FINA UNIT 9 REVIEW - Stocks and Stock Valuation

Multiple Approaches to Stock

Valuation

1. Intrinsic or fundamental valuation: This method carefully

examines various types of cash flows generated by the company

and discounts them to arrive at a value.

2. Relative valuation: This method dispenses with examination of a

company’s financials and instead values the subject company

against peer companies by using a common financial ratio (e.g.,

price earnings, price to book, enterprise value multiples).

* A third approach, technical analysis, is not a valuation method per

se but is often used to provide insights into buy-sell-hold decisions

about stock.

Define and calculate a P/E (price-

to-earnings) ratio

Define and calculate a P/B (price-to-

book) ratio

Define and detail alternative valuation

multipliers, including P/S ratio, P/CF

ratio, and dividend yield.

Enterprise Value (EV) Multipliers

Enterprise Value (EV) Multipliers 2

– EV/Revenue (EV/R). Also called EV/Sales, EV/R is a valuation metric

used to understand a company’s total valuation compared to its annual

sales levels. EV/R can help provide an analyst with an idea of exactly

how much investors pay for every dollar of a company’s sales revenue.

EV/R is considered a relatively crude metric but can be useful when

analyzing companies that have different methods of revenue recognition.

– EV/EBIT. A firm’s earnings before interest and taxes (EBIT) is an

indicator of its profitability before the effects of interest or taxes. EBIT is

also referred to as operating earnings, operating profit, and profit before

interest and tax.

– EV/EBITDA. EV/EBITDA is a ratio that compares a company’s

enterprise value (EV) to its earnings before interest, taxes, depreciation,

and amortization (EBITDA). EBITDA is often used by analysts as a

substitute for cash flow and can be applied to capital analysis using tools

such as net present value and internal rate of return. It is relatively easy

to calculate, EV/EBITDA ratio is a commonly used metric to compare the

relative values of different businesses.

Identify and use DDMs (dividend

discount models)

The dividend discount model (DDM) is a stock

valuation method based on the concept that a

share’s worth is the present value of all the future

dividends it pays.

• The DDM has many forms depending on assumptions made about

the company and future dividends it pays.

– The Gordon Growth Model

– Zero Growth Model

– Constant Growth Model

– Variable or Non-constant Growth Model

– Two-Stage Model

Dividend Discount Models (DDMs)

• Companies normally pay dividends in relation to the

company’s growth and profitability.

• No growth in profits/dividends may be assumed.

Alternately, profits/dividends may grow consistently or at

different rates over different time periods. All of these

scenarios can be modeled using spreadsheet software.

Gordon Growth Model

Zero Growth Model

Constant Growth DDM

Final Thoughts on DDMs

Discounted Cash Flow (DCF) Model

• When investors buy stock, they do so in order to receive cash inflows at

different points in time in the future. These inflows come in the form of cash

dividends (provided the stock does indeed pay dividends, because not all do) and

also in the form of the final cash inflow that will occur when the investor decides to

sell the stock.

• The investor hopes that the final sale price of the stock will be higher than the

purchase price, resulting in a capital gain. The hope for capital gains is even

stronger in the case of stocks that do not pay dividends.

• When securities have been held for at least one year, the seller is eligible for

long-term capital gains tax rates, which are lower than short-term rates for most

investors. This makes non-dividend-paying stocks even more attractive, provided

that they do indeed appreciate in value over the investor’s holding period.

• Meanwhile, short-term gains, or gains made on securities held for less than

one year, are taxed at ordinary income tax rates, which are usually higher and

offer no particular advantage to an investor in terms of reducing their taxes.

Discounted Cash Flow (DCF) Model

• The DCF model is an absolute valuation model, meaning that it does

not involve comparisons with other firms within any specific industry but

instead uses objective data to evaluate a company on a stand-alone

basis.

• The DCF model focuses on a company’s cash flows, determining the

present value of the entire organization and then working this down to

the share-value level based on total shares outstanding of the subject

organization.

• This highly regarded methodology is the evaluation tool of choice for

experienced financial analysts when evaluating companies and their

common stock.

• Many analysts prefer DCF methods of valuation because these are

based on a company’s cash flows, which are far less easily manipulated

through accounting treatments than revenues or bottom-line earnings.

Applying the DCF Model

How the DCF model differs from DDMs

Define preferred stock.

Preferred stock is a form of equity sold by some

firms that offers preferential claims in ownership.

• Preferred stock features a dividend that a company is obligated to

pay before any dividend payments to common stockholders.

• In bankruptcy and liquidation, preferred stockholders have priority

claim to assets before common stockholders.

• Preferred stockholders are usually entitled to a set (or constant)

dividend every period.

Calculate the intrinsic value of

preferred stock.

Common Stock vs. Preferred Stock

Efficient Markets

Operational and Informational

Efficiency

• Operational efficiency involves the “mechanics” of the

market that allow buyers and sellers to execute their

orders as quickly and accurately as possible. Such

systems continue to evolve as the technology employed

evolves.

