After purchase, you should make certain to store collectibles in a safe place and adequately insure them against all relevant perils Despite these obstacles, collectibles can provide highly competitive rates of return and can be good inflation hedges during periods of abnormally high inflation CONCEPTS IN REVIEW Answers available at http://www.pearsonglobaleditions com/smart 18.18 What are other tangibles? Briefly describe the conditions that tend to cause tangibles to rise in price 18.19 What are the three basic forms of tangible investments? Briefly discuss the investment merits of tangibles Be sure to note the key factors that affect the future prices of tangibles 18.20 Describe the different ways in which one can hold gold and other precious metals as a form of investing Discuss gemstone investments in terms of quality, commissions, and liquidity 18.21 What are some popular types of collectibles? What important variables should be taken into account when investing in them? M19_SMAR3988_13_GE_C18.indd 31 13/05/16 9:46 AM Find more at www.downloadslide.com 18-32 I Web Chapter 18 Real Estate and Other Tangible Investments MyFinanceLab Here is what you should know after reading this chapter MyFinanceLab will help you identify what you know and where to go when you need to practice What You Should Know Key Terms Where to Practice Describe how real estate investment objectives are set, how the features of real estate are analyzed, and what determines real estate value The starting point for investing in real estate is setting objectives Investment real estate includes income properties, which can be residential or commercial, and speculative properties, such as raw land, which are expected to provide returns from appreciation in value rather than from periodic rental income The investor also needs to analyze important features such as the physical property, the rights that owning it entails, the relevant time horizon, and the geographic area of concern The four determinants of real estate value are demand, supply, the property, and the property transfer process Demand refers to people’s willingness to buy or rent, and supply includes all those properties from which potential buyers or tenants can choose To analyze a property, one should evaluate its restrictions on use, location, site, improvements, and property management The transfer process involves promotion and negotiation of a property convenience (in real estate), p 18–6 demand (in real estate), p 18–5 demographics, p 18–5 environment (in real estate), p 18–6 improvements (in real estate), p 18–7 income property, p 18–3 principle of substitution, p 18–6 property management, p 18–7 property transfer process, p 18–8 psychographics, p 18–5 real estate, p 18–2 speculative property, p 18–3 supply (in real estate), p 18–5 tangibles, p 18–2 MyFinanceLab Study Plan 18.1 Discuss the valuation techniques commonly used to estimate the market value of real estate A market value appraisal can be used to estimate real estate value The three imperfect approaches to real estate valuation are the cost approach, the comparative sales approach, and the income approach The cost approach estimates replacement cost The comparative sales approach bases value on the prices at which similar properties recently sold The income approach measures value as the present value of all the property’s future income appraisal (in real estate), p 18–9 comparative sales approach, p 18–9 cost approach, p 18–9 income approach, p 18–10 market capitalization rate, p 18–10 market value (in real estate), p 18–9 net operating income (NOI), p 18–10 MyFinanceLab Study Plan 18.2 Understand the procedures involved in performing real estate investment analysis Real estate investment analysis considers the underlying determinants of a property’s value It involves forecasting a property’s cash flows and then calculating either their net present value or the IRR to evaluate the proposed investment relative to the investor’s objectives Risk and return parameters vary depending on the degree of leverage employed in financing a real estate investment Any quantitative analysis of real estate value and returns must be integrated with various subjective and market considerations after-tax cash flows (ATCFs), p 18–13 discounted cash flow, p 18–13 investment analysis, p 18–11 leverage (in real estate), p 18–11 negative leverage, p 18–11 net