Stock Valuation

Dr.
Michael Burry
From 2003 to 2006 (before the bet against
subprime loans), they turned $110,000 to
$120,000,000.
Charlie Ledley and James Mai

Peter Lynch
• ran the Magellan Fun at Fidelity Investments from 1977 to 1990 with an annual
return of 29.2%.
Warren Buffett
• ran Buffet Partnership, Ltd. from 1956 to 1969 with an annual return of 24% net
of fees.
Stock Valuation
Common Stock
Residual claim on assets and income. # of shares # of
Voting right (the election of the firm’s board of owned directors
directors). Two voting procedures:
• Majority voting (each share of stock allows the Majority 1 8 Only have
shareholder one vote, and each position on the voting 1 vote per
board of directors is voted on separately.) position.
• Cumulative voting (each share of stock allows the
Cumulative 1 8 Only have
shareholder a number of votes equal to the
voting 8 votes in
number o directors being elected).
all and it
Does not necessarily have stock dividends. can be
used all at
once or
split among
the
candidates.
Stock Valuation
Common Stock Preferred stock

Residual claim on assets and income. Priority claim on assets and income over those of
common stockholders, but have a lower priority
than the claims of the firm’s debt holders.
Voting right (the election of the firm’s board of No voting rights.
directors). Two voting procedures:
• Majority voting (each share of stock allows the
shareholder one vote, and each position on the
board of directors is voted on separately.)
• Cumulative voting (each share of stock allows the
shareholder a number of votes equal to the
number o directors being elected).
Does not necessarily have stock dividends. Size of stock dividend is fixed.
Stock Valuation
Intrinsic value is value given to an asset by an investor with full knowledge of an

asset's characteristics.
• If an asset's price is equal to its intrinsic value, then it is fairly valued.
• If an asset's price is less than its intrinsic value, then it is undervalued.
• If an asset's price is greater than its intrinsic value, then it is overvalued.
To be profitable, a security must be mispriced and that price must converge

towards intrinsic value.
Securities followed by most tend to be fairly valued. Therefore, look at

securities which are unpopular or neglected to look for opportunities.
Stock Valuation: Absolute Valuation Models
Absolute Valuation Models Relative Valuation Models

• estimate an asset’s intrinsic value • estimate an asset’s value relative to other
assets
Dividend discount models: Price multiples:
• Constant dividend growth model/ Gordon growth • Price- earnings ratio
model
• Preferred stock valuation model
Absolute Valuation Models

• estimate an asset’s intrinsic
value
Dividend discount models:
• Constant dividend growth
model/ Gordon growth
model
• Preferred stock valuation
model

value
Dividend discount models:
• Constant dividend growth
model
• Preferred stock valuation
model

value
Dividend discount models: Dividend discount models- assumptions:
• Constant dividend growth • Corporations have indefinite life.
• Cash dividends are a source of value.
model Dividend discount models- advantage:
• Preferred stock valuation • Widely accepted and easy to calculate.
model
Dividend discount models- disadvantages:
• Estimates are very sensitive to inputs.
Dividends will vary with a firm's profitability and its stage of growth.
• In early stage companies, they need to reinvest their money to finance
growth so they don't really pay dividends.
• In mature companies, tend to be stable and have little to no investment
opportunities enough to sufficiently increase shareholder value so they
pay dividends instead.
Which of the following would most appropriately be valued using the

constant growth DDM?
a. A producer of bread and snack foods.

b. A biotechnology firm in existence for two years.
c. An auto manufacturer.
Which of the following would most appropriately be valued using the

constant growth DDM?
a. A producer of bread and snack foods.

b. A biotechnology firm in existence for two years.
c. An auto manufacturer.
Answer: The correct answer is (a), because the automotive industry is

cyclical while a biotechnology firm has only been existence for two
years so cash generated will most likely be reinvested into the business
and not used to pay dividends.
If Pepperdine, Inc.’s return on equity is 16 percent and the

management plans to retain 60 percent of earnings for investments
purposes, what will be the firm’s growth rate?
If Pepperdine, Inc.’s return on equity is 16 percent and the

management plans to retain 60 percent of earnings for investments
purposes, what will be the firm’s growth rate?
Answer: Growth rate will be 9.60%.

If the Stanford Corporation’s net income is $200 million, its common

equity is $833 million, and management plans to retain 70% of the
firm’s earnings to finance new investments, what will be the firm’s
growth rate?
If the Stanford Corporation’s net income is $200 million, its common

equity is $833 million, and management plans to retain 70% of the
firm’s earnings to finance new investments, what will be the firm’s
growth rate?
Answer: Growth rate will be 16.81%.

