VALUATING STOCKS

Learning Goals
Explain the role that company’s future plays in the
stock valuation process.
Develop a forecast of a stock’s expected cash flow
starting with corporate sales and earnings, and then
moving to expected dividends and share price.
Discuss the concepts of intrinsic value and
required rates of return, and note how they are
used.
4. Determine the underlying value of stock using
the zero-growth, constant-growth and variable
growth dividend valuation models.

5. Use other types of present value- based

models to derive the value of a stock, as well as
alternative price-relative procedures.
6. Gain a basic appreciation of the procedures
used to value different types of stocks, from
traditional dividend-paying shares to more
growth- oriented stocks.
Valuation: Obtaining a standard of performance

Obtaining a standard performance that can be used to

judge the investment merits of a share of stock is the
underlying purpose of stock valuation.

Stock valuation- is the process by which the underlying

value of a stock is established on the basis of its
forecasted risk and return performance.
• A stock’s intrinsic value provides such a standard, as it
indicates the future risk and return performance of a
security. The question of whether and to what extent
a stock is under valued or over valued is resolved by
comparing its current market price to its intrinsic value
 At any given point in time, the price of a share of
common stock depends on investor expectations
about the future behavior of the security.

Valuing a company and its future

After examining several aspects of security analysis:
economic and industry analysis, and historical
(company) phase of fundamental analysis, it should be
clear that, it’s not the past that’s important but the
future. The primary reason for looking at past
performance is to gain insight about the future
direction of the firm and its profitability.
Granted, past performance provides no guarantees
about future returns, but it can give us a good idea of
a company’s strengths and weaknesses.

For ex. It can tell us how well the company’s products

have done in the marketplace, how the company’s
fiscal health shapes up, and how management tends to
respond to difficult situations. In short, the past can
reveal how well the company is positioned to take
advantage of the things that may occur in the future.
Because the value of a stock is a function of its
future returns, the investor’s task is to use
available historical data to project key financial
variables in the future.

FORECASTED SALES AND PROFITS

• The key to forecast is the future behavior of the
company and the most important aspects to
consider in this regard are :
• The outlook for sales
• The trend in the net profit margin
One way to develop a sales forecast is to assume
that the company will continue to perform as it has
in the past and simply extend the historical trend.
• For ex., if a firm’s sales have been growing at a
rate of 10% per year, then assume they will
continue at that rate.
• Given a satisfactory sales forecast and estimate of
the future net profit margin, we can combine these
two pieces of information to arrive at future
earnings.
future after-tax earnings in year t= estimated sales x net
profit margin expected in year t
• The year t notation in this equation simply denotes
a given calendar or fiscal year in the future. It can
be next year, the year after that, or any other year
in which we are interested. Lets say that in the
year just completed, a company reported sales of $
100 million, we estimate that revenues will grow at
an 8% annual rate, and the net profit margin should
be about 6%. Thus, estimated sales next year will
equal $108m($100m x 1.08) and, with a 6% profit
margin, we should expect to see earnings next year
of
Future after-tax earnings next year =
$108m x .06 = $6.5m
FORECASTED DIVIDENDS AND PRICES
Given a corporate earnings forecast three additional
pieces of information is needed to evaluate the effects
of earnings performance on returns to common stock
investors.
1. an estimate of future dividend payout ratios.
2. the number of common shares that will be
outstanding
3. a future price/earnings (P/E) ratio.
For the first two pieces of information, we can
simply project the firm’s recent experience into the
future. Payout ratios are usually fairly stable, so
there is a little risk in using a recent figure.

It is also generally safe to assume that the number

of common stock outstanding will hold at the latest
level or perhaps change at some moderate rate of
increase(decrease that’s reflective of the recent
past.
GETTING A HANDLE ON THE P/E RATIO
The estimate of the future P/E ration is the only thorny
issue a figure that has considerable bearing on the
stock’s future price behavior. The P/E ratio is a function of
several variables including:
 The growth rate in earnings
 The general state of the market
 The amount of debt in a company’s capital structure
 The current and projected rate of inflation
 The level of dividends.
 As a rule, higher P/E ratios can be expected
with higher rates of growth in earnings, an
optimistic market outlook, and lower debt levels
(less debt means les financial risk).

