Stock and Stock Valuation Study Notes

Principles of Finance

Chapter 11: Stock and Stock Valuation

11.1 Multiple Approaches to Stock Valuation

  • Methodologies for Stock Valuation: Two primary methodologies are utilized to value stocks issued by corporations:

    • Intrinsic or Fundamental Valuation:

    • This method involves a detailed examination of various types of cash flows generated by a company.

    • Cash flows are discounted to ascertain a company’s intrinsic value.

    • Relative Valuation:

    • This method compares the subject company against peer companies.

    • A common financial ratio is utilized (e.g., price earnings, price to book, enterprise value multiples).

    • Technical Analysis:

    • Although not strictly a valuation method, it aids in making buy-sell-hold decisions regarding stock transactions.

11.1 LO 1: Price-to-Earnings (P/E) Ratio

  • Definition and Calculation of P/E Ratio:

    • P/E Ratio Formula:

    • P/EextRatio=Price per ShareEarnings per ShareP/E ext{ Ratio} = \frac{\text{Price per Share}}{\text{Earnings per Share}}

    • Calculation Steps:

    1. Determine Earnings Per Share (EPS):

      • EPS=Net IncomeShares Outstanding\text{EPS} = \frac{\text{Net Income}}{\text{Shares Outstanding}}

    2. Identify the P/E ratio for the respective industry.

    3. Rearrange to find the share price:

      • Price per Share=EPS×P/E Ratio\text{Price per Share} = \text{EPS} \times \text{P/E Ratio}

11.1 LO 3: Price-to-Book (P/B) Ratio

  • Definition and Calculation of P/B Ratio:

    • P/B Ratio Formula:

    • P/B Ratio=Market Price per ShareBook Value per ShareP/B \text{ Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}

    • Calculation Steps:

    1. Calculate Book Value Per Share:

      • Book Value per Share=Shareholders’ EquityShares Outstanding\text{Book Value per Share} = \frac{\text{Shareholders’ Equity}}{\text{Shares Outstanding}}

    2. Determine the appropriate P/B ratio for the industry.

    3. Rearrange to find market price per share:

      • Market Price per Share=P/B Ratio×Book Value per Share\text{Market Price per Share} = \text{P/B Ratio} \times \text{Book Value per Share}

11.1 LO 5: Alternative Valuation Multipliers

  • Other Common Valuation Multipliers:

    • Valuation methods include:

    • P/S (Price-to-Sales) Ratio

    • P/CF (Price-to-Cash-Flow) Ratio

    • Dividend Yield

    • Valuation Process Steps:

    1. Select the benchmark.

    2. Identify comparable companies.

    3. Calculate the benchmark multiple.

    4. Apply the multiple to the target company.

    • Examples of Alternative Multipliers:

    • Price/Earnings Growth Ratio (PEG)

    • Enterprise Value/Revenue

    • Enterprise Value/EBIT

    • Enterprise Value/EBITDA

    • Enterprise Value/EBITDAR

11.2 Dividend Discount Models (DDMs)

  • Identification and Use of DDMs:

    • The Dividend Discount Model (DDM) is a stock valuation method based on the present value of expected future dividends.

    • Forms of DDMs Include:

    • Gordon Growth Model

    • Zero Growth Model

    • Constant Growth Model

    • Variable or Non-Constant Growth Model

    • Two-Stage Model

11.2: Dividend Payment Considerations

  • Dividends Relative to Company Growth:

    • Typically tied to company growth and profitability; possibilities include:

    • No growth in profits or dividends.

    • Consistent profit/dividend growth.

    • Variable growth rates over time.

    • All scenarios can be modeled using spreadsheet software.

11.3 Discounted Cash Flow (DCF) Model

  • Comparison with DDMs:

    • DCF models differ from DDMs in structure:

    • DCF focuses on cash flows rather than periodic dividends.

    • Determines the present value of the entire organization and allocates cash flows to shares outstanding.

    • DCF is considered a fundamental method of valuation due to its detailed operational analysis, unlike the shortcut approach of relative valuation.

    • General DCF Valuation Formula:

    • Stock Value=CF<em>1(1+r)1+CF</em>2(1+r)2+⋯+(TCF−g)(1+r)n\text{Stock Value} = \frac{CF<em>1}{(1 + r)^1} + \frac{CF</em>2}{(1 + r)^2} + \cdots + \frac{(TCF - g)}{(1 + r)^{n}}

11.3: Cash Flow Forecasting

  • Importance in DCF Models:

    • Detailed forecasts of income statement and balance sheet accounts are necessary for accurate cash flow estimation and discounting.

11.4 Preferred Stock

  • Definition of Preferred Stock:

    • Preferred stock is a form of equity providing preferential claims in ownership.

    • Features include:

    • Obligated dividends paid before any dividends to common stockholders.

    • Priority claim to assets during bankruptcy and liquidation over common stockholders.

    • Typically entitled to set or constant dividends paid each period.

11.4 LO 2: Valuing Preferred Stock

  • Valuation Model for Preferred Stock:

    • Valuing preferred stock can be treated as a form of DCF due to its fixed dividend nature.

    • Valuation Formula:

    • Stock Value=DividendDiscount Rate\text{Stock Value} = \frac{\text{Dividend}}{\text{Discount Rate}}

11.5 Efficient Markets

  • Characteristics for Market Confidence:

    • For market participants to feel confident, two essential characteristics must be fulfilled:

    • Operational Efficiency: Processes allowing buyers and sellers to execute orders promptly and accurately. Continuous evolution of technology plays a role in this.

    • Informational Efficiency: Refers to how well and timely relevant information about companies and markets is processed by investors.

11.5: Efficient Market Assumptions

  • Efficient Markets Hypothesis:

    • The hypothesis outlines how effectively the market processes information based on:

    1. Mandated public disclosure of relevant information about securities since the 1930s (Securities Act of 1933 and Securities Exchange Act of 1934).

    2. Dependency of informed decision-making by investors based on this information.

    • The market's efficiency can be categorized as strong, semi-strong, or weak, based on varying perspectives.