present value (NPV), p 18–13 positive leverage, p 18–11 MyFinanceLab Study Plan 18.3 M19_SMAR3988_13_GE_C18.indd 32 13/05/16 9:46 AM Find more at www.downloadslide.com Web Chapter 18 I Real Estate and Other Tangible Investments What You Should Know Key Terms 18-33 Where to Practice Demonstrate the framework used to value a prospective real estate investment, and evaluate results in light of the stated investment objectives The framework for analyzing a potential real estate investment involves five steps: (1) set investor objectives; (2) analyze important features of the property; (3) collect data on determinants of value; (4) perform valuation and investment analysis, which involves forecasting the property’s cash flows and either applying discounted cash flow techniques to find the net present value (NPV) or estimating the IRR; (5) synthesize and interpret results of analysis depreciation (in real estate), p 18–19 MyFinanceLab Study Plan 18.4 Describe the structure and investment appeal of real estate investment trusts Real estate investment trusts can provide investors with an alternative to active real estate ownership REITs allow investors to buy publicly traded ownership shares in a professionally managed portfolio of real estate properties, mortgages, or both The risk–return characteristics of REITs can be analyzed much like stocks, bonds, and mutual funds real estate investment trust (REIT), p 18–23 MyFinanceLab Study Plan 18.5 Understand the investment characteristics of other tangibles such as gold and other precious metals, gemstones, and collectibles, and review the suitability of investing in them Tangibles represent a non–real estate investment vehicle that can be seen and touched and that has an actual form and substance The three basic types of tangibles are gold and other precious metals, gemstones, and collectibles Some tangibles, particularly precious metals, can be held in a variety of forms Tangibles generally provide substantial returns during periods of high inflation precious metals, p 18–28 MyFinanceLab Study Plan 18.6 Log into MyFinanceLab, take a chapter test, and get a personalized Study Plan that tells you which concepts you understand and which ones you need to review From there, MyFinanceLab will give you further practice, tutorials, animations, videos, and guided solutions log into www.myfinancelab.com Discussion Questions Q18.1 Assume you have inherited a large sum of money and wish to use part of it to make a real estate investment a Would you invest in income property or speculative property? Why? Describe the key characteristics of the income or speculative property on which you would focus your search b Describe the financial and nonfinancial goals you would establish prior to initiating a search for suitable property c What time horizon would you establish for your analysis? What geographic area would you isolate for your property search? M19_SMAR3988_13_GE_C18.indd 33 13/05/16 9:46 AM Find more at www.downloadslide.com 18-34 I Web Chapter 18 Real Estate and Other Tangible Investments Q18.2 Imagine that you have been hired by a wealthy out-of-town investor to find him a residential income property investment with to 10 units located within a 5-mile radius of the college or university you attend a Search the defined area to find three suitable properties You may want to use a real estate agent to isolate suitable properties more quickly b Research the area to assess the demand for the properties you’ve isolated Be sure to consider both the demographics and the psychographics of the area’s population Also assess mortgage market conditions as they would relate to financing 75% of each property’s purchase price c Assess the supply of competitive properties in the geographic area you’ve isolated Identify the key competitive properties by using the principle of substitution d Compare the competitive positions of the properties, and isolate the best property on the basis of the following features: (1) restrictions on use, (2) location, (3) site, (4) improvements, and (5) property management Q18.3 Contact a local commercial realtor and obtain a copy of a valuation he or she has performed on an investment property in your general geographic area a Review the analysis and critically evaluate the realtor’s work Specifically review the cost approach, the comparative sales approach, and the income approach b