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    1. 1. Valuation of Common Stock Corporate Finance: March 26 (LA) and March 20 (OCC)
    2. 2. Valuation of Stocks <ul><li>Stock analysts as discussed first week - buy side, sell side focus on stock research </li></ul><ul><li>Strategy departments of corporations and others value companies in close parallel to stock analysis except for control issues and integrating strategic changes into intrinsic value calculations </li></ul><ul><li>Problem is always to estimate future cash flows and choose risk-adjusted discount rate </li></ul>
    3. 3. Fundamental vs. Technical Analysis of Stocks <ul><li>Fundamental analysis depends on thorough analysis of a firm’s business and prospects </li></ul><ul><li>This approach is associated with Graham and Dodd, Warren Buffett, and Copeland et al </li></ul><ul><li>Technical analysis depends on patterns in prices over time </li></ul><ul><li>Academic research supports the use of fundamental analysis </li></ul>
    4. 4. Fundamental Analysis <ul><li>Approach used by Value Line Investment Survey is one example of fundamental analysis </li></ul><ul><li>Fundamental analysis requires research and analysis of a firm’s past performance and estimates of future performance </li></ul><ul><li>Can find examples in the Wall Street Transcript , brokerage reports summarized in Zack’s Earnings Forecast </li></ul>
    5. 5. Stocks and Stock Indices <ul><li>Stocks values reflect specific firm (or idiosyncratic) and general economic factors </li></ul><ul><li>Stock indices reflect factors general to a class of stocks </li></ul><ul><li>Stock indices and related statistics (e.g. PE ratio or dividend yield) provide benchmarks </li></ul><ul><li>Stocks are often classified as blue chip, growth , value, small caps, or cyclical stocks , and others, by market observers </li></ul>
    6. 6. Stock Market Indices <ul><li>Dow-Jones Industrials (30 blue chips ) </li></ul><ul><li>S&P 500 - larger than average companies </li></ul><ul><li>NYSE Index - mainly larger than average </li></ul><ul><li>NASDAQ Index - includes smaller companies but also Intel, Apple, Microsoft </li></ul><ul><li>Wilshire 5000 - in dollars </li></ul><ul><li>Industry and other indices </li></ul><ul><li>“Beating the market” - what does it mean? </li></ul>
    7. 7. Investment Strategies <ul><li>Value Investors - Low P-Es, low Market/Book, Current Assets/Market Value -- typical of Graham and Dodd </li></ul><ul><li>Growth Stocks - High P-Es, high growth, often have momentum </li></ul><ul><li>Market Timers - Switch between stocks in different industries and/or fixed incomes </li></ul><ul><li>Sector Balance - Switch between cyclical and trend stocks </li></ul>
    8. 8. Simple patterns in cash flows from stocks <ul><li>All cash flows from stocks can be considered dividends </li></ul><ul><li>May include regular dividends, special dividends, or liquidating dividends </li></ul><ul><li>Other cash flows are from distribution of securities or rights or cash sales </li></ul><ul><li>Using (5.4) we have: </li></ul>
    9. 9. Preferred Stock <ul><li>Preferred stock is a hybrid security with a fixed commitment to pay but counts as equity </li></ul><ul><li>Preferred often arises out of financial distress or special situations </li></ul><ul><li>Valuation of perpetual preferred is easy: </li></ul>
    10. 10. Common Stock <ul><li>Payments to common shareholders are not contractual </li></ul><ul><li>Common stock represents a residual claim on the cash flows and assets of the firm </li></ul><ul><li>Dividends to common stock must be declared by the board of directors </li></ul><ul><li>Many other claimants (bondholders and preferred shareholders) may restrict payment to common </li></ul>
    11. 11. Simple Price-Earnings Multiples Come from Simple Dividends <ul><li>If dividends grow forever at g and the firm pays out a constant proportion d of earnings and dividends, we have (P. 148) </li></ul><ul><li>The Price-Earnings multiple (P-E) is </li></ul>
    12. 12. What Determines Growth (g)? <ul><li>Future sales and costs must be supported by investment in fixed and working capital </li></ul><ul><li>If a firm is projected to have a constant return on investment (ROI) then dividend growth depends on amount of investment </li></ul><ul><li>If investment is financed by retained earnings (or a constant proportion by equity in form of retained earnings), g = (1-d)*ROI </li></ul>
    13. 13. P-E Multiples From other Simple Dividend Patterns <ul><li>Constant growth (as above) </li></ul><ul><li>No growth (perpetuity) </li></ul><ul><li>Fast growth then no growth (consisting of areas in diagram of A+B+C+D </li></ul><ul><li>Explore values of different growth periods and discount rates to assess determinants of real stock P-Es </li></ul><ul><li>Current vs. forecasted P-Es </li></ul>
    14. 14. Differential Growth (g 1 and g 2 ) <ul><li>Many analysts use two growth rates (see Fig. 5.3), an early rate (presumably high) and a long-run rate (presumably close to average): </li></ul><ul><li>No company can grow faster than the discount rate forever but can for a few years </li></ul>
    15. 15. Examples of Differential Growth
    16. 16. Non-Dividend Paying Stocks <ul><li>Value for all assets comes from future cash flows for consumption </li></ul><ul><li>Non-dividend paying stocks must promise future cash flows at some point in the future </li></ul><ul><li>Value of stock may increase while no dividends paid because of growth of expected future dividends </li></ul><ul><li>Remember by dividends we mean any cash flow, including sale of company for cash </li></ul>
    17. 17. Stock Value can be Interpreted as Value of Current and Future Cash <ul><li>Value of a firm can be conceptually thought of as value of current cash plus present value of future cash from retained earnings </li></ul><ul><li>Although it looks different, this is the same as the dividend growth model (see pp. 144ff) </li></ul>
    18. 18. For Next Class <ul><li>Review the “Financial Statement Analysis and Assumptions for Valuation </li></ul><ul><li>Start thinking about Part 2 of PVFIRM05 </li></ul><ul><li>Be sure that each member of the team understand how Part 1 of PVFIRM05 works and review those estimates for plausibility </li></ul>