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.

1. Valuing Stocks
Session 3

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. • 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. 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. 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. 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. 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. Common Stock Valuation
• These methods are grouped into two
categories:
– Dividend discount models
– Price ratio models

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Thank You