Drive by the property and assess the demand for and supply of competitive properties in the area c On the basis of your review of the realtor’s professional analysis and your own assessment of the property, make a list of your questions and comments on the professional analysis d Make an appointment with the realtor who provided you with the analysis, and in your meeting with him or her, go over your list of questions and comments Q18.4 Contact a stockbroker and obtain and study a copy of a prospectus for a currently popular real estate investment trust (REIT) a Indicate what type of REIT (equity, mortgage, or hybrid) it represents b Evaluate the quality of the properties it holds c Assess the REIT’s financial and management track record, using the Internet to provide current performance data d Would you invest in this REIT? Explain why, including how it does or doesn’t meet your investment objectives Q18.5 Assume you’re interested in investing in gold to protect against an expected significant decline in consumer confidence and securities values a Isolate and evaluate the various alternatives for investing in gold coins, gold stocks, gold futures, and gold certificates b Prepare a comparative grid of the costs, ease of purchase and sale, commissions (if any), and potential returns from each of these alternative ways to invest in gold c Choose and justify your choice of the best of these alternative investments in gold Discuss the risks you associate with this investment d What alternative forms of tangible investment (excluding real estate) would you consider as possible substitutes for gold? Problems P18.1 Charles Cook, an investor, is considering two financing plans for purchasing a parcel of real estate costing $50,000 Alternative X involves paying cash; alternative Y involves obtaining 80% financing at 10.5% interest If the parcel of real estate appreciates in value M19_SMAR3988_13_GE_C18.indd 34 13/05/16 9:46 AM Find more at www.downloadslide.com Web Chapter 18 I Real Estate and Other Tangible Investments 18-35 by $7,500 in year, calculate (a) Charles’s net return and (b) his return on equity for each alternative If the value dropped by $7,500, what effect would this have on your answers to parts a and b? P18.2 In the coming year, the Sandbergs expect a rental property investment costing $120,000 to have gross potential rental income of $20,000, vacancy and collection losses equaling 5% of gross income, and operating expenses of $10,000 The mortgage on the property is expected to require annual payments of $8,500 The interest portion of the mortgage payments and the depreciation are given below for each of the next years The Sandbergs are in the 25% marginal tax bracket Year Interest Depreciation $8,300 $4,500 $8,200 $4,500 $8,100 $4,500 The net operating income is expected to increase by 6% each year beyond the first year a Calculate the net operating income for each of the next years b Calculate the after-tax cash flow for each of the next years P18.3 Walt Hubble is contemplating selling rental property that originally cost $200,000 He believes that it has appreciated in value at an annual rate of 6% over its 4-year holding period He will have to pay a commission equal to 5% of the sale price to sell the property Currently, the property has a book value of $137,000 The mortgage balance outstanding at the time of sale currently is $155,000 Walt will have to pay a 15% tax on any capital gains and a 25% tax on recaptured depreciation a Calculate the tax payable on the proposed sale b Calculate the after-tax net proceeds associated with the proposed sale, CFR P18.4 Bezie Foster has estimated the annual after-tax cash flows and after-tax net proceeds from sale (CFR) of a proposed real estate investment as noted below for the planned 4-year ownership period Case Problem 18.1 Year ATCF $6,200 $8,000 $8,300 $8,500 CFR $59,000 The initial required investment in the property is $55,000 Bezie must earn at least 14% on the investment a Calculate the net present value of the proposed investment b Estimate the IRR (to the nearest whole percentage point) from the investment c From your findings in parts a and b, what recommendation would you give Bezie? Explain Gary Sofer’s Appraisal of the Wabash Oaks Apartments Gary Sofer wants to estimate the market value of the Wabash Oaks Apartments, a 12-unit building with one-bedroom units and two-bedroom