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20 Cards in this Set
- Front
- Back
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Valuing a Company and Its Future
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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 |
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Steps in Valuing a Company
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Step 1: Forecast future sales & profits
Step 2: Forecast future EPS and dividends Step 3: Forecast future stock price |
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Step 1: Forecast Future Sales and Profits
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Forecasted Future Sales based upon:
-“Naïve” approach based upon continued historical trends, or - Historical trends adjusted for anticipated changes in operations or environment Forecasted Net Profit Margin based upon: -“Naïve” approach based upon continued historical trends, or - Historical trends adjusted for anticipated changes in operations or environment, or - Earnings forecasts from brokerage houses, Value Line, Forbes, or other sources |
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Future after-tax earnings in year t - formula
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Estimated sales for year t * Net profit margin expected in year t
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Step 2: Forecast Future EPS
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Forecasted outstanding shares of common stock based upon:
- “Naïve” approach based upon continued historical tends, or - Historical trends adjusted for anticipated changes in operations or environment Forecasted Earnings Per Share (EPS) based upon: Est. EPS for year t = Future after tax earnings in year t / # of shares of common stock outstanding in year t |
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Forecast Future Dividends
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Forecasted Dividend Payout ratio based upon:
- “Naïve” approach based upon continued historical trends, or - Historical trends adjusted for anticipated changes in operations or environment Est dividends per share in year t = Est EPS for year t * Est payout ratio |
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Forecast P/E Ratio
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Estimated P/E ratio based upon:
- “Average market multiple” of all stocks in the marketplace, or “Relative P/E multiple” of individual stocks - Adjust up or down based upon expectations of economic conditions, general stock market outlook in near term, or anticipated changes in company’s operating results Estimated P/E ratio is function of several variables, including: -Growth rate in earnings -General state of the market -Amount of debt in a company’s capital structure -Current and projected rate of inflation -Level of dividends |
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Step 3: Forecast Future Stock Price formula
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est share price in year t = Est EPs in year t * est PE ratio
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Using Stock Valuation
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Once we have an estimated future stock price, we can compare it to the current market price to see if it may be a good investment candidate:
current price < estimated price undervalued current price = estimated price fairly valued current price > estimated price overvalued |
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The Valuation Process - Valuation
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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 |
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Required Rate of Return
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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 = RF rate + [Stock's Beta * (MArket return - RF rate)] |
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Other Stock Valuation Methods
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- Dividend Valuation Model
*Zero growth *Constant growth *Variable growth - Dividend and Earnings Approach - Price/Earnings Approach - Other Price-Relative Approaches *Price-to-cash-flow ratio *Price-to-sales ratio *Price-to-book-value ratio |
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Dividend Valuation Model: Zero Growth
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Uses present value to value stock
Assumes stock value is capitalized value of its annual dividends Potential capital gains are really based upon future dividends to be received Assumes dividends will not grow over time value of a share of stock = annual dividends / Required rate of return |
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Dividend Valuation Model: Constant Growth
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Uses present value to value stock
Assumes stock value is capitalized value of its annual dividends Assumes dividends will grow at a constant rate over time Works best with established companies with history of steady dividend payments value of a share of stock = Next years dividends / RR of return - Constant rate of growth in dividends |
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Dividend Valuation Model: Variable Growth
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Uses present value to value stock
Assume stock value is capitalized value of its annual dividends Allows for variable growth in dividend growth rate Most difficult aspect is specifying the appropriate growth rate over an extended period of time value of a share of stock = PV of dividends during the initial varible-growth period + PV of Price of the stock at the end of the varible-growth period. |
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Dividends-and-Earnings Approach
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Very similar to variable-growth DVM
Uses present value to value stock Assumes stock value is capitalized value of its annual dividends and future sale price Works well with companies who pay little or no dividends PV of share of stock = PV of future dividends + PV of the price of the stock at date of sale |
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Price/Earnings (P/E) Approach
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Future price is based upon the appropriate P/E ratio and forecasted EPS
Simple to use and easy to understand Widely used in stock valuation Stock Price = EPS * PE Ratio |
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Price-to-Cash-Flow (P/CF) Approach
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Similar to P/E approach, but substitutes projected cash flow for earnings
Widely used by investors Many consider cash flow to be more accurate than profits to evaluate a stock P/CF ratio = Mkt price of Common stock / CF per share |
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Price-to-Sales (P/S) Approach
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Similar to P/E approach, but substitutes projected sales for earnings
Useful for companies with no earnings or erratic earnings P/S ratio =Mkt price of common stock / Sales per share |
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Price-to-Book-Value (P/BV) Approach
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Similar to P/E approach, but substitutes book value for earnings
P/BV Ratio = Market price of common stock / BV per share |
