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Entire Unit Module.doc.doc

1. 1. The Iowa Electronic Markets Stock Valuation Curriculum using the IEM Prepared for the Spring 2001 IEM*IDEA/NSF Conference By: Dr. Roger Ignatius Associate Professor of Finance Husson College Dr. Thomas A. Rietz Associate Professor of Finance University of Iowa April 2001
2. 2. Teaching Objectives Stock Valuation Motivation What is the goal of business, of management and of financial management in particular? Answers will vary, but typically have a common theme: the creation and management of value. Stock valuation is the attempt to measure the value of a business and that business’ equity in particular. Understanding valuation helps investors and managers alike in meeting their goals. Understand several common stock and business valuation models. Students will learn about several common methods of valuation. These include the dividend discount model, market multiples and the discounted cash flow model. Students should understand how to value companies according to each method and understand the factors driving value for each. Be able to look up data for these models on the internet. Students should be able to look up basic information required for each valuation method on the internet. For the dividend discount model, this information includes current dividend and re-investment rates, return on equity and CAPM inputs. For the market multiples method, this information included P/ E, P/S and market-to-book ratios for the firm and industry. For the discounted cash flow method, this includes free cash flows and inputs necessary to compute the weighted average cost of capital. Apply these models to a corporation to value it and understand the major factors influencing value. In an assignment, students will apply these valuation models to several companies: IBM, MSFT and AAPL. At each state, students are asked to ponder differences in the valuations of the models from each other and the actual stock price. They will consider the impact of changes in inputs to these models as well. Trade in IEM based on earnings and valuation predictions. Students will use current information to form expectations on the firm’s value. They will combine this with current prices to trade in the IEM Computer Industry Returns market. As the markets progress, they will monitor prices and returns to determine whether their own assessments prove correct. 2
3. 3. Lecture Outline Stock Valuation 1. Introduction a. Principles of Valuation 2. Discounted Dividend Models a. Constant Dividend Model b. Constant Growth Model 3. Discounted Cash Flow Model 4. Market Multiple Models a. P/E Model b. P/S Model c. P/CF Model 5. Summary 3
5. 5. Accessing the IEM You can access the IEM through its website address: http://www.biz.uiowa.edu/iem/ The IEM market has several contracts trading under it. The contracts of interest for our course are the Computer Industry Returns Market (Comp_Ret, for short). You access your trading account from the market pages or directly at: http://iemweb.biz.uiowa.edu/ Computer Industry Returns Contracts The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing contracts in the series are liquidated and payments are made as described below. Then, new contracts are created as described below. These events occur on the Monday after the exchange- traded options for the underlying stocks expire (the Monday after the third Friday of each month). The liquidation values for the contracts in this market are determined solely by the rates of return of Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock (MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified below will payoff \$1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this market, you will need to understand what determines real stock market returns. Contracts are designated by a ticker symbol and a letter denoting the month of contract liquidation. Thus, the contracts traded in this market for liquidation in month “m” are: Code Underlying Asset Liquidation Value AAPLm Apple Computers \$1.00 if AAPL Return Highest IBMm IBM \$1.00 if IBM Return Highest MSFTm Microsoft \$1.00 if MSFT Return Highest SP500m S&P 500 Market Index \$1.00 if SP500 Return Highest In these contract codes, “m” refers to the month of expiration as given by the following table: Month Designation Month Designation Month Designation January a May e September i February b June f October j March c July g November k April d Augus h December l t For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing stock prices of the underlying listed firm between the third Friday in the liquidation month and the third Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return 5
7. 7. Completing Your Assignments and Submitting Them As you can see below, the IEM assignments are extensive, multi-part assignments that draw together many concepts from the class. It would be wise to work on the various parts of the assignments as we go over the relevant topics in class. To prepare the assignments for submission, please use the following guidelines: 1. Each assignment must be typed. Label clearly each assignment with a cover page giving your name, student number, and section number. 2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc. 3. Within each section, give the requested information, including sources of information gathered and equations used to calculate results. 4. Turn in your completed assignment to your instructor on the date it is due. 7