units The present owner of Wabash Oaks provided Gary with the following annual income statement Today’s date is March 1, 2016 M19_SMAR3988_13_GE_C18.indd 35 13/05/16 9:46 AM Find more at www.downloadslide.com 18-36 I Web Chapter 18 Real Estate and Other Tangible Investments Owner’s Income Statement Wabash Oaks Apartments, 2016 Gross income $65,880 Less: Expenses Utilities $14,260 Property insurance $ 2,730 Repairs and maintenance $ 1,390 Property taxes $ 4,790 Mortgage payments $18,380 Total expenses $41,550 Net income $24,330 Current rental rates of properties similar to Wabash Oaks typically run from $425 to $450 per month for one-bedroom units and $500 to $550 per month for two-bedroom units From a study of the market, Gary determined that a reasonable required rate of return for Wabash Oaks would be 9.62% and that vacancy rates for comparable apartment buildings are running around 4% Questions a Using Figure 18.1 on page 18-16 as a guide, discuss how you might go about evaluating the features of this property b Gary has studied economics and knows about demand and supply, yet he doesn’t understand how to apply them to an investment analysis Advise Gary in a practical way how he might incorporate demand and supply into an investment analysis of the Wabash Oaks Apartments c Should Gary accept the owner’s income statement as the basis for an income appraisal of Wabash Oaks? Why or why not? d In your opinion, what is a reasonable estimate of the market value for the Wabash Oaks? e If Gary could buy Wabash Oaks for $10,000 less than its market value, would it be a good investment for him? Explain Case Problem 18.2 Analyzing Dr Davis’s Proposed Real Estate Investment Dr Marilyn Davis, a single, 34-year-old heart specialist, is considering the purchase of a small office condo She wants to add some diversity to her investment portfolio, which now contains only corporate bonds and preferred stocks In addition, because of her high federal tax bracket of 33%, Marilyn wants an investment that produces a good after-tax rate of return A real estate market and financial consultant has estimated that Marilyn could buy the office condo for $200,000 In addition, this consultant analyzed the property’s rental potential with respect to trends in demand and supply He discussed the following items with Marilyn: (1) The office condo was occupied by a tenant, who had years remaining on her lease, and (2) it was only years old, was in excellent condition, and was located near a number of major thoroughfares For her purposes, Marilyn decided the office condo should be analyzed on the basis of a 3-year holding period The gross rents in the most recent year were $32,000, and operating expenses were $15,000 The consultant pointed out that the lease had a built-in 10% per year M19_SMAR3988_13_GE_C18.indd 36 13/05/16 9:46 AM Find more at www.downloadslide.com Web Chapter 18 I Real Estate and Other Tangible Investments 18-37 rent escalation clause and that he expected operating expenses to increase by 8% per year He further expected no vacancy or collection loss because the tenant was an excellent credit risk Marilyn’s accountant estimated that annual depreciation would be $7,272 in each of the next years To finance the purchase of the office condo, Marilyn has considered a variety of alternatives, one of which would involve assuming the existing $120,000 mortgage On the advice of a close friend, a finance professor at the local university, Marilyn decided to arrange a $150,000, 10.5%, 25-year mortgage from the bank at which she maintains her business account The annual loan payment would total $16,995 Of this, the following breakdown between interest and principal would apply in each of the first years: Year Interest Principal Total $15,688 $1,307 $16,995 $15,544 $1,451 $16,995 $15,384 $1,611 $16,995 The loan balance at the end of the years would be $145,631 The consultant expects the property to appreciate by about 9% per year to $259,000 at the end of years Marilyn would incur a 5% sales commission expense on this assumed sale price The office condo’s book value at the end of years would be $178,184 The net proceeds on the sale would be taxed at Marilyn’s 15% long-term capital gains rate for any capital gains and a 25% rate for recaptured depreciation Questions a What is the expected annual after-tax cash flow for each of the years (assuming Marilyn has