Finance chapter 15- Stock valuation

3 methods used in fundumental analysis

1. target stock price analysis 2. relative variation 3. discounted cash flow (DCF) anaysis

Free cash Flow to Firm Valuation

4 Steps: 1. forecast compnay's expected cash flows 2. Estimate company's WACC 3. calculate the enterprise value of the company 4. calculate intrinsic stock value

Factors that affect stock price outside of company control

Decrease: 1. increases in interest rates 2. lower earnings forecasts for the industry or market as a whole 3. fears of inflation or deflation 4. corporate governance or accounting scandals 5. terrorist attacks 6. An international economic crisis Increase: 1. positive economic events, Ex: settlement of a labor strike 2. new breakthrough in technology, Ex: computers in the 80s and internet in the 90s 3. If the company is a target of a takeover bid and there is a tender offer for the company's stock

perpetuities

a set payment amount that continues infintiely on regualr intervals Ex: receiving 100 every year forever

target price analysis

analysts forecast a firm's earnings per share and then multiply EPS by the firm's price to earnings ratio to find firm's target stock price -if target stock price is above the actual stock price the stock is good stock to buy *forecasts earnings per share (EPS) of a firm and multiplies EPS by the projected P/E ratio to arrive at a target stock price. Example: Suppose the projected EPS of XYZ Inc. is $2.50 and the market P/E ratio is 10. The target stock price of XYZ Inc. is $25. If the current market price of the stock is $20, a financial analyst would recommend buying the stock*

Stock valuation relationships

company's profit - market value of stock = DIRECT interest rates (required yield) - stock values = INVERSE

relative valuation

compare a company's measure of value such as P/E, P/BV, P/S, to similar companies within the industry -often used in conjunction with target stock price analysis to value a firm's stock

residual value

once company loses comp. advantage, company's after-tax earning can be treated and valued as a perpetuity -usually makes up 60-90% of stock value

common stock

represents ownership in a public company - have a residual claim on assets (claim on assets if firm liquidates or bankrupts) - limited liability (can only lose as much as invested) *The value of a stock is crucially dependent upon the future profits or cash flows that the firm is expected to generate and the interest rate or required yield level that is expected from the investment

excess return period

return a company earns on a new investment is greater than the WACC due to competitive advantages over other firms in the industry more competition= shorter excess return period -loss of a company's comp. advantage means stock value can still grow but only at markets required rate of return for that stock 1. boring companies= 1 year excess return period 2. decent companies= 5 year 3. good companies= 7 year 4. great companies= 10 year

Dividend policy

should not effect current value of stock price - expected future value of stock price is greatly affected When a company does not pay dividends and reinvests its earnings in projects, the investors receive no current dividend but instead receive an increase in stock price

Modern Portfolio Theory

stock prices always reflect intrinsic value, and that any type of fundamental or technical analysis is already embedded in the stock price -useless to search for undervalued stock -timing of purchases doesnt matter -investors should pick a level of risk and diversify portfolio -However, empirical evidence shows there is value to careful stock selection

technical analysis

stock prices are influenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company -generally have a shorter-term stock holding orientation and more frequent trading activity -timing of purchase and sale of stock is important Use: 1.historic stock price movements 2. volume of trading activity 3.price/volume aspects of related equity and debt markets

Dividends

stock prices increase when dividends increase and vice versa -managers increase dividends only when they expect higher earning in future -decrease dividends when they expect bad performance in future 3 Most important dividend policy issues 1. firm determines its dividend policy based on its investment and growth opportunities 2. firm's stock price tends to increase when a firm increases its dividend; the stock price tends to decrease when a firm decreases its dividend 3. the change in the firm's stock price is not to the dividend itself; instead, it is due to the information conveyed by the announcement of the change in dividend policy

fundamental analysis

the company's current and future operating and financial performance determine the value of the company's stock intrinsic value: true value of a company's stock, which is believe the stock price will move to overtime Look at overall economic, industry, and company data to value a company's stock -investors look for stock priced below intrinsic value

DCF analysis

the sum of the expected cash flows of the company, discounted at an appropriate interest rate 1. Dividend Discount Model DDM- most basic approach, value of stock is pv of the dividends that an investor expects to receive from the stock if the investor holds the stock forever 2. Free Cash Flow to Equity (FCFE)- measures company's cash flows after accounting for payments for working capital, capital expenditures, interest principal on debt, and dividends on p.stock; then discounts those cash flows at the company's cost of equity to arrive at stock value 3. Free Cash Flow to firm (FCFF)