Introduction to Valuation

1. Introduction to Valuation Chapter 3 Chapter 3: Introduction to Valuation

2. Price vs. Value • Price • cost to acquire something • “willing buyer and willing seller” • market clearing amount • Value • measure of “worth” • an opinion, not a certainty

3. Valuing Coca-Cola at Different Discount Rates • Coca-Cola (ticker symbol: KO) is currently selling for $54 • You expect the selling price in one year to be $64 and that KO will pay $0.80 in dividends during the year • Based on that information, your expected rate of return would be: Chapter 3: Introduction to Valuation

4. Coca-Cola; Price =$54

5. Time Value of Money: Multi-Period Models • Present value model can value investments that span multiple time periods • Since some cash flows can be expected to last forever, sometimes the terminal time period is infinity Chapter 3: Introduction to Valuation

6. Time Value of Money: Multi-Period Models • The value of a cash flow series is the discounted present value of all future cash flows • Where the discount rate, k, represents the cash flow’s appropriate required rate of return Chapter 3: Introduction to Valuation

7. Time Value of Money: Multi-Period Models • Cash flows can be • Cash dividends • Coupon interest • Rent income from real estate • Asset’s selling price, etc. Chapter 3: Introduction to Valuation

8. Example: PV of a Bond • Bond investors receive periodic coupon payments and a principal repayment upon maturity • For a three-year T-note this can be represented as:

9. Example: Estimating Value of Stock • You are considering purchasing stock • You think you should earn a required rate of return of 14.5% based on the stock’s risk level • You expect to sell the stock for $40 in two years • You expect to receive $2 in cash dividends each year for the next 2 years • What is the most you would be willing to pay for the stock?

10. Example: Estimating Value of Stock Chapter 3: Introduction to Valuation

11. Example: Stock With Constant Perpetual Growth Rate • You are considering purchasing stock in a large corporation: • The current price of the stock is $51.50 • You believe the current dividend of $3 will grow at a 3% rate in the future • You think 13% is a fair discount rate for stock of its risk level • What is the most you would be willing to pay for the stock?

12. Example: Stock With Constant Perpetual Growth Rate Chapter 3: Introduction to Valuation

13. Making Buy-Sell Decisions • Professional investors use their value estimates to make buy-sell decisions • If an investor could compute the value of an investment with certainty, the following simplified buy-sell rules would apply • If a security’s price < value it is underpriced and the investor should buy • If a security’s price = value it is correctly priced and the investor should not trade • If a security’s price > value it is overpriced and the investor should sell (or sell short) Chapter 3: Introduction to Valuation

14. Making Buy-Sell Decisions • Selling overpriced securities brings their price down • Buying underpriced securities brings their price up • Security prices are constantly changing as new information arrives • In a world of uncertainty it is impossible to know the value of an asset with certainty Chapter 3: Introduction to Valuation

15. Comparing Differences Between Prices and Values • Consensus value estimate • Will be narrow if most security analysts have similar value estimates • Security’s price will fluctuate in a narrow range around this value estimate • Will be wide if there is a great deal of variability in security analysts’ value estimates • Security’s price will fluctuate wildly Chapter 3: Introduction to Valuation

16. Active Investment Management • You forecast a P-E ratio of 40 times 2003’s estimated EPS of $2.09 • Your expected price in year 2003 is • 40 x 2.09 = $83.60 which has a present value (in 2000) of $51.27 • Your estimate of KO’s value in 2000 is • $2.18 + $51.27 = $53.45 Chapter 3: Introduction to Valuation

17. Passive Investment Management • Many studies suggest that the market is efficient in the semi-strong form • Suggests that the search for incorrectly-valued stocks may be too much trouble • Many passive investors invest in index funds • Mutual funds designed to track a particular market index • S&P500 Composite Index is the most popular Chapter 3: Introduction to Valuation

18. The Bottom Line • Value estimates form the basis for wealth-maximizing investment decisions • Security prices fluctuate due to changing value estimates by investors • Some investors follow an active investment strategy while others follow a passive one • Market prices adjust to rapidly reflect new information • Actions taken by profit-seeking speculators, short sellers, hedgers and arbitrageurs help allocate scarce resources Chapter 3: Introduction to Valuation

19. Problem 3-4

20. Problem 3-4

21. Problem 3-8

22. Problem 3-10-a

23. Problem 3-10-b