other passive income that can be used to offset any losses from this property)? b At a 15% required rate of return, will this investment produce a positive net present value? c What is the estimated IRR for this proposed investment? d Could Marilyn increase her returns by assuming the existing mortgage at a 9.75% interest rate rather than arranging a new loan? What measure of return you believe Marilyn should use to make this comparison? e Do you believe Marilyn has thought about her real estate investment objectives enough? Why or why not? M19_SMAR3988_13_GE_C18.indd 37 13/05/16 9:46 AM Find more at www.downloadslide.com Key Equations equation 2.1 equation 2.1a equation 2.2 Value of securities - Debit balance Value of securities V - D = V Margin = Total Total Market Market current interest value of value of + income paid on securities securities Return on received margin loan at sale at purchase invested capital = from a margin Amount of equity at purchase transaction equation 4.1 Required return Real rate Expected inflation Risk premium = + + on investment j of return premium for investment j equation 4.2 Risk@free rate = equation 4.3 Required return Risk@free Risk premium = + on investment j rate for investment j equation 4.4 equation 4.5 equation 4.6 equation 5.1 Real rate Expected inflation + of return premium Income Capital gain (or loss) + during period during period Holding period return = Beginning investment value Capital gain (or loss) Ending Beginning = during period investment value investment value n Return for Average or a a outcome t - expected return b t=1 Standard deviation = Total number - b of outcomes Proportion of Proportion of , , portfolio s total Return portfolio s total Return Portfolio = • dollar value * on asset µ + • dollar value * on asset µ + Á + Return invested in invested in asset asset Proportion of Proportion of , , portfolio s total Return portfolio s total Return n • dollar value * on asset µ = a • dollar value * on asset µ j=1 invested in n invested in j asset n asset j equation 5.2 Total risk = Diversifiable risk + Undiversifiable risk equation 5.3 Expected return Beta for Expected market Risk@free = Risk@free + c *a bd on investment j investment j return rate rate Z02_SMAR3841_13_SE_IDX.indd 15/12/15 5:59 PM Key Equations Proportion of Proportion of Beta Beta , , Portfolio portfolio s total portfolio s total = ± * for ≤ + ± * for ≤ + Á + beta dollar value dollar value asset asset in asset in asset Equation 5.4 Equation 6.1 Find more at www.downloadslide.com Proportion of Proportion of Beta Beta , , n portfolio s total portfolio s total ± * for ≤ = a ± * for ≤ dollar value dollar value j=1 asset n asset j in asset n in asset j Net profit - Preferred dividends after taxes EPS = Number of shares of common stock outstanding Annual dividends received per share Current market price of the stock Equation 6.2 Dividend yield = Equation 6.3 Dividend payout ratio = Equation 6.4 Equation 6.5 Dividends per share Earnings per share Total returns Current income Capital gains Changes in currency = + { exchange rates 1in U.S dollars 1dividends2 or losses2 Returns from current Returns from Total return = income and capital gains { changes in currency in U.S dollars 1in local currency2 exchange rates Equation 6.6 Exchange rate Ending value of Amount of dividends at end of stock in foreign + received in currency foreign currency holding period Total return * = G W -1 (in U.S dollars) Beginning value of stock Exchange rate in foreign currency at beginning of holding period Equation 7.1 Current ratio = Equation 7.2 Quick ratio = Equation 7.3 Net working capital = Current assets - Current liabilities Equation 7.4 Accounts receivable turnover = Equation 7.5 Inventory turnover = Z02_SMAR3841_13_SE_IDX.indd Current assets Current liabilities Current assets - inventory Current liabilities Sales revenue Accounts receivable Sales revenue Inventory 15/12/15 6:00 PM Find more at www.downloadslide.com Sales revenue Total assets Equation 7.6 Total asset turnover = Equation 7.7 Debt@equity ratio = Long@term debt Stockholders’ equity Equation 7.8 Equity multiplier = Total assets Stockholders’ equity Equation 7.9 Times interest earned = Equation 7.10 Net profit margin = Equation 7.11 ROA = Net profit after taxes Total assets Equation 7.12 ROE = Net profit after taxes Stockholders’ equity Equation 7.13 ROA = Net profit margin * Total