Valuing Stocks

Valuing Stocks - Study Notes

Learning Objectives

After studying this chapter, you should be able to:

  • 7-1: Understand stock trading reports in newspapers and online.
  • 7-2: Calculate the present value of a stock from future dividends and understand the implications on stock prices and P/E ratios.
  • 7-3: Apply valuation models to an entire business.
  • 7-4: Grasp the concept of "no free lunches" on Wall Street.

Introduction to Stock Valuation

  • Corporations can raise cash by either:
    • Borrowing money (fixed obligation to repay lenders)
    • Issuing shares of common stock (new shareholders become part-owners of the firm, no fixed obligation)
  • Understanding stock prices is essential for:
    • Valuating stock of non-traded companies (e.g. IPOs)
    • Making informed capital budgeting decisions
    • Trading on Wall Street
  • The chapter begins with an overview of how stocks are traded and factors determining stock prices.
Stock Trading Reports
  • Stock trading reports include:
    • Latest stock price
    • Price changes
    • Trading volume
    • Dividend yields
    • Price-to-earnings (P/E) ratios
  • Examples include:
    • FedEx stock trading report on platforms like Yahoo Finance presents:
    • Market capitalization: $43.867 billion
    • Daily trading volume: 2,730,374 shares
    • Current share price on July 28, 2020: $167.46
    • Earnings per share (EPS): $4.90
    • P/E ratio: rac167.464.90=34.18rac{167.46}{4.90} = 34.18
Importance of Stock Prices
  • Important for estimating:
    • Potential selling prices for upcoming IPOs
    • Making capital budgeting decisions to enhance shareholders' wealth
    • Analyzing investment opportunities on Wall Street

Stock Market and Valuation Models

Common Stocks and Stock Market
  • FedEx's initial public offering (IPO) in 1978 allowed it to raise capital from public investors.
  • The sale of additional shares is termed a primary offering and occurs in the primary market.
  • Secondary market allows previously issued securities to be traded among investors (e.g. NYSE, NASDAQ).
    • Trading primarily executed electronically.
Order Types in Stock Trading
  • Market orders and Limit orders:
    • Market Order: Buy or sell at the best available price.
    • Limit Order: Buy or sell at a specified price; not executed immediately if unable.
  • Example:
    • Ms. Jones sells 30 shares under a market order at $167.40.
    • Mr. Brown places a limit order at $167.50.
Reading Stock Market Listings
  • Investors leverage online tools like Yahoo Finance to check:
    • Stock price changes
    • Trading volumes
    • Market capitalization, P/E ratios, and historical price trends

Valuation Approaches

Market Values, Book Values, and Liquidation Values
  • Book Value: Total asset values minus liabilities on the balance sheet (e.g. FedEx’s total assets: $73,537 million and total liabilities: $55,242 million).
  • Book values may not reflect market values; for instance, FedEx's shares trade at $130, while the book value per share is $70.03.
  • Liquidation Value: Cash available after selling all assets and paying off liabilities; this metric does not account for a company's going-concern value.
Intrinsic Value and Going-Concern Value
  • Going-Concern Value includes:
    • Extra Earning Power: Higher returns than book value.
    • Intangible Assets: Expertise not documented on the balance sheet (e.g. R&D).
    • Future Investments Opportunities: Expectations of profitable investments increase current stock prices.
Understanding Stock Value Components
  • Market value considers:
    • Current earning capacity
    • Growth opportunities
  • Investors may assess stocks as having higher values due to expected future earnings and market positioning (e.g. Amazon, estimated at over 130 times earnings).

Pricing Models & Ratios

Valuation by Comparables
  • Analysts often use Comparables: ratio of market values to book values (Market-to-Book ratios).
    • Example: Johnson & Johnson and others referenced to derive comparable values.
Present Value of Future Cash Flows
  • Intrinsic Value formula: P_0 = rac{DIV_1 + P_1}{1 + r}
  • The present stock value includes all anticipated dividends and stock price at a specified discount rate (r).
  • Define intrinsic value as the present value of future cash inflows from dividends and capital gains.

Dividend Discount Model

Dividend Valuation Approaches
  • Without Growth: {P_0 = rac{DIV_1}{r}}
  • Constant Growth Model: P_0 = rac{DIV_1}{r - g} where g is the growth rate of dividends.
  • Horizon Valuation: When growth phases are anticipated to change, explore present values of dividends up to a transition point then use a constant growth model post-transition.

Conclusion & Real-World Applications

  • Investors face challenges valuing stocks due to future uncertainties, leading to reliance on market-based estimates in practice.
  • Comparison tools and internal methodologies such as the Dividend Discount Model facilitate informed investment decisions across various company types and growth phases.
  • The market's efficiency challenge often suggests trusting established market prices unless significant advantages are foreseen, emphasizing thorough analysis in investment decisions.

Summary of Key Insights

  • Market behaviors and valuation methods are crucial for assessing stock values.
  • The Dividend Discount Model offers foundational principles for valuing stocks based on future expected dividends.
  • Behavioral finance introduces considerations for investor psychology influencing market valuations, such as overconfidence and risk aversion.
Listing of Equations
  • V_0 = rac{DIV_1 + P_1}{1 + r}
  • P_0 = rac{DIV_1}{(1 + r)} + rac{DIV_2}{(1 + r)^2} + rac{DIV_H + P_H}{(1 + r)^H}
  • P_0 = rac{DIV_1}{r - g} (Constant-growth model)
  • r = rac{DIV_1}{P_0} + g
  • Sustainable Growth Rate (g): g=ROEimesplowback<br/>atiog = ROE imes plowback<br /> atio