Chapter 6 Stock Valuation Model ✓ Solved

Chapter 6stock Valuation Modelcopyright 2014 Pearson Education Inc

Explain the role that a company’s future plays in the stock valuation process. Develop a forecast of a stock’s expected cash flow, starting with corporate sales and earnings, and then moving to expected dividends and share price. Discuss the concepts of intrinsic value and required rates of return, and note how they are used. Determine the underlying value of a stock using the zero-growth, constant-growth, and variable-growth dividend valuation models. Use other types of present value-based models to derive the value of a stock, as well as alternative price-relative procedures.

Gain a basic appreciation of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

Sample Paper For Above instruction

Introduction

Stock valuation is a fundamental aspect of investment analysis, involving the process of determining the intrinsic or true value of a stock based on its expected future performance. This process hinges on understanding the company's potential to generate future cash flows and the various models used to quantify this potential. Investors utilize these models to make informed decisions by comparing the estimated intrinsic value to the current market price, thus identifying undervalued or overvalued stocks.

The Role of the Future in Stock Valuation

The future plays a pivotal role in stock valuation because the worth of a stock is essentially the present value of all its expected future cash flows, including dividends and capital gains. Investors base their valuation on forecasts of future sales, earnings, dividends, and ultimately the share price. These projections incorporate an analysis of the company's growth prospects, industry trends, economic conditions, and management strategies. Because future performance is uncertain, assumptions are often based on historical data, adjusted for expected changes or economic outlooks.

Forecasting Future Cash Flows: A Step-by-Step Approach

The valuation process involves three critical steps: forecasting future sales and profits, predicting future earnings per share (EPS) and dividends, and estimating the future stock price. Each step integrates different valuation models and methodologies, and accurate forecasting is essential to determine a stock's true value.

Step 1: Forecast Future Sales and Profits

Forecasting future sales involves analyzing historical sales data and adjusting for anticipated operational or environmental changes. For instance, if a company's sales have been growing at a rate of 10%, investors might project continued growth at this rate, unless external factors suggest otherwise. Similarly, net profit margins are forecasted based on past trends or industry benchmarks, considering expected operational efficiencies or economic factors.

Example: Suppose last year's sales were $100 million, with an 8% growth rate, and the net profit margin is 6%. Future sales would then be projected as:

Future Sales = $100 million x (1 + 0.08) = $108 million

Future profits = $108 million x 6% = $6.48 million

Step 2: Forecast Future EPS and Dividends

EPS forecasts derive from predicted profits, divided by the number of outstanding shares. For example, if profits are projected at $6.5 million with 2 million shares outstanding, EPS would be:

EPS = $6.5 million / 2 million shares = $3.25

The dividend payout ratio, which is the percentage of earnings paid as dividends, influences dividend forecasts. If the payout ratio is 40%, then dividends per share (DPS) would be:

DPS = EPS x Payout Ratio = $3.25 x 40% = $1.30

Step 3: Forecast Future Stock Price

The P/E ratio, which reflects investor expectations and market conditions, is used to estimate future stock prices. It can be based on the average market multiple or relative to similar companies. For instance, if the forecasted EPS is $3.25 and the expected P/E ratio is 17.5, the predicted stock price would be:

Stock Price = EPS x P/E ratio = $3.25 x 17.5 = $56.88

Valuation Models and Their Application

Intrinsic Value and Dividend Discount Models

Intrinsic value assesses the true worth of a stock based on expected future cash flows. The dividend discount model (DDM) is central in this regard, with variants including zero-growth, constant-growth, and variable-growth models.

Zero-Growth Model

This model assumes dividends remain constant over time, ideal for mature firms with stable dividends. The stock’s value (P) is calculated as:

P = D / k

Where D is the annual dividend and k is the required rate of return. For example, if a stock pays a dividend of $3 and the required return is 10%, the value is:

P = $3 / 0.10 = $30

Constant-Growth Model (Gordon Growth Model)

This model assumes dividends grow at a constant rate (g). The formula is:

P = D₁ / (k - g)

Where D₁ is the dividend in the next period. For instance, if D₁ is $1.88, the required return is 10%, and dividends grow at 7%, the intrinsic value is:

P = $1.88 / (0.10 - 0.07) = $62.67

Variable-Growth Model

This approach accommodates changing growth rates over different periods, then stabilizing. It combines the present value of dividends during the high-growth phase with the value of the stock in the stable-growth phase, calculated via the Gordon model.

Final valuation involves summing the present values of these components, providing a more nuanced valuation for companies with irregular dividend growth patterns.

Other Valuation Approaches

Price/Earnings (P/E) Ratio

The P/E ratio measures how much investors are willing to pay per dollar of earnings. It is calculated as:

P/E ratio = Market Price / EPS

For example, with an EPS of $2 and a stock price of $20, the P/E ratio is 10. To estimate future stock price, multiply forecasted EPS by a suitable P/E ratio, which can be adjusted based on market outlook.

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

This ratio uses operating cash flows, often considered more reliable than earnings. The value per share is calculated as:

Share Price = Cash Flow per Share x P/CF multiple

For example, if EBITDA is $325 million, and there are 56 million shares, the cash flow per share is approximately $5.80. If the P/CF multiple is 8, the stock’s value is:

$5.80 x 8 = $46.40 per share

Price-to-Sales and Price-to-Book-Value

These multiples are useful for valuing companies with no earnings or inconsistent profits. They compare market price to sales or book value, with typical ratios varying across industries.

Risk and Required Rate of Return

The required rate of return (k) compensates investors for risks associated with the stock. It is commonly derived using models like CAPM, which considers beta (systematic risk), the risk-free rate, and the expected market return. The formula is:

k = Rf + β (Rm - Rf)

Where Rf is the risk-free rate, β is beta, and Rm is the expected market return. For example, with a beta of 1.30, a risk-free rate of 5.5%, and a market return of 15%:

k = 5.5% + 1.30 x (15% - 5.5%) = 5.5% + 1.30 x 9.5% = 5.5% + 12.35% = 17.85%

Conclusion

Valuing stocks requires integrating forecasts of future cash flows with appropriate valuation models. The choice among models depends on the company's dividend history, growth prospects, and industry characteristics. Precise forecasts and understanding of risk factors are essential in estimating the intrinsic value and making sound investment decisions.

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