High P/E ratio should be expected with high

dividend payouts. In practice however, most
companies with high P/E ratios have low dividend
payouts. The reason: earnings growth tends to be
more valuable than dividends, especially in
companies with high rates of return on equity.
A RELATIVE PRICE/EARNINGS MULTIPLE
A useful starting point for evaluating the P/E ratio is
the average market multiple, which is simply the
average P/E ratio of all the stocks in a given market
index, like the S & P 500 or DJIA. The average market
multiple indicates the general state of the market. Other
things being equal, the higher the P/E ratio, the more
optimistic the market-unless, of course, the economy is in
a slump, in which case a high P/E could simply be the
result of lower earnings.
relative P/E multiple- is a measure of how a stock’s
P/E behaves relative to the average market multiple.
You can calculate P/E multiple by dividing a stock’s
P/E by a market multiple. For ex., if a stock
currently has a P/E of 35 and the market multiple for
the S&P 500 is, say, 25, the stock’s relative P/E is
35/25=1.40.

DEVELOPING AN ESTIMATE OF FUTURE BEHAVIOR

Using information obtained from Universal Office
Furnishing (UVRS), we can illustrate the forecasting
procedures.
Summary Forecast Statistics, Universal Office Furnishing
Forecasted Figures
Latest actual Average for 2005 2006 2007
figures (fiscal the past 5
2004) years
(2000-
2004)
Annual rate of growth in 9.7% 18.1% 22% 19% 15%
sales
Net sales(millions) 1,938.0 N/A 2,364.4** 2,813.6** 3,235.6*
*
X net profit margin 7.2% 5.6% 8.0% 8.5% 8.5%
=net after-tax earnings 139.7 N/A 189.2 239.2 275.0
(millions)
/ common shares 61.2 71.1 61.5 60.5 59.0
outstanding (millions)
= earnings per share 2.26 N/A 3.08 3.95 4.66
X payout ratio 6.6% 6.2% 6.0% 6.0% 6.0%
 Latest actual Average for the 2005 2006 2007
figures(fiscal past 5 years
2004) (2000-2004)
Earnings per share 2.26 N/A 3.08 3.95 4.66
X P/E ratio 18.4 16.8 20 19 20
=share price at 41.58 N/A 61.60 75.00 93.20
year end
Highlights of the key assumptions and reasoning
behind the financial forecast for 2005-2007 are
as follows:
• NET PROFIT MARGIN. Various published industry and company
reports suggest a comfortable improvements in earnings, so
we decide to use a profit margin of 8% in 2005 (up a bit from
the latest margin of 7.2% recorded in 2004.) We’re
projecting even better profit margins (8.5%in 2006 and 2007,
as some cost improvements start to take hold.

• COMMON SHARES OUTSTANDING. We believe the company

will continue to pursue its share buyback program, but at a
substantially lower pace than in 2001-2004 period. From
current level of 61.8 million shares, we project that the
number of shares outstanding will drop to 61.5 million in
 PAYOUT RATIO. We assume that the dividend payout ratio
will hold at a steady 6% of earnings, as it has for most of the
recent past.
 P/E RATIO. Primarily on the basis of expectations for
improved growth in revenues and earnings, we are projecting
a P/E multiple that will rise from its present level of 18 ½
times earnings to roughly 20 times earnings in 2005.

SEQUENCE INVOLVED IN ARRIVING A FORECASTED DIVIDENDS

AND PRICE BEHAVIOR.
1. The company dimensions of the forecast are handled first.
These include sales and revenue estimates, net profit margins,
net earnings, and the number of shares of common stock
outstanding.
2. Next, we estimate earnings per share.