8. 8. Stock Valuation Assignment Part 1: Discounted Dividend Models DUE: ___________ GOAL In this part of the assignment, you will learn where to find information necessary to apply the discounted dividend models discussed in class. You will use this information to see what discounted dividend models imply for IBM. Background Information To complete this exercise, you will need to collect some basic information on IBM: the annual dividend, an estimate for the risk free rate, the beta for IBM’s stock and some information to help estimate the likely dividend growth rate. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages. To get information on IBM, go to the Microsoft MoneyCentral webpages at the address: http://moneycentral.msn.com/ In the upper left corner, enter “IBM” as the ticker symbol and press the “go” button. Obtain the required information as follows: 1. Recent IBM Price: The recent price per share is given on the default screen or the “Quotes— Quote Detail” screen. 2. Dividend and Dividend Yield: The annual dividend per share and dividend yield are given on the default screen or the “Quotes—Quote Detail” screen. 3. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column. 4. Return on Equity (ROE): ROE is listed on the “Financial Results—Highlights” page. 5. Payout Ratio: The payout ratio is also listed on the “Financial Results—Highlights” page. 6. Historical Dividend Growth Rate: The 5 year historical dividend rate is given on the “Financial Results—Key Ratios—Growth Rates” page. 7. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page. 8. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3 Month Treasury bills. 8
9. 9. Question 1: Estimating the Required Return Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for IBM stock. Use the 3-month Treasury rate obtained above for the risk free rate, the beta obtained above for the beta and a risk premium of 8.74% (which is the historical average from 1926-1996). Recall that the CAPM equation is: k = rf + β × RP Question 2: Constant Dividend Model Suppose that IBM’s dividends will remain constant at their current level. Use the constant dividend model to value IBM’s stock. Does this number seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that might be? D Recall that the Constant Dividend pricing relationship is: P0 = k Question 3: Estimating Dividend Growth There are a variety of means of estimating IBM’s likely future dividend growth. Determine what the estimated growth rate would be using each of the following methods: a. If the past can be used as an indicator of the future, then the historical average is a good estimate. What is the historical average dividend growth rate? b. Analysts forecast growth and their average forecast is often used. What is the average estimated 5-year growth rate according to analysts? c. Another commonly used estimate is the “sustainable growth” rate computed by the (1-Payout Ratio) x ROE. What is the growth rate estimated by these means? d. Finally, since capital gains are driven by growth they should be approximately the same as growth. The total return in a stock (from Question 1) should equal the dividend yield plus the capital gain yield. Thus, you can estimate the growth rate by subtracting the dividend yield from the required return calculated in Question 1 above. What does this give for a growth rate? Given all this information, what do you think is a reasonable long run growth rate for IBM’s dividend? (Remember that, in the long run, growth cannot exceed the required return, which is calculated in Question 1 above.) Question 4: Constant Growth Model Given the dividend, the required return calculated in Question1 and the growth rate calculated in Question 2, what should the price of IBM stock be given the constant growth model? Does this number seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that might be? D1 D (1 + g ) Recall that the Constant Growth pricing relationship is: P0 = = 0 k −g k −g 9
10. 10. Question 5: Implied Growth There is one final way of forecasting the growth rate. Equate the price of the stock today to the value that should exist according to the constant growth model. If you assume that next year’s dividend will grow at the same rate as the projected growth rate and use the required return calculated in Question 1, you can solve for the growth rate. This is called the implied growth rate. What is it? How does it compare to your estimate from Question 3 above? Recall that the Constant Growth pricing relationship implies: 10
11. 11. Stock Valuation Assignment Part 2: Discounted Cash Flow Models DUE: ___________ GOAL In this part of the assignment, you will learn where to find information necessary to apply the discounted cash flow models discussed in class. You will use this information to see what discounted dividend models imply for IBM, Apple and Microsoft. Background Information To complete this exercise, you will need to collect some basic information on all three companies to help estimate cash flows the likely cash flow growth rate. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages. To get information, go to the Microsoft MoneyCentral webpages at the address: http://moneycentral.msn.com/ For each of the companies, you will undertake the following steps to gather information. In the upper left corner, enter the ticker symbol for the company (e.g., “IBM”) and press the “go” button. Obtain the required information as follows: 1. Recent Price: The recent price per share is given on the default screen or the “Quotes—Quote Detail” screen. 2. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column. 3. Historical Income Statement Information: A five-year history of income statements is available from “Financial Results—Statements.” If it does not come up as the default, select “Income Statement” and “Annual” from the pull-down menus. Make a table like the one that appears below and fill in (1), (2) and (3) below from the income statement and calculate the cash flow as (1) total net income plus (2) depreciation and amortization minus (3) preferred dividends. Year (1) Total Net Income (2) Depreciation & Amortization (3) Preferred Dividends Calculate Cash Flow (1)+(2)-(3) Calculate the growth in cash flow for each year, t, as (CF t-CFt-1)/CFt-1 and calculate the average growth rate for the available years. 4. Historical Growth Rate: The 5 year historical sales growth rate is given on the “Financial Results —Key Ratios—Growth Rates” page. (We will use this as a proxy for cash flow growth.) 11
