Stock
Valuation
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Valuing a Company and Its Future
• The single most important issue in the stock
valuation process is what a stock will do in
the future
• Value of a stock depends upon its future returns
from dividends and capital gains/losses
• We use historical data to gain insight into the
future direction of a company and its profitability
• Past results are not a guarantee of future results
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Steps in Valuing a Company
• Three steps are necessary to project key
financial variables into the future:
– Step 1: Forecast future sales & profits
– Step 2: Forecast future EPS and dividends
– Step 3: Forecast future stock price
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Step 1: Forecast Future
Sales and Profits
Future after-tax Estimated sales Net profit margin
earnings in year t for year t expected in year t
• Example: Assume last year’s sales were $100
million, revenue growth is estimated at 8% and the
net profit margin is expected to be 6%.
Future after-tax
$108 million 0.06 $6.5 million
earnings next year
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Step 2: Forecast Future EPS
• Forecasted outstanding shares of common stock
based upon:
– “Naïve” approach based upon continued historical
tends, or
– Historical trends adjusted for anticipated changes in
operations or environment
• Forecasted Earnings Per Share (EPS) based
upon: Future after-tax
Estimated EPS earnings in year t
in year t Number of shares of common stock
outstanding in year t
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Step 2: Forecast Future EPS
(cont’d)
• Example: Assume estimated profits are $6.5
million, 2 million shares of common stock
are outstanding, and the dividend payout
ratio is estimated at 40%.
Estimated EPS $6.5 million
$3.25
next year 2 million
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Step 2: Forecast Future Dividends
• Forecasted Dividend Payout ratio
based upon:
– “Naïve” approach based upon continued
historical trends, or
– Historical trends adjusted for anticipated
changes in operations or environment
Estimated dividends Estimated EPS Estimated
per share in year t in year t payout ratio
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Step 2: Forecast Future
Dividends (cont’d)
• Example: Assume estimated profits are $6.5
million, 2 million shares of common stock
are outstanding, and the dividend payout
ratio is estimated at 40%.
Estimated dividends
$3.25 .40 $1.30
per share next year
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Step 3: Forecast P/E Ratio
• Estimated P/E ratio based upon:
– “Average market multiple” of all stocks in the
marketplace, or
– “Relative P/E multiple” of individual stocks
– Adjust up or down based upon expectations of
economic conditions, general stock market
outlook in near term, or anticipated changes in
company’s operating results
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Step 3: Forecast Future Stock
Price
Estimated share price Estimated EPS Estimated P/E
at end of year t in year t ratio
• Example: Assume estimated EPS are $3.25 and
the estimated P/E ratio is 17.5 times.
Estimated share price
$3.25 17.5 $56.88
at the end of next year
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Using Stock Valuation
• Once we have an estimated future stock price, we
can compare it to the current market price to see if
it may be a good investment candidate:
current price < estimated price undervalued-BUY!
current price = estimated price fairly valued-BUY!
current price > estimated price overvalued-Don’t
Buy
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The Valuation Process
• Valuation is a process by which an investor uses risk and
return concepts to determine the worth of a security.
– Valuation models help determine what a stock ought to be worth
– If expected rate of return equals or exceeds our target yield, the
stock could be a worthwhile investment candidate
– There is no assurance that actual outcome will match expected
outcome
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Required Rate of Return
• Required Rate of Return is the return
necessary to compensate an investor for
the risk involved in an investment.
– Used as a target return to compare forecasted
returns on potential investment candidates
Required Risk-free Stock's Market Risk-free
rate of return rate beta return rate
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Required Rate of Return
(cont’d)
• Example: Assume a company has a beta of
1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?
Required return 5.5% 1.30 15.0% 5.5% 17.85%
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Other Stock Valuation Methods
• Dividend Valuation Model
– Zero growth
– Constant growth
– Variable growth
• Dividend and Earnings Approach
• Price/Earnings Approach
• Other Price-Relative Approaches
– Price-to-cash-flow ratio
– Price-to-sales ratio
– Price-to-book-value ratio
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Dividend Valuation Model:
Zero Growth
• Uses present value to value stock
• Assumes dividends will not grow over time
Value of a Annual dividends
share of stock Required rate of return
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Dividend Valuation Model:
Constant Growth
• Uses present value to value stock
• Assumes dividends will grow at a constant rate
over time
• Works best with established companies with
history of steady dividend payments
Value of a Next year's dividends
share of stock Required rate Constant rate of
of return growth in dividends
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Dividend Valuation Model:
Variable Growth
• Uses present value to value stock
• Allows for variable growth in dividend
growth rate
• Most difficult aspect is specifying the appropriate
growth rate over an extended period of time
Present value of
Present value of the price
Value of a share future dividends
of the stock at the end of
of stock during the initial
the variable-growth period
variable-growth period
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Dividends-and-Earnings Approach
• Uses present value to value stock
• Assumes stock value is capitalized value of its
annual dividends and future sale price
• Works well with companies who pay little or
no dividends
Present value of
Present value of Present value of
the price of the stock
a share of stock future dividends
at date of sale
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Price/Earnings (P/E) Approach
• Future price is based upon the appropriate
P/E ratio and forecasted EPS
• Simple to use and easy to understand
• Widely used in stock valuation
Stock price EPS P/E ratio
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Price-to-Cash-Flow (P/CF)
Approach
• Similar to P/E approach, but substitutes
projected cash flow for earnings
• Widely used by investors
• Many consider cash flow to be more
accurate than profits to evaluate a stock
Market price of common stock
P/CF ratio
Cash flow per share
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Price-to-Sales (P/S) Approach
• Similar to P/E approach, but substitutes
projected sales for earnings
• Useful for companies with no earnings or
erratic earnings
Market price of common stock
P/S ratio
Sales per share
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Price-to-Book-Value
(P/BV) Approach
• Similar to P/E approach, but substitutes
book value for earnings
Market price of common stock
P/BV
Book value per share
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Table 3.1 Using the Variable-Growth
DVM to Value Sweatmore Stock
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