3. The bottom line of the forecast is, the returns in the

form of dividends and capital gains expected from a share
of universal stock, given the assumptions about net sales,
profit margins, earnings per share and so forth hold up.

THE VALUATION PROCESS

Valuation- is a process by which an investor uses risk and

return concepts to determine the value of a security.
 This process can be applied to any asset that
produces a stream of cash flow- a share of stock, a
bond, a piece of real estate, or an oil well. To
establish the value of an asset, the investor must
determine certain key inputs, including the amount
of future cash flows, the timing of these cash flows,
and the rate of return required on the investment.
• In terms of common stock, the essence of valuation is to
determine what the stock ought to be worth, given
estimated returns to stockholders (future dividends and
price behavior) and the amount of potential risk
exposure.
The stock valuation models determines either an expected
rate of return or the intrinsic worth of a share of stock,
which in effect represents the stock’s “justified price”. In
this way, we obtain a standard of performance, based on
future stock behavior, that can be used to judge the
investment merits of a particular security.
Either of two • 1. if the computed rate of return
conditions would equals or exceeds the yield we
make us consider feel is warranted, or
a stock a
• 2. if the justified price (intrinsic
worthwhile
investment worth) is equal to or greater
candidate: than the current market price.
Remember: Even though valuation plays an important part
in the investment process, there is absolutely no
assurance that the actual outcome will be even remotely
similar to the forecasted behavior. The stock is still
subject to economic, industry, company and market risks,
anyone of which could negate all your assumptions about
the future.
• One of the key ingredients in the
stock valuation process is the
required rate of return.
REQUIRED RATE •
required rate of return -is the
OF RETURN return necessary to compensate
an investor for the risk involved in
an investment.
Required rate of return= risk-free rate+
(stock’s beta x (market return-risk free rate)
The required inputs for this equation are readily available:
You can obtain a stock’s beta from value line or S & P stock’s
report. The risk-free rate is basically the average return on
treasury bills for the past year or so. And a good proxy for the
market return is the average stock return over the past 10 to
15 years.

Ex. Consider the Universal’s stock, which we’ll assume has

a beta of 1.30. Given that the risk-free rate is 5.5% and the
expected market return is, say, 15%, this stock would have a
required return of
Required return= 5.5% +(1.30x (15% - 5.5%)= 17.8%
• This return can now be used in stock valuation model to
assess the investment merits of a share of stock.
STOCK VALAUTION MODELS
• Investors employ a number of different types of stock
valuation models. Those investors who search for
value in a company’s financials-by keying in on such
factors as book value, debt load, return on equity,
and cash flow are called value investors. They rely as
much on historical performance as on earnings
projections to identify under valued stock.
While those concentrate primarily on growth in earnings are
the growth investors. To them, though past growth is
important, the real key lies in projected earnings- that is,
finding companies that are going to produce big earnings,
along with big price/earnings multiples, in the future.

THE DIVIDEND VALUATION MODEL

In the valuation process, the intrinsic value of any investment

equals the present value of its expected cash benefits. One
way to view the cash flow benefits from common stock is to
assume that the dividends will be received over an infinite
time horizon- an assumption that is appropriate so long as
the firm is considered a “ going concern”.
Dividend Valuation Model (DVM)- is a model that values a
share of stock on the basis of the future dividend stream
it is expected to produce.

