CH15 Stock Valuation
Formula for value to common equity?
(Corporate value) - (Long-term debt) - (short-term liabilities) - (preferred stock)
How do you calculate the return to stock holders? AKA formula
(Dividends + change in Stock Price) / Beginning Stock Price
What are the characteristics to owning common stock?
-Common stockholders have a residual claim on the firm's assets -Common stockholders have limited liability
What are three methods used in fundamental analysis?
-Discounted Cash flow analysis -Target stock price analysis -Relative Valuation
What is fundamental analysis?
-States that the company's current and future operating and financial performance determines the value of the company's stock -Stock analysis based on determining a stock's intrinsic value and the assumption that the company's stock price will move to its intrinsic value over time.
What are boring companies?
1-year excess return period -Companies in highly competitive, low-margin industries
What are the four categories of companies relative to their excess return period?
1. Boring companies 2. Decent companies 3. Good companies 4. Great companies
What are the four steps of the FCF to the firm-valuation approach?
1. Forecast the company's expected cash flows 2. Estimate the company's weighted average cost of capital (WACC) 3. Calculate the enterprise value of the company 4. Calculate the intrinsic stock value
What are good companies?
7-year excess return period -Companies with good brand names and large economies of scale
What is relative valuation?
Analysts compare a company's measure of value to similar companies within the industry -relative valuation is often used in conjunction with target stock price analysis to value a firm's stock
What if the formula for value of a perpetuity?
Annual cash flows / Discounting rate
What do drops in dividends show?
Bad signal to market place so will see drop in stock prices
What are the two most important variables for determine the value of a firm's stock?
EXPECTED CASH FLOWS AND INTEREST RATE -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
What are other DCF approached?
Free cash flow to equity model (FCFE) and free cash flow to the firm model (FCFF)
What do fundamental analysts look at?
Fundamental analysts look at OVERALL economic, industry, and company data to value a company's stock
How do interest rates relate to a stock's market value?
Higher interest rates decrease a stock's market value and lower interest rates increase a stock's market value - An inverse relationship
What kind of stocks are investors looking to purchase going with this idea of intrinsic value?
Investors are looking to purchase stocks that are prices below their intrinsic value.
What is common stock?
It represents ownership in a publicly held company
Excess Return Period
Period where the return a company earns on a new investment is greater than the company's WACC
What do big jumps in dividends show?
Shows optimism from management of firm about future -> generates a jump in stock prices
Formula for intrinsic value per share?
Value to common equity / number of shares outstanding
What are factors that cause a stock price to increase that are outside of the company's control?
1. Positive economic events, like the settlement of a labor strike 2. A new breakthrough technology, like computers in the 80s and the 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
What are factors that cause a stock price to decrease that are outside the company's control?
1. increase 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 or currency crisis
What are great companies?
10-year excess return periods -Companies with great growth potential, brand names, and marketing power
What are decent companies?
5-year excess return period -Companies with decent reputations but that don't control pricing or growth in their industry
What is free cash flow to the firm-valuation approach?
A four-step process to determine the value of a companies stock
What is a perpetuity?
A set payment amount that continues infinitely on regular intervals ex: receiving $100 every year forever
What is Discounted Cash Flow (DCF) Analysis?
A stock's value is determined by finding the sum of company's expected cash flows discounted back to today's dollar at an appropriate interest rate.
What is Target Stock Price Analysis?
Analysts forecast a firm's earning per share (EPS) and then multiply EPS by the firm's price to earnings (P/E) ratio to determine the firm's target stock price
What is Modern Portfolio Theory (MPT)?
Based on the belief that stock prices always reflect intrinsic value and that any type of fundamental or technical analysis is already embedded in the stock price
What do you have to do with corporations and stock valuation?
Corporations have infinite life, so the stock valuation procedure should be able to value cash flow to infinity - you use an equation to solve for the present value of a perpetuity
How do profits relate to a stock's market value?
Higher profits increase a stocks market value and lower profits decrease a stocks market value - A direction relationship
What do technical analysts base their predictions on?
Historic price movements, volume of trading activity, and the price/volume aspects of related equity and debt markets -they use charts and graphs
How does the target stock price determine if you should buy a stock or not?
If the target stock price is below the actual stock price, the stock is a good stock to buy
What is the idea behind fundamental analysis and intrinsic value?
In the short run, a company's stock price may move away from its intrinsic value, but over the long run, the company's stock price with return to its intrinsic value.
What does the free cash flow to equity (FCFE) model measure?
Measures the company's cash flow after accounting for payments for working capital, capital expenditures, the interest and principal on debt, and dividends on preferred stock; then discounts those cash flows at the company's cost of equity to arrive at the stock's value.
Does the dividend policy of a firm affect the current value of a firm?
No, the dividend policy of the firm should not affect the current value of a firm. -However, the expected future value of a stock is greatly affected by dividend policy
What is Residual value?
Once the company loses its competitive advantage, the company's after-tax earnings can be treated and valued asa perpetuity
What is technical analysis?
Stock analysis based on the belief that prices are influenced more by investor psychology and the emotions of investors than by changes in the fundamentals of a company
How do you calculate the intrinsic stock value?
Subtract the value of the company's debt and preferred stock from the corporate value to find the value of the company's common equity, and then divide the value of common equity by the number of shares of common stock outstanding to get the intrinsic value per share of the company's common stock.
What is the formula for target stock price?
Target Stock Price = EPS x P/E ratio
What are the ways to value a stock?
Technical analysis and Fundamental analysis
What does professor point out about MPT?
That this does not always hold true. There is empirical evidence that shows there is value to careful stock selection.
What will the WACC be?
The WACC is the discount rate used to value the company's stock
What is the most basic DCF approach?
The dividend discount model (DDM) - under which an analyst estimated future dividend growth and the required rate of return on the stock and discounts those expected dividends to arrive at a stock's value.
What does it mean to have limited liability?
The most a stockholder can lose is the amount the stockholder has invested in the company
What is intrinsic value?
The true value of a company's stock, which is a function of the company's revenue, growth, earnings, dividends, cash flows, profit margins, risk, interest rate and any other factors that affect the value of the company
What to MPT devotees advice?
They tell investors not to bother to search for undervalued stocks but instead to pick a risk level that they can live with and diversify holdings among a portfolio of stocks.
How to technical analysts tend to trade?
They tend to trade stock frequently and have a shorter-term stock holding orientation
How do you calculate the enterprise value of the company?
Use the company's WACC to discount expected cash flows during the excess return period to find company's cash flow from operations; then you will solve for the company's residual value and finally, add the company's short-term assets to get the value of the company as a whole
What do you have to keep in mind when using the formula to value a perpetuity?
You are given an interest rate and must put it in the equation as a decimal!
