Stock valuation

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In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.

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Stock valuation

  1. 1. Valuing Stocks Session 3
  2. 2. Stock Exchange • It is an institution, organization or association that serves as a market for trading financial instruments such as stocks, bonds and their related derivatives. • Large companies arrange their stocks to be traded on a stock exchange
  3. 3. • Firms that wish to raise new capital – May borrow money or – Bring new ‘partners’ by selling shares of common stock • Components for buying stocks – Price change – Volume – Dividend yield – Price-earning (P/E) ratio
  4. 4. 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.
  5. 5. 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 – If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment candidate – There is no assurance that actual outcome will match expected outcome
  6. 6. 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 R equired R isk-free Stock's M arket R isk-free rate of return rate beta return rate
  7. 7. 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? R equired return 5.5% 1.30 15.0% 5.5% 17.85%
  8. 8. Common Stock Valuation • These methods are grouped into two categories: – Dividend discount models – Price ratio models
  9. 9. The Dividend Discount Model • The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by discounting all expected future dividend payments. The DDM equation is: V(0) D(1) 1 k D(2) 1 k • In the DDM equation: D(3) 2 1 k 3  D(T) 1 k P(T) T – V(0) = the present value of all future dividends – D(t) = the dividend to be paid t years from now – k = the appropriate risk-adjusted discount rate 1 k T
  10. 10. Example: The Dividend Discount Model • Suppose that a stock will pay three annual dividends of $200 per year, and the appropriate risk-adjusted discount rate, k, is 8%. Terminal price $ 1200. • In this case, what is the value of the stock today? V(0) D(2) 1 k V(0) D(1) 1 k $200 1 0.08 D(3) 2 1 k $200 1 0.08 P(3) 3 3 1 k $200 2 1 0.08 $1,200 3 1 0.08 3 $1,468.01
  11. 11. The Dividend Discount Model: the Constant Growth Rate Model • Assume that the dividends will grow at a constant growth rate g. • Then, the dividend next period (t + 1) is: D t 1 D t 1 g • In this case, the DDM formula becomes: V(0) D(0)(1 k g) g 1 1 g 1 k T P(T) 1 k T
  12. 12. Example: The Constant Growth Rate Model • Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly dividends, and the appropriate discount rate is 8%. Terminal value $200. • What is the value of the stock, based on the constant growth rate model? V(0) D(0)(1 k V 0 $10 .08 g) g 1.10 .10 1 g 1 1 1 T k 1.10 1.08 P(T) 1 20 k T 200 1 .08 20 $286.77
  13. 13. The Dividend Discount Model: the Constant Perpetual Growth Model. • Assuming that the dividends will grow forever at a constant growth rate g. • In this case, the DDM formula becomes: V 0 D1 k g
  14. 14. Example: Constant Perpetual Growth Model • Think about the electric utility industry. • In mid-2003, the dividend paid by the utility company, American Electric Power (AEP), was $1.40. • Using D(0)=$1.40, k = 6.5%, and g = 1.5%, calculate an estimated value for AEP. V 0 $1.40 .065 1.015 .015 $28.42
  15. 15. The Sustainable Growth Rate Sustainabl e Growth Rate ROE ROE Retention Ratio (1 - Payout Ratio) • Return on Equity (ROE) = Net Income / Equity • Payout Ratio = Proportion of earnings paid out as dividends • Retention Ratio = Proportion of earnings retained for investment
  16. 16. Example: Calculating and Using the Sustainable Growth Rate • In 2003, AEP had an ROE of 10%, projected earnings per share of $2.20, and a per-share dividend of $1.40. What was AEP’s – Retention rate? – Sustainable growth rate? • Payout ratio = $1.40 / $2.20 = .636 • So, retention ratio = 1 – .636 = .364 or 36.4% • Therefore, AEP’s sustainable growth rate = 10% .364 = 3.64%
  17. 17. Example: Calculating and Using the Sustainable Growth Rate, Cont. • What is the value of AEP stock, using the perpetual growth model, and a discount rate of 6.5%? V 0 $1.40 .065 1.0364 .0364 $50.73
  18. 18. Price Ratio – P/E Ratio • Price-earnings ratio (P/E ratio) – Current stock price divided by annual earnings per share (EPS) Intel Corp (INTC) - Earnings (P/E) Analysis • • • Current EPS 5-year average P/E ratio EPS growth rate $0.48 38.72 5.50% Expected stock price = historical P/E ratio $19.61 = 38.72 ($0.48 projected EPS 1.055)
  19. 19. Thank You

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