• 1. zero growth model- assumes that

dividends will not grow over time.
• 2. constant-growth model – which is
3 versions of the basic version of dividend valuation
model, assumes that dividends will
dividend grow by a fixed/constant rate over
valuation time.
• 3. variable- growth model- assumes
that the rate of growth in dividends
will vary over time.
ZERO GROWTH
• The simplest way to picture the dividend valuation
model is to assume the stock has a fixed stream of
dividends. In other words, dividends stay the same
year in and year out, and they’re expected to do so in
the future. Under such conditions, the value of a zero-
growth stock is simply the capitalized value of its
annual dividends. To find the capitalized value, just
divide annual dividends by the required rate of return,
which in effect acts as the capitalization rate.
Value of a share of stock= annual dividends/ required
rate of return.
Ex. If a stock paid a (constant) dividend of $ 3 a
share and you wanted to earn 10% on your
investment , the value of a stock would be $30 a
share ( $ 3/.10 = $ 30).
• As you can see, the only cash flow variable that’s used
in this model is the fixed annual dividend. Given that
the annual dividend on this stock never changes, does
that mean the price of the stock never changes?
Absolutely not! For as capitalization rate- that is the
required rate of return- changes, so will the price of
the stock. Thus if capitalization rate goes up to, say,
15% the price of stock will fall to $20 ($3/.15)
 • The standard and more widely
recognized version of the dividend
valuation model assumes that
dividends will grow over time at a
specified rate. In this version, the
CONSTANT value of a share of stock is still
GROWTH considered to be a function of its
future dividends, but such dividends
are expected to grow forever (to
infinity) at a constant rate of
growth.
Value of a share of
stock = net year’s
dividends/ required • V = D1/k-g
rate of return –
constant rate of
growth in dividends
Where
D1= annual dividends expected to be paid next year
(the first year in the forecast period)
k= the capitalization rate, or discount rate (which
defines the required rate of return on the investment)
g= the annual rate of growth in dividends, which is
expected to hold constant to infinity.
This model succinctly captures the essence of stock
valuation: Increase the cash flow ( through D or g) and/or
decrease the required rate of return (k) and the value of
the stock will increase.
The constant growth DVM should not be used with just
any stock. Rather, it is best suited to the valuation of
mature, dividend-paying companies that hold
established market positions. These are companies with
strong transaction records that have reached the
“mature” stage of growth.
To see this dividend valuation model at work, consider a
stock that currently pays an annual dividend of $1.75 a
share. Lets say that by using the present value approach,
you find that dividends are growing at a rate of 8% a year,
and you expect they will continue to do so into the future.
In addition, you feel that because of the risk involved, the
investment should carry a required rate of return of 12%.
That is, given D(o)= $1.75; g=.08 and k=.12
Value of a share of stock = D (o) (1/g) / k-g

• = $1.75 (1.08) = $ 1.89 = $ 47.25

• .12- .08 .04
Thus if you want to earn 12% return on this investment
–made up of 8% in capital gains (g) plus 4% in dividend
yield (i.e. $1.89/$47.25= .04, then according to the
constant growth dividend valuation model you should
pay no more than $47.25 a share for this stock.
VARIABLE GROWTH
Essentially, the variable growth DVM derives, in two stages,
a value based on future dividends and the future price of the
stock (which price is a function of all future dividends.)
Value of a share of stock = present value of future dividends
during the initial variable growth period + present value of the
price of the stock at the end of the variable growth period.
V= (D1 x PVIF1) + (D2 x PVIF2) +….
+ Dv x PVIFv) +( Dv (1+g) x PVIFv)
k-g
Where
• D1, D2, etc= future annual dividends
• PVIF1 = present value interest factor, as specified by
the required rate of return for a given year t.
• v= number of years in the initial variable growth
period.
• This form of the DVM is appropriate for companies that
are expected to experience rapid or variable rates of
growth for a period of time-perhaps for the first 3 to 5
years- and then settle down to a constant (average)
growth rate thereafter.
Finding the value of a stock using the formula is actually a lot
easier than it looks. All you need to do is follow these steps:
Estimate annual dividends during the initial variable growth
period and then specify the constant rate, g, at which
dividends will grow after the initial period.
Find the present value of the dividends expected during
the initial variable growth period.
Using the constant growth DVM, find the price of the stock
at the end of the initial growth period.

