BUS 205 Ch. 11

Free Cash Flow Model (FCFM)

based on present values of future cash flows. First, estimate the free cash flows that will results from operations, then subtract existing liabilities to determine the value of the firm, then divide the value of the firm by the number of shares to derive a value per share

When investors attempt to value a firm based on discounted cash flows

determine the required rate of return by investors who invest in that stock

Capital Gain

difference between the price at which a stock is sold versus the price at which it was purchased

Limitations of FCFM

difficulty of obtaining an accurate estimate of free cash flow per period

Market-Related Factors

drive stock prices, include investor sentiment and so-called January effect

Factors That Affect Stock Prices

economic, market-related, and firm-specific factors

Acquisitions

expected acquisition of a firm typically results in an increased demand for the target's stock, which raises its price. Investors recognize the stock will bid up once the acquiring firm attempts to acquire the stock.

Limitations of ADDM

Can result in inaccurate valuation if errors are made in deriving the present value of dividends over the investment horizon or the present value of the forecasted price at which stock can be sold at the end of the investment horizon.

Limitations of DDM

Can result in inaccurate valuation of a firm if errors are made in estimating the dividend to be paid over the next year OR in estimating the growth rate or the RRR by investors. Limitations are more pronounced when valuing firms that retain most of their earnings, rather than distributing them.

Adjusted Dividend Discount Model (ADDM)

DDM can be adapted to assess the value of any firm, even ones that retain all their earnings.

Economic Factors

Investors consider various economic factors that affect a firm's cash flows when valuing a firm to determine whether its stock is over or undervalued

Estimating the Market Risk Premium

Term within the parentheses in the CAPM is the market risk premium. (return of market in excess of the risk-free rate). Historical data for 30+ years can be used to determine the average market risk premium over time.

Integration of Factors Affecting Stock Prices

Whenever indicators signal the expectation of higher interest rates, there is upward pressure on the required return by investors and downward pressure on a firm's value.

Change in Dividend Policy

an increase in dividends may reflect the firm's expectation that it can more easily afford to pay dividends. A decrease in dividends may reflect the firm's expectation that it will not have sufficient cash flow

Price-Earnings Method

apply the mean price-earnings (PE) ratio (based on expected rather than recent earnings) of all publicly traded competitors in the respective industry to the firm's expected earnings for the next year

Impact of the Dollars Exchange Rate Value

foreign investors prefer to purchase U.S. stock when the dollar is weak and sell when the dollar is at its peak. Stock prices are affected by the dollar's changing value on cash flows (exporting is favorably affect by a weak dollar & adversely by a strong one) (importing is opposite). Stocks prices may also be affected by exchange rates if participants measure performance by reported earnings. Changing value of the dollar affects stock prices by affecting expectations of economic factors that influence firm's performance.

Fundamental Analysis

fundamental financial characteristics (such as earnings) of the firm and its corresponding industry that are expected to influence stock vales

Logic of PE Method

future earnings are important determinant of a firm's value. This method implicitly assumes that the growth in earnings in future years will be similar to that of the industry

Long-Term Capital Gain

gain on a stock position held for a year or longer

Application of CAPM

given the risk-free rate as well as estimates of the firm's beta and the market risk premium, it's possible to estimate the required rate of return from investing in the firm's stock

Impact of Economic Growth

increase in economic growth, increase in demand, increase in firm's cash flows and valuation. Monitor factors like employment, GDP, retail sales, personal income, and govt's fiscal & monetary policy. Also country relationships (war, political tension, etc.)

January Effect

invest in riskier stocks at the beginning of the year, then shift to larger/ more stable ones at the end of the year to lock in gains. Tendency places upward pressure on small stocks in January (begins in December b/c investors discover early)

Expectations for Firm-Specific Factors

investors attempt to anticipate new policies so that they can make their move in the market before other investors. In this way, they may be able to pay a lower price for a specific stock or sell the stock at a higher price.

Short-Term Capital Gain

investors hold a stock position less than a year

Reasons for Different Valuations of PE Method

investors may use different forecasts for the firm's earnings or the mean industry earnings of the next year

Limitations of PE Method

may result in inaccurate valuation of a firm if errors are made in forecasting the firm's future earnings. Some firms use creative accounting methods to exaggerate their earnings in a particular period and are unable to sustain that earnings level in the future. Stock buybacks (repurchases) by firms can distort a firm's earnings and therefore distort a valuation derived from earnings

Impact of Interest Rates

most prominent economic forces driving stock market prices is the risk-free interest rate. In theory, high interest rate should raise the required rate of return by investors and reduce the present value of future cash flows generated by a stock. Lower interest rates should boost the present value of cash flows and boost stock prices. Effect of interest rates should be considered along with economic growth

Investors who rely on fundamental analysis commonly use

price-earnings method, dividend discount model, or free cash flow model to value stocks

Investor Sentiment

represents the general mood of investors in the stock market (optimistic expectations = positive sentiment)

Firm-Specific Factors

some firms are more exposed to conditions within their own industry than to general economic conditions, so participants monitor industry sales forecasts, entry into the industry by new competitors, and price movements of industry's products. (Stock participants may focus on firms sales growth, earnings, other characteristics that may cause a revision in the expected cash flows to be generated by that firm)

Technical Analysis

stock price trends to determine stock values

Tax Effects

tax laws affect the after-tax cash flows that investors receive from selling stocks and can affect the demand for them. Can cause some stocks to be more desirable than others (depends on potential for larger gains). Stocks that pay dividends are affect by dividend tax laws.

Divestitures

tend to be regarded as a favorable signal about a firm if the divested assets are unrelated to the firm's core business.

Dividend Discount Model (DDM)

the price of a stock should reflect the present value of the stocks future dividends

Stock buybacks complicate the stock valuation process because

they reduce the number of shares outstanding and increase earnings per share even when the company's total earnings have not increased

Estimating the Firm's Beta

typically measured by applying regression analysis to determine the sensitivity of the asset's return to the market return based on monthly or quarterly data over the last four years or so.

Capital Asset Pricing Model (CAPM)

used to estimate the required rate of return for any firm with publicly traded stock. Based on the premise that the only important risk of a firm is systematic risk, or the risk that results from exposure to general stock market movements (not concerned with unsystematic risk, that is specific to an individual firm)

Earnings Surprises

when a firm's announced earnings are higher than expected, some investors raise their estimates of the firm's future cash flows and hence revalue its stock upward. However, an announcement of lower-than-expected earnings can cause investors to reduce their valuation of a firm's future cash flows & its stock

DDM Relationship with PE Ratio for Valuing Firms

when required rate of return (RRR), (DDM) is high, the PE will be low, which results in low valuation of the firm for its level of expected earnings. When growth rate (DDM) is high, PE is high, which results in high valuation. The inverse relationship between RRR and value exists when applying PE or DDM . Positive relationship between firm's growth rate and its value when applying either method.