asset turnover Equation 7.14 ROE = ROA * Equity multiplier Equation 7.15 ROE = ROA * Equity multiplier = (Net profit margin * Total asset turnover) * Equity multiplier Equation 7.16 P>E = Equation 7.17 PEG ratio = Equation 7.18 Dividends per share = Equation 7.19 Dividend payout ratio = Equation 7.20 Book value per share = Equation 7.21 Price@to@book@value = Equation 8.1 Future after@tax earnings in year t Z02_SMAR3841_13_SE_IDX.indd Earnings before interest and taxes Interest expense Net profit after taxes Sales revenue Price of common stock EPS Stock’s P > E ratio 3@ to 5@year growth rate in earnings = Annual dividends paid to common stock Number of common shares outstanding Dividends per share Earnings per share Stockholders’ equity Number of common shares outstanding Market price of common stock Book value per share Estimated sales in year t * Net profit margin expected in year t 15/12/15 6:00 PM Find more at www.downloadslide.com Key Equations Equation 8.2 Future after@tax earnings in year t Estimated EPS = in year t Number of shares of common stock outstanding in year t Equation 8.3 EPS = Equation 8.4 Estimated dividends Estimated EPS Estimated = * per share in year t for year t payout ratio Equation 8.5 Equation 8.6 After@tax earnings Book value of equity * = ROE * Book value per share Book value of equity Shares outstanding Estimated share price Estimated EPS Estimated P/E = * at end of year t in year t ratio , Required Risk@free Stock s Market Risk@free = + c * a bd rate of return rate beta return rate Equation 8.7 Value of a Annual dividends = share of stock Required rate of return Equation 8.8 , Next year s dividends Value of a = Required rate Dividend growth share of stock of return rate Equation 8.9 Value of a share = of stock Equation 8.10 , g = ROE * The firm s retention rate, rr Present value of Present value of the price future dividends + of the stock at the end of during the initial the variable@growth period variable@growth period Equation 8.10a rr = - Dividend payout ratio Equation 8.11 present value of future free cash flows going to equity shares outstanding Free cash flow = after@tax earnings + depreciation - investments in working capital - investments in fixed assets Value of a share of stock = Equation 8.12 Stock price = EPS * P / E ratio Equation 8.13 P/CF ratio = Equation 8.14 P/S ratio = Equation 9.1 Abnormal return (or alpha) = Actual return - Expected return Equation 9.3 Z02_SMAR3841_13_SE_IDX.indd Market price of common stock Cash flow per share Market price of common stock Sales per share Average yield on 10 high@grade corporate bonds Confidence = index Average yield on 10 intermediate@grade bonds 15/12/15 6:00 PM Find more at www.downloadslide.com Fundamentals of Investing For these Global Editions, the editorial team at Pearson has collaborated with educators across the world to address a wide range of subjects and requirements, equipping students with the best possible learning tools This Global Edition preserves the cutting-edge approach and pedagogy of the original, but also features alterations, customization, and adaptation from the North American version Global edition Global edition Global edition Fundamentals of Investing THIRTEENTH edition Scott B Smart • Lawrence J Gitman • Michael D Joehnk THIRTEENTH edition Smart • Gitman • Joehnk This is a special edition of an established title widely used by colleges and universities throughout the world Pearson published this exclusive edition for the benefit of students outside the United States and Canada If you purchased this book within the United States or Canada, you should be aware that it has been imported without the approval of the Publisher or Author Pearson Global Edition Smart_13_1292153989_Final.indd 5/12/16 12:36 PM ... $2, 8 32, 000 $2, 8 32, 000 , 1.09 = $2, 598,165 20 17 $3,115 ,20 0 $3,115 ,20 0 , 1.0 92 = $2, 622 ,0 02 Next, calculate the present value as of 20 17 of all the cash flows that Victor’s will generate in years 20 18... 8 .2 SELECTED HISTORICAL FINANCIAL DATA, UNIVERSAL OFFICE FURNISHINGS 20 12 2013 20 14 20 15 $554 .20 $ 694.90 $ 755.60 $ 761.50 $ 941 .20 1. 72 1.85 1.98 2. 32 2.06 Sales revenue (millions) $953 .20 ... (as of 20 17) of all cash flows generated in years 20 18 and beyond as follows: PV2017 = FCF 20 18 , 1r - g2 = FCF 20 17 11 + g2 , 1r - g2 PV2017 = $3,115 ,20 0 11 + 0. 02 , 10.09 - 0. 02 = $45,3 92, 914