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