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  • 1. Chapter 18 Investing in Stocks Lawrence J. Gitman Jeff Madura Introduction to Finance
  • 2.
    • Explain how stocks can be valued using valuation models that are alternatives to the dividend discount model.
    • Explain the valuation of the stock market.
    • Describe the valuation and performance of initial public offering (IPO) stocks.
    • Identify benchmarks commonly used for assessing investment performance.
    • Describe the forms of stock market efficiency.
    • Describe the valuation, performance, measurement, and efficiency of foreign stocks.
    Learning Goals
  • 3. Alternative Stock Valuation Models
    • The Basic Stock Valuation Equation
      • Recall from Chapter 7, the basic stock valuation method (also referred to as the dividend discount model) can be expressed as:
      • Unfortunately, this model is not directly applicable to valuing firms that have low or zero dividends—so alternative methods must be used.
  • 4.
    • P/E Multiples
      • This approach is popular because many investors believe earnings are a good proxy for a firm’s cash flows.
      • A firm’s stock can be valued using the P/E method by multiplying the industry average P/E ratio by the firm’s expected earnings.
    Alternative Stock Valuation Models
  • 5. Alternative Stock Valuation Models
    • P/E Multiples
      • Critical to this approach is the determination of a firm’s forecasted earnings.
      • Unfortunately, it is not uncommon for these forecasts to be off by as much as 20 to 40 percent.
      • Earnings can be forecast using outside sources (Value Line), or can be forecast directly using pro forma income statements.
      • This is demonstrated on the following slide.
  • 6. Alternative Stock Valuation Models
    • P/E Multiples
    Table 18.1
  • 7. Alternative Stock Valuation Models
    • P/E Multiples
  • 8. Alternative Stock Valuation Models
    • P/E Multiples
      • Limitations of applying P/E multiples include the following:
        • Uncertainty surrounding the proper earnings forecast.
        • Uncertainty surrounding the proper P/E multiple (see Table 18.2 on the following slide).
        • P/E multiple is not applicable to firms with negative earnings.
  • 9. Alternative Stock Valuation Models
    • P/E Multiples
    Table 18.2
  • 10. Alternative Stock Valuation Models
    • Book Value Multiples
      • A book value multiple is the market value of the firm’s common stock in relation to (as a multiple of) the book value of the firm’s common stock as shown in the financial statements.
      • The market/book (M/B) ratio is the market value per share dividend by the book value per share and can be used for valuation purposes as shown below:
  • 11.
    • Book Value Multiples
      • The M/B ratio is subject to error if an improper M/B is applied.
      • A second problem with this approach is that the book value of a firm does not reflect relevant information such as the firm’s potential for growth.
      • Investors may adjust the industry M/B ratio for firms differences.
      • However, these adjustments are also subject to error.
    Alternative Stock Valuation Models
  • 12. Alternative Stock Valuation Models
    • Revenue Multiples
      • A common revenue multiple used for valuing a firm’s stock is the price/revenue (P/R) ratio , which is the ratio of the share price to a stock’s revenue per share.
      • Unfortunately, the P/R ratio generally suffers from the same shortcomings as the M/B ratio.
  • 13. Alternative Stock Valuation Models
    • Revenue Multiples
    Table 18.3
  • 14. Alternative Stock Valuation Models
    • Valuation During the Recent Market Run-Up
      • Explanations based on the dividend discount model
      • Explanations based on the speculative-bubble theory
  • 15. Valuation and Performance of IPO Stocks
    • Valuation
    • Performance
  • 16. Stock Performance Benchmarks for Investors
    • Market Indexes
      • Dow Jones Industrial Average
      • Standard & Poor’s 500
      • New York Stock Exchange Index
      • Nasdaq Composite
    • Sector Indexes
    • Stock Price Quotations
  • 17. Stock Quotations Figure 18.2 (Panel 1)
  • 18. Stock Quotations Figure 18.2 (Panel 2)
  • 19. ADR Quotations Figure 18.3
  • 20. Stock Market Data Bank Figure 18.4 (Panel 1)
  • 21. Stock Market Data Bank Figure 18.4 (Panel 2)
  • 22. Stock Market Efficiency
    • Forms of Efficiency
    Table 18.4
  • 23. Stock Market Efficiency
    • Evidence of Inefficiency
      • January effect
      • Monday and weekend effects
      • Size effect
      • Price/earnings effect
  • 24. Stock Market Efficiency
    • Limitations on Capitalizing on Price Discrepancies
      • Trading commissions
      • Tax effects
      • Relationships are not applicable to all firms
  • 25. Foreign Stocks
    • Valuing Foreign Stocks
      • Dividend discount model
      • Price/earnings (P/E) method
    • Foreign Stock Performance Benchmarks
    • Foreign Stock Market Efficiency
  • 26. Chapter 18 End of Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance