Chapter 8

Stock Valuation

Valuing a Company and Its Future

Value of a stock depends upon its future returns
from dividends and capital gains/losses
We use historical data to gain insight into the
future direction of a company and its profitability
Past results are not a guarantee of future results

Information used for forecasting:

Past price, volume
Financial reports (income statement, balance sheet, cash
flow statement)
Macroeconomic series

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Valuing a Company and Its Future

Forecasts normally involves (an overview):
Sales and sales growth
Profit margin: converts sales into earnings
Returns (ROE): converts equity into earnings
Payout ratio: converts earnings into dividends.
ROE & payout ratio are also used to project future growth rates. High
return and low payout leads to higher growth in the future.

Price to earning/book ratios: If these ratios are stable, one

can use forecasted earnings/book to predict future prices.
Book value refers to the accounting value of the firm recorded on the
balance sheet.

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Table 8.1 Comparative Dollar-Based and

Common-Size Income Statements Universal
Office Furnishings, Inc. 2010 Income Statements

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Steps in Valuing a Company

Three steps are necessary to project key
financial variables into the future:
Step 1: Forecast future sales & profits
Step 2: Forecast future EPS and dividends
Step 3: Forecast future stock price

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Step 1: Forecast Future Sales and

Profits
Forecasted Future Sales based upon:
Nave approach based upon continued historical trends,
or
Historical trends adjusted for anticipated changes in
operations or environment

Forecasted Net Profit Margin based upon:

Nave approach based upon continued historical trends,
or
Historical trends adjusted for anticipated changes in
operations or environment, or
Earnings forecasts from brokerage houses, Value Line,
Forbes, or other sources

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Step 1: Forecast Future Sales and

Profits (contd)

Example: Assume last years sales were $100

million, revenue growth is estimated at 8% and the
net profit margin is expected to be 6%.

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Step 2: Forecast Future EPS

Forecasted outstanding shares of common stock
based upon:

Nave approach based upon continued historical tends,

or
Historical trends adjusted for anticipated changes in
operations or environment

Forecasted Earnings Per Share (EPS) based upon:

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Step 2: Forecast Future EPS (contd)

Example: Assume estimated profits are
$6.5 million, 2 million shares of common
stock are outstanding, and the dividend
payout ratio is estimated at 40%.

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Step 2: Forecast Future Dividends

Forecasted Dividend Payout ratio based
upon:
Nave approach based upon continued
historical trends, or
Historical trends adjusted for anticipated
changes in operations or environment

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Step 2: Forecast Future Dividends

(contd)
Example: Assume estimated profits are
$6.5 million, 2 million shares of common
stock are outstanding, and the dividend
payout ratio is estimated at 40%.

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Step 3: Forecast P/E Ratio

Estimated P/E ratio based upon:
Average market multiple of all stocks in the
marketplace, or
Relative P/E multiple of individual stocks
Adjust up or down based upon expectations of
economic conditions, general stock market
outlook in near term, or anticipated changes in
companys operating results

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Step 3: Forecast P/E Ratio

Estimated P/E ratio is function of several
variables, including:
Growth rate in earnings
General state of the market
Amount of debt in a companys capital structure
Current and projected rate of inflation
Level of dividends

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Step 3: Forecast Future Stock Price

Example: Assume estimated EPS are $3.25 and the

estimated P/E ratio is 17.5 times.

To estimate the stock price in three years, extend

the EPS figure for two more years and repeat the
calculations.
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Table 8.3 Summary Forecast Statistics,

Universal Office Furnishings

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Using Stock Valuation

Once we have an estimated future stock
price, we can compare it to the current
market price to see if it may be a good
investment candidate:
current price < estimated price

undervalued

current price = estimated price

fairly valued

current price > estimated price

overvalued

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The Valuation Process

Valuation is a process by which an investor uses
risk and return concepts to determine the worth of
a security.
Valuation models help determine what a stock ought to be
worth
If expected rate of return equals or exceeds our target
yield, the stock could be a worthwhile investment
candidate
If the intrinsic worth equals or exceeds the current market
value, the stock could be a worthwhile investment
candidate
There is no assurance that actual outcome will match
expected outcome

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Required Rate of Return

Required Rate of Return is the return
necessary to compensate an investor for
the risk involved in an investment.
Used as a target return to compare forecasted
returns on potential investment candidates

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Required Rate of Return (contd)

Example: Assume a company has a beta of
1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?

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Other Stock Valuation Methods

Dividend Valuation Model
Zero growth
Constant growth
Variable growth

Dividend and Earnings Approach

Price/Earnings Approach
Other Price-Relative Approaches
Price-to-cash-flow ratio
Price-to-sales ratio
Price-to-book-value ratio

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Dividend Valuation Model:

Zero Growth
Uses present value to value stock
Assumes stock value is capitalized value of
its annual dividends
Potential capital gains are really based upon
future dividends to be received
Assumes dividends will not grow over time

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Dividend Valuation Model:

Constant Growth
Uses present value to value stock
Assumes stock value is capitalized value of its
annual dividends
Assumes dividends will grow at a constant rate
over time
Works best with established companies with history
of steady dividend payments

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Growth rate forecast

Based on historical sales/EPS growth
Based on earnings power (ROE) and how much is
reinvested:
Expected growth = ROE*(1- PayoutRatio)
ROE (return on equity) = Net Income/Total Equity

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Dividend Valuation Model:

Variable Growth
Uses present value to value stock
Assume stock value is capitalized value of its
annual dividends
Allows for variable growth in dividend growth rate
Most difficult aspect is specifying the appropriate
growth rate over an extended period of time

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Dividends-and-Earnings Approach
Very similar to variable-growth dividend-valuation
model
Uses present value to value stock
Assumes stock value is capitalized value of its
annual dividends and future sale price
Works well with companies who pay little or
no dividends
Present value of
a share of stock

Present value of
Present value of

the price of the stock

future dividends
at date of sale

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Price/Earnings (P/E) Approach

Future price is based upon the appropriate
P/E ratio and forecasted EPS
Simple to use and easy to understand
Widely used in stock valuation

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Price-to-Cash-Flow (P/CF) Approach

Similar to P/E approach, but substitutes
projected cash flow for earnings
Widely used by investors
Many consider cash flow to be more
accurate than profits to evaluate a stock

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Price-to-Sales (P/S) Approach

Similar to P/E approach, but substitutes
projected sales for earnings
Useful for companies with no earnings or
erratic earnings

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Price-to-Book-Value (P/BV)
Approach
Similar to P/E approach, but substitutes
book value for earnings

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