• Informational efficiency describes how much and how

well relevant information about companies, markets, and

economics is processed by investors.

Efficient Market Assumptions

The well-known efficient markets hypothesis describes

how well the market processes relevant information. It

rests on two assumptions:

1. Since the 1930s, with the Securities Act of 1933 and the Securities

Exchange Act of 1934, securities issuers must provide to the public all

relevant and correct information regarding a securities issuance.

2. Investors use this information to make knowledgeable buy-sell-hold

decisions.

Depending on one’s view, the market may be considered

efficient, but to varying degrees it is categorized having as

strong, semi-strong, or weak efficiency.

Summary

• This section introduced common stock and some of the models and

calculation methods used by investors and financial analysts to determine the

prices or values of common shares. The most evaluative ratios that can be

computed from a company’s financial statements include the price-to-earnings

(P/E), price-to book (P/B), price-to-sales (P/S), and price-to cash-flow (P/CF)

ratios.

• The dividend discount model, or DDM, is a method used to value a stock

based on the concept that its worth is the present value of all of its future

dividends. The most common DDM is the Gordon growth model, which values

stock entirely on expected future dividends. Other techniques include the zero

growth DDM, which depends on fixed dividends; the constant growth DDM, which

assumes that dividends will grow at a constant rate; and the variable growth or

nonconstant growth DDM, which is based on the assumption that stock value will

progress through different stages of growth. There is also the two-stage DDM,

which is based on the assumption of two stages of dividend growth: an initial

period of higher growth and a subsequent period of lower, more stable growth.

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Summary (2 of 2)

• Investors buy stock to receive cash inflows at different points in the future. These

inflows may come in the form of dividends or a final cash inflow. If the investor

chooses to wait for a final cash flow, the hope is that capital gains will be even

stronger. The DCF model is usually used to evaluate firms that are relatively young

and do not pay dividends to their shareholders. The DCF model focuses on a

company’s cash flows, determining the present value of an entire organization using

objective data and then working this down to the share-value level based on total

shares outstanding of the subject organization.

• Preferred stock is a unique form of equity sold by some firms that offers preferential

claims in ownership. Preferred stock carries a stated par value, but unlike bonds,

there is no maturity date, and consequently, there is no final payment of the par value.

The term preferred comes from preferred shareholders receiving all past (if

cumulative) and present dividends before common shareholders receive any cash

dividends.

• Efficient markets are markets in which costs are minimal and prices are current and

fair to all traders. There are two forms of efficiency: operational efficiency and

informational efficiency. Operational efficiency concerns the speed and accuracy of

processing a buy or sell order at the best available price. Informational efficiency

concerns how quickly a source reflects comprehensive information in the available

trading prices. Financial economists have devised three forms of efficient markets

from an information perspective: weak form, semi-strong form, and strong form.

Key Terms

Amortization

the process of spreading business costs in accounting; similar

to depreciation, but differs in that it generally refers to intangible assets such as

patents or copyrights

capital employed

also known as funds employed; the total amount of capital

used for the acquisition of profits by a firm or on a project

common stock

a security that represents partial ownership of a corporation

comparable company analysis (comps)

a method for valuating a company

using the metrics of other businesses of similar size in the same industry

Depreciation

the process of spreading business costs in accounting; similar to

amortization, but differs in that it generally refers to fixed, tangible assets such as

buildings, machinery, furniture, fixtures, and equipment

discounted cash flow (DCF)

a method for estimating the value of an

investment based on the present value of its expected future cash flows

Dividend

a sum of money paid regularly (typically quarterly) by a company to

its shareholders out of its profits or reserves

dividend discount model (DDM)

a quantitative method for predicting the

price of a company’s stock based on the theory that its present-day price is worth

the sum of all of its future dividend payments when discounted back to their

present value

dividend yield

a financial ratio (dividend/price) that shows how much a

company pays out in dividends each year relative to its stock price, expressed as

a percentage

earnings per share (EPS)

the ratio of a company’s profits to the outstanding

shares of its common stock; serves as an indicator of a company’s profitability

EBIT

short for earnings before interest and taxes; an indicator of a firm’s

profitability before the effects of interest or taxes; also referred to as operating

earnings, operating profit, and profit before interest and tax

efficient markets

markets in which costs are minimal and prices are current,

fair, and reflective of all available relevant information

enterprise value (EV)

a company’s total value; often used as a more

comprehensive alternative to equity market capitalization

enterprise value (EV) multiples

also known as company value multiples;

ratios used to determine the overall value of a company and, by extension, the

value of its common stock

equity multiples

metrics that calculate the expected or achieved total return

on an initial investment

Gordon growth model

a methodology used to determine the intrinsic value of

a stock based on a future series of dividends that grow at a constant rate

growth rate

the rate at which the dollar amount of dividends paid on a specific

stock holding increases

intangible assets

assets that are not physical in nature, such as goodwill,

brand recognition, and intellectual property (i.e., patents, trademarks, and

copyrights)

Review Questions

1. Briefly discuss one of the primary benefits of using comparative P/E ratios.

Primary benefits of using comparative P/E ratios: Comparative P/E ratios provide a straightforward, relative valuation method. They allow investors to quickly benchmark a company against industry peers to determine if its stock is overvalued or undervalued based on current earnings rather than relying on complex cash flow projections.