12. 12. 5. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page. 6. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3 Month Treasury bills. Question 1: Estimating the Required Return Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for each company’s stock. Use the 3-month Treasury rate obtained above for the risk free rate, the beta obtained above for the beta and a risk premium of 8.74% (which is the historical average from 1926-1996). Recall that the CAPM equation is: k = rf + β × RP Question 2: Estimating Cash Flow Growth There are a variety of means of estimating likely future cash flow growth. Determine what the estimated growth rate would be for each company using each of the following methods: a. If the past can be used as an indicator of the future, then the historical average is a good estimate. What is the historical average cash flow growth rate? b. If the past can be used as an indicator of the future and cash flows vary directly with sales, then the historical average sales growth rate is a good estimate. What is the historical average sales growth rate? c. Analysts forecast earnings growth and their average forecast is often used. Under the assumption that cash flows vary directly with earnings. What is the average estimated 5-year growth rate according to analysts? Given all this information, what do you think is a reasonable long run growth rate for IBM’s cash flow? (Remember that, in the long run, growth cannot exceed the required return, which is calculated in Question 1 above.) Question 3: Discounted Cash Flow Model Given the most recent cash flow (calculated in the table used to collect income statement information above), the required return calculated in Question 1 and the growth rate calculated in Question 2, what should the price of each company’s stock be given current cash flows and the estimate growth rate? Does this number seem too high or too low when comparing it to the company’s current stock price? Can you explain why that might be? CF1 CF0 (1 + g ) Recall that the discounted cash flow pricing relationship is: P0 = = k −g k −g 12
13. 13. Stock Valuation Assignment Part 3: Market Multiples Models DUE: ___________ GOAL In this part of the assignment, you will learn where to find information necessary to apply the market multiples valuation models discussed in class. You will use this information to see what these models imply for IBM, Apple and Microsoft. Background Information To complete this exercise, you will need to collect some basic information on all three companies to apply each model. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages. To get information, go to the Microsoft MoneyCentral webpages at the address: http://moneycentral.msn.com/ For each of the companies, you will undertake the following steps to gather information. In the upper left corner, enter the ticker symbol for the company (e.g., “IBM”) and press the “go” button. Obtain the required information as follows: 1. Recent Price: The recent price per share is given on the default screen or the “Quotes—Quote Detail” screen. 2. Company and Industry Ratios: For each company, collect the company and industry P/E, P/S and P/CF ratios. These can be found under “Financial Results—Key Ratios—Price Ratios.” (Use the current P/E ratio.) Also, note the industry for each company listed at the bottom of the page. 3. Average Earnings Forecast from Analysts for Next Year: The average forecast can be found at “Analyst Info—Earnings Estimates.” Use the next fiscal year listed in the “FY” columns. Question 1: Determining Current Earnings, Sales and Cash Flows Since reported ratios are computed on the last 12 months of data and the most recent income statement typically is not, we cannot use the income statements to figure out the earnings, sales and cash flows used in the ratios. Instead, we need to figure out what the earnings per share, sales per share and cash flows per share were from the ratios themselves. This is easy enough to do using the reported ratios and the current price. For each company, undertake the following steps to do this: (a) Determine the earnings for each company by dividing the current price by the P/E ratio. (This works because you know that P = Earnings x P/E, so P/(P/E) = Earnings.) (b) Determine the sales for each company by dividing the current price by the P/S ratio. (This works because you know that P = Sales x P/S, so P/(P/S) = Sales.) 13
14. 14. (c) Determine the cash flows for each company by dividing the current price by the P/CF ratio. (This works because you know that P = Cash Flow x P/CF, so P/(P/CF) = Cash Flow.) Question 2: P/E Valuation Use earnings and P/E ratios to calculate three estimates for each company’s stock. These three estimates are: (1) Current earnings (from Question 1) times the industry P/E ratio. This gives the company’s value at current earnings levels if it were valued as its industry peers are relative to current earnings. (2) Forecast earnings (from analysts) for next year times the company’s P/E ratio. This gives the company’s future value at current P/E levels if the forecasts are accurate. (3) Forecast earnings (from analysts) for next year times the industry P/E ratio. This gives the company’s future value if the forecasts are accurate and the company is valued as its industry peers are relative to earnings in the future. Question 3: P/S Valuation Use sales and P/S ratios to calculate another estimate for each company’s stock. Take current sales (from Question 1) times the industry P/S ratio. This gives the company’s value at current sales levels if it were valued as its industry peers are relative to current sales. Question 4: P/CF Valuation Use cash flows and P/CF ratios to calculate another estimate for each company’s stock. Take current cash flows (from Question 1) times the industry P/CF ratio. This gives the company’s value at current cash flow levels if it were valued as its industry peers are relative to current cash flows. Question 5: Interpretation For each company, you have the current market price and a range of valuations depending on current and forecast earnings, current sales and current cash flows. Of course, these numbers will not all be the same. Do these differences appear random? Or, can you think of good reasons that these valuations differ? Elaborate on any reasons that the company might be priced differently from the valuations suggested by the industry ratios. Can you come up with specific reasons for the differences of each company? 14