Find the present value of the price of the stocks ( as

determined in step 3). Note that the price of the stock is
discounted at the same PVIF as the last dividend payment
in the initial growth period, because the stock is being
priced (per step3) at the end of this initial period.
5. Add the two present value components (from steps 2 and 4) to
find the value of a stock.
Ex. Lets assume that dividend of Sweatmore Industries will
grow at a variable rate for the first 3 years (2004,2005,and
2006.). After that, the annual rate of growth in dividends is
expected to settle down to 8% and stay there for the foreseeable
future. Starting with the latest (2003 annual dividend of $2.21 a
share, we estimate that Sweatmore’s dividends should grow by
20% next year (in 2004), by 16% in 2005, and then by 13% in 2006
before dropping to an 8% rate. Using these (initial) growth
rates, we therefore project that dividends in 2004 will amount
to $ 2.65 a share (2.21 x 1.20), and will rise to 3.08 ( 2.65 x
1.16) in 2005 and to 3.48 (3.08 x 1.13) in 2006.
In addition, given Sweatmore’s risk profile, we feel that the
investment should produce a minimum ( required) rate of
return(k) of at least 14%. We now have all the input we need
and are ready to put a value on Sweatmore Industries.

Using the variable growth DVM to value Sweatmore Stock

Steps:
1.Projected annual dividends: 2004 $ 2.65
2005 3.08
2006 3.48
Estimated annual rate of growth in dividends, g. for 2007
and beyond: 8%
2. Present value of dividends, using a required rate of
return, k, of 14%, during the initial variable growth period:

Year Dividends x PVIF = Present Value

(k=14%)
2004 $2.65 .877 $2.32
2005 3.08 .769 2.37
2006 3.48 .675 2.35
Total $ 7.04(to step 5)
3. Price of the stock at the end of the initial growth period:
P 2006= D 2007 =D 2006 x (1+g) = $ 3.48 x (1.08) = $3.75 = $62.50
k-g k-g .14-.08 .06
4. Discount the price of the stock (as computed above) back to
its present value, at k= 14%.
PV (P 2006) = $ 62.50 x PVIF (14%,3yr) = $62.50 x .675 = $ 42.19 (
to step 5).
5. Add the present value of the initial dividend stream (step) to
the present value of the price of the stock at the end of the
initial growth period (step 4).
Value of Sweatmore stock = $ 7.04 + 42.19 = $ 49.23
SOME ALTERNATIVES TO DVM
1. DIVIDENDS-AND EARNINGS- APPROACH (D & E)
It is stock valuation approach that uses projected dividends, EPS
and P/E multiples to value a share of stock.
Present value of a share of stock=present value of future dividends
present value of the price of the stock at the date of sale
V= (D1 x PVIF1) + D2 x PVIF2)+…
(Dn x PVIFn) + (SPn x PVIFn)
Where Dt = future annual dividend in year t
PVIFt= present value interest factor, specified at the required
rate of return)
SPn= estimated share price of the stock at date of sale, year N
N= number of years in the investment horizon
Note its similarities to the variable growth DVM: It’s also
presented value –based, and its value is also derived from future
dividends and the expected future price of the stock. The big
difference between the two procedures revolves around the rile
that dividends play in determining the future price of the stock.
That is, the D & E approach doesn’t rely on dividends as the
principal layer in the valuation process.
Therefore, it works just as well with lot in dividends, And
along that line, whereas the variable growth DVM relates on
future dividends to price the stock, the D&E approach
employs projected earnings per share and estimated P/E
multiples.

2. PRICE/EARNINGS (P/E ) APPROACH

The P/E approach is a favorite of professional security
analyst and is widely used in practice. It’s relatively
simple to use, because it’s based on the standard P/E
formula:
Stock price = EPS x P/E ratio
OTHER PRICE-RELATED PROCEDURES

 Price-to-cash-flow (P/CF) ratio

 Price-to-sales (P/S) ratio
 Price-to-book-value (P/BV) ratio

PCF has long been popular with investors, because

cash flow is felt to provide a more accurate picture of a
company’s earning power than net earnings. When used in
stock valuation, the procedure is almost identical to the
P/E approach.
Formula:

P/CF ratio = market price of common stock

cash flow per share

P/BV ratio= market price of common stock

Book value per share

P/S ratio = market price of common stock

Sales per share
 Thank you.

God bless you all.