2. Name an important characteristic of companies for which the price-to-book (P/B) ratio does

not work well.

Characteristic of companies where P/B ratio does not work well: The price-to-book ratio is ineffective for technology, service-oriented, or asset-light companies that have few tangible assets but derive significant value from intangible assets (like intellectual property, software, or human capital) not reflected on the balance sheet.

3. Briefly describe the main type of scenario in which the two-stage DDM approach might be

used to value a firm and its stock.

Scenario for the two-stage DDM approach: This approach is best used to value companies expected to experience an initial phase of rapid, high dividend growth (e.g., due to a new product line or market expansion), followed by a transition into a steady, sustainable, and lower long-term growth rate.

4. Briefly describe a major shortcoming of the zero growth DDM model.

Major shortcoming of the zero growth DDM model: The model unrealistically assumes that a company's dividend payments will remain exactly the same fixed dollar amount in perpetuity, ignoring inflation, earnings growth, and changing economic conditions.

5. Briefly describe the required inputs for the discounted cash flow (DCF) model.

Required inputs for the DCF model: A discounted cash flow model requires projected future cash flows for a specific forecast period, an estimated terminal value at the end of that period, and a discount rate (the required rate of return) to calculate the present value of those flows.

6. Briefly describe preferred stock and some of its ownership advantages compared to

common stock.

Preferred stock and ownership advantages: Preferred stock is an equity security with priority over common stock. Its main advantages are receiving a predetermined, constant dividend before any common dividends are paid and having a higher priority claim on the company's assets during liquidation.

7. Briefly explain what is meant by the terms cumulative and noncumulative as they relate to

preferred stocks.

• Cumulative vs. noncumulative preferred stocks: "Cumulative" means any unpaid past dividends (dividends in arrears) accumulate as a liability and must be paid to preferred shareholders before any dividends can be issued to common shareholders. "Noncumulative" means missed dividends do not accrue; if the company skips a payment, the shareholder loses the right to collect it later.

8. What were Super DOT and SOES, and what were they designed to do?

Super DOT and SOES: These were early electronic order routing and execution systems used by major stock exchanges (NYSE and NASDAQ) to increase operational efficiency. They allowed brokers to instantly route and execute trades (especially small orders) electronically rather than relying on manual, human floor trading.

9. What are operational efficiency and informational efficiency, and how do they differ in terms

of trading markets?

Operational vs. informational efficiency: Operational efficiency refers to the "mechanics" of the market—how quickly, accurately, and cheaply buyers and sellers can execute orders. Informational efficiency refers to how rapidly and accurately relevant public information is processed and reflected in current security prices.

10. What is meant by informational efficiency, and how does it affect the price of a stock?

Informational efficiency and stock prices: Informational efficiency implies that a stock's current market price already incorporates all available relevant information. Therefore, an investor cannot consistently achieve higher-than-average returns by trading on public information, as the price has already adjusted to reflect that data.

Problems

1. Today, Sysco Enterprises paid dividends on its common stock of $1.25 per

share. If dividends per share are expected to increase to $3.50 per share six years

from now, what is the percentage dividend growth rate?

2. Let’s say you want to purchase shares of Fontaine Ltd. and then hold this stock

for six years. The company has a stated dividend policy of $2.00 annually per share

for the next six years, at the end of which time you will sell the stock. You expect to

be able to sell the stock for $35.00 at that time. If you want to earn an 8% return on

this investment, what price should you pay today for this stock?

3. Damian Painting Systems has established a dividend policy of $3.00 per share

per year. If the company plans to be in business forever, what is the value of this

stock if an investor wants a 10% return?

4. Wilk Productions wants its shareholders to earn a 12% return on their

investment in the company. At what value would Wilk stock be priced if the

company paid $2.75 per share in constant annual dividends forever?

5. Dax Industrial Systems has stock currently priced at $50.00 per share. If

investors are earning a 7% return on Dax Industrial, what is the company’s annual

dividend payment per share?

6. If a stock is selling at $400 with a current dividend of $40 and a potential

investor’s required rate of return is 15%, what would be the anticipated dividend

growth rate?

7. Mind Max Inc. has a dividend policy that increases annual dividends by 3%

each year. If last year’s dividend was $2.00, the company intends to stay in

business for 50 years, and an investor wants a 9% return, what would be the

price of Mind Max stock?

8. Odon Corp. paid dividends today in the amount of $1.50 per share. If Odon will

pay dividends of $5.00 10 years from today, what is the annual dividend growth

rate over this 10-year period?

9. The Kirkson Distributors common stock is currently selling at $52.00 per share,

pays dividends annually at $2.50 per share, and has an annual dividend growth

rate of 2%. What is the required return?

10. If a preferred share of stock pays dividends of $2.50 per year and the

required rate of return for the stock is 6%, what is its intrinsic value?