week 22 Stock Valuation - Summary

Stock Valuation

Learning Goals

• Discuss intrinsic value and required rates of return.

• Determine stock value using zero-growth, constant-growth, and variable growth dividend valuation models.

• Use present value-based models and price-relative procedures.

Valuation

• Stock valuation compares market price to intrinsic value to determine if a stock is under- or over-valued.

• Valuation is the process of determining a security's worth considering risk and return.

• Investors must determine future cash flows, timing, and required rate of return.

• A stock is worthwhile if:

  • Expected rate of return >= required return.

  • Justified price >= current market price.

• Required Rate of Return: The return required to compensate for investment risk.

  • Based on stock's beta, risk-free rate, and market return.

Stock Valuation Models

• Dividend Valuation Model (DVM): stock value as a function of future dividends.

  • Zero-growth: Assumes dividends will not grow over time.

  • Constant-growth: Assumes dividends grow at a constant rate.

  • Variable-growth: Assumes dividend growth varies over time.

Zero Growth

• Value of a zero-growth stock: PV of its annual dividends.

Constant Growth

• Estimating the dividend growth rate:

  • Historical dividend behavior.

  • Use PV arithmetic to find embedded growth rate.

• Stock Price Behavior:

  • Stock's price will grow at the same rate that dividends grow; growth rate + dividend yield = required return.

Variable Growth

• Allows variable dividend growth rates over time.

• Steps to value a stock:

  • Estimate annual dividends during initial variable-growth period; specify constant growth rate (g) after the initial period.

  • Find PV of dividends during initial period.

  • Use constant-growth DVM to find stock price at the end of the initial growth period.

  • Find PV of price from constant-growth period.

  • Add the two PV components together.

• The growth rate, g, has a large impact on the value derived.

Other Approaches to Stock Valuation

• Free cash flow to equity method: Estimates cash flow to stockholders.

• P/E approach: Stock valuation based on price-to-earnings ratio.

• Advantage: do not rely on dividends.

Free Cash Flow to Equity

• Estimates cash flow a company generates for its shareholders and discounts that to the present to determine the company’s total equity value.

• Free cash flow: cash flow remaining after expenses and investments.

• Can assume free cash flows: constant, grow at a constant rate, or grow at a rate that varies over time.

Price-to-Earnings (P/E) Approach

• Simpler approach using forecasted EPS for next year.

Other Price-Relative Procedures

• Base valuations on the assumption that stock value is linked to a performance characteristic.

  • Price-to-cash-flow (P/CF) ratio.

  • Price-to-sales (P/S) ratio.

  • Price-to-book-value (P/BV) ratio.

• Involve judgment and intuition.

Price-to-Cash-Flow (P/CF) Procedure

• Substitutes projected cash flow for earnings.

• Cash flow measures: cash flow from operating activities, free cash flow, EBITDA.

Price-to-Sales (P/S) and Price-to-Book-Value (P/BV) Ratios

• Substitutes sales or book value for earnings.

• Useful for companies with no earnings or volatile earnings.