McGraw-Hill/Irwin

1. Chapter Seven Valuation of the Individual Firm © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

2. Basic Valuation Concepts Based on: • Dividend valuation models (sum of the present value of dividends expected to be received in the future) • Earnings valuation model (price-earnings ratio, or multiplier of earnings) Value (price of a share/stock)

3. Basic Valuation Concepts cont. • Long-run historical relationships between “market price” of the stock and • Sales (or revenues) • Book value • Market value of assets • Cash • Liquid assets • Replacement value of plant & equipment • Hidden assets (undervalued holdings)

4. Review ofRisk & Required Return Concepts • Required rate of return: • Required rate of return on the various RISK CLASSES of assets

5. Risk & Required Return Concepts cont. RF (Risk free rate) = (1+ Real rate)(1 + Expected rate of inflation) – 1

6. Risk & Required Return Conceptscont. Adding a “risk” component to the risk free rate Ke = RF + b(KM- RF) Ke = Required rate of return RF = Risk free rate b = Beta coefficient KM = Expected return for common stocks in the market (KM - RF ) = Equity risk premium (ERP) beta risk free rate Equity risk premium

7. Beta (β) b • Individual company risk • Compare with market risk (e.g. S&P 500) • b > 1 more risk than the market • b < 1 less risk than the market • b = 1 same risk as the market

8. Dividend Valuation Models • General Dividend Model • Constant Growth Model • A Nonconstant Growth Model

9. General Dividend Model …+ P0 = where: P0 = Present value of the stock price Dt = Dividend for each year, e.g.1, 2, 3,..∞ Ke = Required rate of return (discount rate)

10. Constant Growth Model P0 = where: P0 = Present value of the stock price Dt = Dividend for each year, for example, 1, 2, 3,..∞ Ke = Required rate of return (discount rate) D0(1+g)1 = Dividends in the initial year D0(1+g)2 = Dividends in year 2, and so on g = Constant growth rate in the dividend

11. Constant Growth Model cont. If the following two conditions are met • Constant growth rate g • Required rate of return Ke > growth rate g Then constant growth model formula becomes P0 = D1/(Ke – g)

12. Numerical Example

13. A Nonconstant Growth Model Combination of different growth rates Example: Constant growth in dividends 20% per year for the first 10 years, and 8% perpetual growth rate after that Application Example – Please click on the Excel to see calculations for JAYCAR Also, Figure 7-1 on page 174 in the textbook

14. Earnings Valuation Model • The Combined Earnings and Dividend Model • More comprehensive, using both EPS (earnings per share) & P/E (earnings multiplier, or P/E Ratio) Combined with a Finite dividend model Application Example – Please click on the Excel to see calculations for J&J I. II.

15. EVA: Economic Value AddedThe Real World of Investing • New valuation concept • Considered by • Coca Cola • Eli Lilly • Merrill Lynch • Monsanto • Emphasize maximizing EVA • Less interested at generating EPS Continued

16. EVA cont. (Capital) Investment decision made or projects accepted ONLY IF > Founders of EVA www.sternstewart.com

17. The Price-Earning Ratio • The P/E Ratio for Individual Stocks • The Pure, Short-Term Earnings Model • Relating an Individual Stock’s P/E Ratio to the Market

18. The Price-Earning Ratio • Mathematically P/E ratio = (1) Price per share (2) Earnings per share • Ultimately P/E ratio is set by investors • Bid price up or down in relation to earnings • (1) Today’s price • (2) Latest 12-month earnings per share

19. Factors Affecting P/E Ratio • Investors’ expectation of EPS • Expected growth in EPS • Historical analysis • Overall conditions in the stock market • Growth prospects in the economy • Inflation inversely related to P/E ratio • CPI goes down P/E ratio goes up • CPI goes up P/E ratio goes down

20. The P/E Ratio for Individual Stocks 1. Growth prospect 2. Risk associated with future performance 3. Debt to equity ratio Continued

21. The P/E Ratio for Individual Stocks cont. 4. Dividend policy 5. Quality of management 6. Technology and research 7. Fads 8. Government policy and politics 9. Can you think of any other factors that could affect the P/E ratio of an individual stock?

22. The P/E Ratio for Individual Stocks cont.

23. The Pure, Short-Term Earnings Model • Investors/speculators • Short term view • Ignore present value analysis of • Dividends & • Earnings per share Instead Compute estimated value of stock

24. Relating an Individual Stock’s P/E Ratio to the Market • Sales per share (SPS) • Dividends per share (DPS) • Cash Flow per share (CFPS) • Book Value per share (BVPS) Continued

25. Relating an Individual Stock’s P/E Ratio to the Market cont. • Stock Price • P/E Ratio of a stock (JNJ • P/E Ratio of S&P 500 • Relative P/E Ratios Relative P/E Ratio = See Table 7-4 on page 183 Company P/E S&P 500 P/E

26. Other Valuation Models Using Average Price Ratios and 10-Year Averages A. Avg. Price/Avg. Sales per share (SPS) Example: Price-to-SPS Ratio = $36.79/$9.61 = 3.83 Price-to-SPS Ratio x Est. SPS = Projected Price 3.83 x $15.12 = $57.91 Please refer to Table 7-5 on page 185

27. Other Valuation Models Using Average Price Ratios and 10-Year Averages cont. Similar calculations as shown on the previous slide for: B. Price to dividends per Share (DPS) C. Price to cash flow per share (CFPS) D. Price to book value per share (BVPS)

28. Forecasting Earnings per Share Investors get earnings forecasts from: • Brokerage house research • Investment advisory firms • Value Line • Standard & Poor’s • Financial magazines • Forbes • Business Week • Worth • Money • Do it themselves

29. Forecasting Earnings per Share • Least Squares Trendline • The Income Statement Method

30. Least Squares TrendlineFor Forecasting EPS • Least squares trend analysis, most popular • Statistical method • Trendline fitted to a time series of historical earnings (observations) • A straight line that minimizes the distance of the individual observations from the line

31. The Income Statement Method • Start with sales forecast • Create standardized set of financial statements • Based on historical relationships • Sales forecast must be accurate to give a meaningful EPS • Important factors • Profitability • Fluctuations in profit margins Before tax After tax

32. Growth Stocks • In assessing the worth of an investment, the term growth stock is used by • Stockholders • Analysts • Investors • Common stock of a company growing faster than the economy or market norm • Predictable earnings growth Definition

33. Growth Companies Definition • Companies that exhibit rising returns on assets each year • Sales growing at an increasing rate (growth phase of the life cycle curve) • Usually, not as well-known as growth stocks Continued

34. Growth Companies cont. Example of industries: • Computer networking • Cable television • Cellular telephones • Biotechnology • Medical electronics • Can you suggest any more industries?

35. Assets as a Sources of Stock Value • Consider assets as opposed to earnings and dividends • Cash & marketable securities • Buildings • Land • Timber • Old movies • Natural resources Continued $ $ $

36. Natural Resources • Present value of the future income stream expected from resources • Assets may not be producing any current income • Market value of resources could be much higher than • Book value • Common stock prices

37. Hidden Assets • Assets not readily apparent to investors • Can add substantial value to firm • Assets do not always show up on the books Example: Fully depreciated movies • Sound of Music • 101 Dalmations • Star Wars Substantial value left in TV or VCR market

41. Summary • Common stock valuation models, use • Dividends (present value) • EPS and P/E ratios • Growth • Risk • Capital structure • Dividend policy • Level of market in general • Industry factors • etc. Continued

42. Summary cont. Indicates • Hi P/E ratios • Lo P/E ratios Indicates