BFM Stocks

Introduction to Financial Management

  • Accredited by AACSB, EQUIS, and AMBA

Valuing Stocks

Chapter Overview

  • Focus on a broad variety of stocks:

    • Ordinary common stocks

    • Preferred stocks

    • Warrants

    • Exchange-Traded Funds (ETFs)

      • Track overall markets (e.g., S&P 500)

      • Track specific industries, commodities, and countries

Learning Objectives

  • Valuation Skills:

    • Apply present value formulas to common stock valuation

    • Define relationships between stock prices, earnings, and growth opportunities

    • Use Free Cash Flow (FCF) to assess company value

Understanding Stocks

Definition and Characteristics

  • Stocks only offer future dividends, which may be indefinite.

  • Stocks are traded in:

    • Primary markets (initial sales)

    • Secondary markets (subsequent trading)

  • Comparison with bonds:

    • Bonds feature defined coupon payments and have a fixed term.

Stock Valuation - Book Value

Key Insights

  • Accounting Practices:

    • Quarterly and annual financial statements provide essential data.

  • Limitations of Book Value:

    • Reflects historical cost; may misrepresent current value.

    • Ignores inflation and intangible assets (e.g., trademarks, patents).

    • Does not capture going-concern value.

    • Generally not a reliable measure for stock valuation.

    • Serves as a benchmark and helps evaluate liquidation value.

Stock Valuation - Market Price Approaches

  • Two primary methods:

    • Comparative analysis with similar firms

    • Forecasting and discounting future dividends or cash flows.

Valuation by Comparables

Core Considerations

  • Investors assess how much they are willing to pay per dollar of earnings or book value.

  • Essential metrics:

    • Price-Earnings (P/E) Ratio

    • Price-to-Book (P/B) Ratio

Valuation by Comparables Analysis

Example: Eastman Chemical (NYSE: EMN)

Company

Market Value

Enterprise Value

P/E Ratio

P/B Ratio

Eastman

$13.31

$19.803

16.95

2.33

Dow Chemicals

$48.83

$60.189

7.35

2.73

DuPont

$33.29

$48.150

21.89

1.27

Air Products

$52.52

$60.405

24.35

3.89

Huntsman

$7.44

$9.428

6.56

1.73

Average

$31.08

$39.595

15.42

2.39

Challenges of Valuation by Comparables

  • Ratios may cluster together for similar companies, but can also display significant variation.

  • This method may not be applicable for start-ups or industries with broad pricing gaps.

Dividend Discount Model (DDM)

Core Understanding

  • Cash flows from stock ownership involve future dividends.

Value Analysis in DDM

  • Investors analyze expected cash flows, which vary with the holding duration:

    • One-Year Investor: Buys at Year 0, sells at Year 1, receives dividends.

    • Longer-Term Investors: Stock price reflects the perpetuity of stocks and dividends.

Implications of DDM

  • A stock has an infinite lifespan; present value is calculated based on future dividends.

Constant Growth Model - Gordon Growth Model

Overview

  • Assumes constant growth in expected dividends over time.

  • Formula breakdown involves:

    • Dividend yield

    • Expected rate of return

    • Assumed growth rate (g)

Estimating Growth Rate in the Constant Growth Model

Components

  • Payout Ratio: Ratio of dividends to earnings.

  • Plowback Ratio: Percentage of earnings reinvested in the firm.

  • Return on Equity (ROE): Measure of returns on past investments.

Calculation Example

  • Current EPS: $6, share price: $60; if dividends are cut to 75% for reinvestment, assess effect on P (price).

Income vs. Growth Stocks

Characteristics

  • Income Stocks: Focus on dividends; consistent dividend payments.

  • Growth Stocks: Emphasize anticipated capital gains; focus on reinvestment rather than immediate dividends.

Valuation Insights

  • PVGO (Net Present Value of Growth Opportunities):

    • Growth stocks have a high PVGO due to expected return on future investments.

    • Income stocks have limited PVGO, prioritizing dividend payouts.

Free Cash Flow (FCF) Valuation

Definition and Importance

  • FCF refers to cash available after operational expenses and necessary investments.

  • FCF is crucial for assessing total market value and potential returns to shareholders.

Valuation Challenges

  • Determining the correct time horizon and estimating horizon value can be complex.

Practical Exercise Example

  • Calculate FCF based on varying growth rates and ROA over specified periods.

Significant Considerations

  • The calculations rely heavily on assumptions, particularly the growth rate, which can significantly impact valuations.