Valuation: Obtaining a Standard Performance:

The underlying purpose of stock valuation is to obtain a performance estimate of a stock's intrinsic value that can be used to judge the investment merits of a share of a stock.

The primary reason for looking at past performance of the company is to gain insight about the future direction of the company.

Sales forecast can be generated by using the past sales rate of the company.

Common-size income statement takes every entry found on a normal dollar-based financial statement and converts it to a percentage by dividing each item by net sales. These statements enable the users to compare operating results from one year to the next.

Future after-tax earnings in year t = Estimated sales for year t x Net profit margin expected in year t

To estimate corporate earnings forecast, we need an estimate of future dividend payout ratio, the number of common shares that will be outstanding over the forecast period, and a future P/E ratio. It is generally safe to use the current payout ratio, and the number of outstanding shares for the forecast.

The P/E ratio is a function of several variables such as 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, and 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. If the inflation increases, so do the bond interest rates. Thus the return on stocks increase and higher required returns on stock mean lower stock prices and lower P/E multiples. We can argue that a 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 because earnings growth tends to be more valuable than dividends, especially in companies with high rates of ROE.

Average market multiple is the average P/E ratio of all the stocks in a given market index and it indicates the general state of the market. Other things being equal, the higher the P/E ratio is, the more optimistic the market.

With the market multiple as a benchmark, you can evaluate a stock's P/E performance relative to the market. Relative P/E multiple can be calculated by dividing a stock's P/E by a market multiple.

The higher the relative P/E measure, the higher the stock will be priced in the market.

Estimated EPS in year t = Future after-tax earnings in year t / Number of shares of common stock outstanding in year t

Once you have EPS, you can combine it with (1) the dividend payout ratio to obtain (future) dividends per share, and (2) the price/earnings multiple to project the (future) price of the stock.

EPS = ROE x Book value per share

Estimated dividends per share in year t = Estimated EPS for the year t x Estimated payout ratio

Estimated share price at the end of year t = Estimated EPS in year t x Estimated P/E ratio

The Valuation Process:

Valuation is a process by which an investor determines the worth of a security using the risk and return concepts. To establish the value of an asset, the investor must determine the amount of future cash flows, the timing of these cash flows, and the rate of required return on the investment.

The stock valuation models determine either an expected rate of return or the intrinsic worth of a share of stock, which represents the stock's justified price. If the computed rate of return equals or exceeds the yield, or if the justified price is equal to or greater than the current market price, then we consider a stock is a worthwhile investment. However, the stock is still subject to economic, industry, company and market risks.

Security analysis and stock valuation models are used not to guarantee success, but to help you better understand the return and risk dimensions of a potential transaction.

We can define a stock's required return, using the CAPM equation:

Required rate of return = Risk-free rate + [Stock's beta x (Market return -Risk-free rate)]

Stock Valuation Models:

Investors employ a number of different types of stock valuation models. Value investors rely as much on historical performance as on earnings projections to identify undervalued stock. The growth investors concentrate primarily on growth in earnings.

The value of a share of stock is equal to the present value of all the future dividends it is expected to provide over an infinite time horizon. The basic dividend valuation model (DVM) reduces the need to estimate all future dividends individually by saying that the value of a share of stock is a function of dividends that are growing at a specified rate over time. In this way, each future dividend can be expressed as a function of the current dividend and a specified rate of growth in dividends. The discount rate applied to these future cash flows is the desired rate of return of the investor relative to the risk of the stock and the other returns available.

Three versions of DVM are:

(1)The zero-growth model assumes that dividends will not grow over time.

Value of a share of stock = Annual dividends / Required rate of return

(2)The constant-growth model assumes that dividends will grow by a fixed/constant rate over time.

Value of share of stock = Next year's dividends / (Required rate of return - Constant rate of growth in dividends

(3)The variable-growth model assumes that the rate of growth in dividends will vary over time.

Value of a share of stock = Present value of future dividends during the initial variable-growth period + Present value of the stock at the end of the variable-growth period

The DVM is very sensitive to the growth rate being used, because that rate affects both the model's numerator and its denominator.

g = ROE x The firms' retention rate, rr

where, rr = 1 - dividend payout ratio

Other Approaches to Stock Valuation:

The motivation for using alternative approaches is to find techniques that are compatible to given investment horizons and/or that can be used with non-dividend-paying stocks. Two of the commonly used alternative approaches are dividends-and-earnings approach, and P/E approach.

Dividends-and-earnings approach (D&E approach):

Dividends-and-earnings approach directly utilizes future dividends and the future selling price of the stock as the relevant cash flows.

Value of a share of stock = Present value of future dividends + Present value of the price of the stock at the date of sale

D&E approach is similar to the variable-growth DVM: It is present-value based, and its value is derived from future dividends and the expected future price of the stock. The difference is that the D&E approach does not rely on dividends as the principal player in the valuation process, and it is more flexible than the DVM and easier to understand and apply.

P/E Approach:

P/E approach builds the stock valuation process around the stock's P/E ratio. The advantage of using these approaches is that they do not rely on dividends as the only input and is widely used by professional security analysts.

Stock price = EPS x P/E ratio

Other Price-Relative Procedures:

Investors prefer to use the price-to-cash-flow (P/CF) procedure because cash flow is felt to provide a more accurate picture of a company's earning power than net earnings. Some investors use cash flow from operating activities, and some use free cash flow.

P/CF ratio = Market price of common stock / Cash flow per share

where, cash flow per share = EBITDA / number of common shares outstanding

Some startup companies may not generate predictable earning. In this case, investors prefer to use the procedures that are based on sales or book value such as price-to-sales (P/S), and price-to-book-value (P/BV) ratios.

P/BV Ratio = Market price of common stock / Book value per share

P/S Ratio = Market price of common stock / Sales per share

Many bargain-hunting investors look for stocks with P/S ratios of 2.0 or less, and P/BV ratios of less than 7.0.

Having reviewed these topics from Chapter 6, please answer the following using your own original examples:

1.What is the purpose of stock valuation and the role of intrinsic value?

2.What is the importance of P/E ratio in stock's future price behavior?

3.Define average market multiple and relative P/E multiple.