Answers to Concepts in Review

1. The purpose of stock valuation is to obtain a standard of performance that can be used to judge the investment merits of a share of stock. A stocks intrinsic value is such a standard; it provides an indication of the future risk and return performance of a security. Expected earnings are indeed important in determining a stocks investment suitability. In making an investment decision, the investor must decide if a stock is under-valued or overvalued by comparing the current market price of the issue to its intrinsic value. And the intrinsic value of a stock depends on an investors expectations about its future cash flows and its risk. To estimate future cash flows, one has to forecast the future earnings of that company. This is done by multiplying forecasted sales by the forecasted net profit margin. Expected future returns (from dividends and capital gains) depend on these forecasted earnings, as well as forecasted dividend payout ratios, the number of shares outstanding, and future price/earnings ratios. Both the growth prospects of a company and the amount of debt it uses can affect the P/E ratio. As the growth rate increases, a higher P/E ratio can be expected. Likewise, as the debt level decreases, the financial risk inherent in the firm decreases, and the P/E ratio can be expected to increase. Other factors that affect the P/E ratio are general market psychology (higher P/E ratios accompany optimistic markets) and the level of dividends (a higher P/E ratio can be expected with higher dividends, so long as the firm is also able to maintain a respectable rate of growth in earnings). The market multiple is the average P/E ratio of stocks in the marketplace. It provides insight into the general state of the market, and it gives the investor information on how aggressively the market is pricing stocks. Over the past twenty years, average market P/E ratios have ranged from 12.2, in 1988, to 46.5, in 2001. Using the market multiple as a benchmark, a stocks P/E performance can be evaluated relative to the market. The relative P/E of a stock is not the market multiple. The relative P/E is found by dividing a stocks P/E by the markets P/E. If the computed rate of return equals or exceeds the yield the investor feels is warranted, based on the stocks risk behavior, or if the justified price is equal to or greater than the current market price, the stock under consideration should be considered a worthwhile investment candidate. The required rate of return provides a standard so that an investor can determine if the expected return on a stock is satisfactory or not. The required rate of return is positively related to the underlying risk involved in an investment. The higher the risk, the higher the return the investor would expect the investment to generate. The investor who picks a stock whose return is less than the required rate of return has really invested in a stock that is overvalued at the current time. This is because the stock is not yielding returns commensurate with the risk exposure. Since the market will learn of such overvaluation in time, market forces will bid down the price of such a security. The investor will incur capital losses when the stock price drops below the purchase price.

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In general, the value of any asset is the present value of all future cash flow benefits received. For common stock, the cash flow is dividends received each year plus the future sale price of the stock. If any future price can be described in terms of subsequent dividends, then the current price can be viewed as the present value of dividends received over an infinite time horizon. The basic dividend valuation model reduces the need to estimate all future dividends individually by saying that the value of a share of stock is a function of dividends that are growing at a specified rate over time. In this way, each future dividend can be expressed as a function of the current dividend and a specified rate of growth in dividends. The discount rate applied to these future cash flows is the desired rate of return of the investor relative to the risk of the stock and the other returns available. The DVM can be used to value a stock that pays a constant dividend; a non-growing stock that pays a dividend that is growing at a constant rate over time; and a stock that pays a dividend that grows at variable rates over time. The CAPM fits into the DVM through its effect on k, the required rate of return. The greater the systematic risk of a particular investment, the greater should be its required rate of return, as computed using the CAPM and, therefore, the lower the value obtained through the DVM. More generally, the CAPM fits into all three of the dividend valuation models and has the same effect described above.

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The difference between the variable growth dividend valuation model and the dividendsandearnings approach is in the determination of the future selling price of the stock. The variable growth dividend valuation model uses the future dividends to derive the price of the stock while the dividends-and-earnings model employs projected EPS and P/E multiples to derive the stock price. The dividends-and-earnings model is preferable to the variable growth model because it is more flexible and easier to understand and apply. This model only requires the estimation of a P/E multiple in one future period as opposed to estimating the dividend growth rate over an infinite period of time.

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Expected return on a stock can be found by using the (present-value based) internal rate of return (IRR). The expected rate of return on a stock would be the discount rate that equates the future stream of benefits from the stock (i.e., the future annual dividends and future price of the stock) to its current market value. In order to accept a stock as an investment vehicle, its expected return (IRR) must at least equal its required rate of return (e.g. using CAPM). If the expected return on a stock is higher than its required rate of return, then it is certainly a good buy.

9. The P/E approach is a simpler, more intuitive approach to valuing a stock. Given an estimated EPS figure, decide on a P/E ratio that is appropriate for the stock, multiply the EPS by the P/E to determine the stock price, and then compare this price to the stocks current price. The P/E approach differs from the variable growth dividend model in that the P/E approach estimates EPS and develops an appropriate P/E for the firm. The variable growth dividend model only uses future dividends and estimated growth rates to determine the stock price. The price-to-cash-flow (P/CF) measure has been popular with investors because cash flow is felt to provide a more accurate picture of a companys earning power. In a manner similar to P/E ratio valuation, cash flow is multiplied by a P/CF ratio. In addition to ease of use, the relatively low level of the P/CF ratio (when compared to the P/E ratio), is viewed as a strength. The obstacle to using the P/CF method is the varying cash flow measures, including cash flow from operations, free cash flow, and EBITDA. 10. Price-to-sales (P/S) and price-to-book-value (P/BV) ratios are alternative price relative measures. They are useful for valuing firms that are new or have volatile earnings streams, where the P/E multiple approach has little value. Unprofitable firms still have sales. Both are used in a similar fashion to estimate future values, by multiplying estimated sales or book value by the relevant ratio. Generally speaking, investors prefer low P/S and P/BV ratios, with desired P/S ratios of less than 2.0 and P/BV ratios of less than 7.0. However, if a company has a high profit margin, it is likely to have high P/S and P/BV ratios, also. An important difference lies in the fact that sales arise in the current period, while book value is based on the issuance of stock and retention of earnings since the firm went public.