Header Motor, Inc., paid a $3.50 dividend last year. At a constant

growth rate of 5 percent, what is the value of the common stock if the
investors require a 20 percent rate of return?
Header Motor, Inc., paid a $3.50 dividend last year. At a constant

growth rate of 5 percent, what is the value of the common stock if the
investors require a 20 percent rate of return?
Answer: The value of the common stock is $24.53.

Thomas, Inc.’s return on equity is 13% and management plans to

retains 20% of earnings for investment in the company.
a. What will be the company’s growth rate?
b. How would the growth rate change if management increased
retained earnings to 25% or decreased retention to 13%?

Answer for A: The company’s growth rate will be 2.6%


Answer for A: The company’s growth rate will be 2.6%

Answer for B: If increased to 25%, then 4.55%.
If decreased to 13%, then 1.69%.
Pioneer’s preferred stock is selling for $33 in the market and pays a
$3.60 annual dividend.
a. If the market or promised yield is 10%, what is the value of the
stock for that investor?
b. Should the investor acquire the stock?
Answer for A: The value of the preferred stock is $36.00.


Answer for B: Yes, because it is currently undervalued.
You own 200 shares of Somner Resources’ preferred stock, which

currently sells for $40 per share and pays annual dividends of $3.40 per
share. If the market yield on similar shares is 10%,
a. What is the value of the stock to you?
b. Should you sell share or buy more?




Answer for B: Sell the stock, because it is overvalued.
Kendra Corporation’s preferred shares on trading for $25 in the market

and pays a $4.50 annual dividend. Assume that market or promise yield
is 14%
a. What is the stock’s value to you, the investor?
b. Should you purchase the stock?

is 14%


is 14%

Answer for B: Yes, because it undervalued.
Stock Valuation: Relative Valuation Models
Relative Valuation Models

• estimate an asset’s value
relative to other assets
Price multiples:
• Price- earnings ratio
Relative Valuation Models

• estimate an asset’s value
relative to other assets
Price multiples: Price multiples- advantage:
• Price- earnings ratio • Widely accepted and easy to calculate.
Price multiples- disadvantages:

• May not be comparable with other firms.
• A stock may be undervalued using relative valuation models,
but are actually overvalued using absolute valuation models.
A privately held company is anticipating selling its first shares to the

public. The following conditions apply to the sale:
• The expected level of earnings at the end of this year (E1) is $4.
• Similar shares of stock sell at multiples of 9.333 times earnings per
shares.
What is the stock price using the P/E valuation method?

A privately held company is anticipating selling its first shares to the

public. The following conditions apply to the sale:
• The expected level of earnings at the end of this year (E1) is $4.
• Similar shares of stock sell at multiples of 9.333 times earnings per
shares.
What is the stock price using the P/E valuation method?

Answer: The stock price is estimated to be $37.33.
Assume the following:

• The investor’s required rate of return is 15%,
• The expected level of earnings at the end of this year is $5,
• The retention ratio is 50%,
• The return on equity is 20% and
• Similar shares of stock sell at multiples of 10 times earnings per share.
a. The retention ratio is 50% and the return on equity is 20%. What is the
expected growth rate for dividends?
b. What is the stock price using the dividend discount model?
Answer for A: The expected growth rate for dividends is 10%.

Answer for B: The value of the common stock is $50.





a. Determine the price earnings ratio.

b. What is the stock price using the P/E ratio valuation method?
Answer for A: Cannot be determined.

Answer for B: The stock price is estimated to be $50.







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Dr.

Charlie Ledley and James Mai

Common Stock Preferred stock

Intrinsic value is value given to an asset by an investor with full knowledge of an

To be profitable, a security must be mispriced and that price must converge

Securities followed by most tend to be fairly valued. Therefore, look at

Absolute Valuation Models Relative Valuation Models

Absolute Valuation Models

Absolute Valuation Models

Absolute Valuation Models

Which of the following would most appropriately be valued using the

a. A producer of bread and snack foods.

Which of the following would most appropriately be valued using the

a. A producer of bread and snack foods.

Answer: The correct answer is (a), because the automotive industry is

If Pepperdine, Inc.’s return on equity is 16 percent and the

If Pepperdine, Inc.’s return on equity is 16 percent and the

Answer: Growth rate will be 9.60%.

If the Stanford Corporation’s net income is $200 million, its common

If the Stanford Corporation’s net income is $200 million, its common

Answer: Growth rate will be 16.81%.

Header Motor, Inc., paid a $3.50 dividend last year. At a constant

Header Motor, Inc., paid a $3.50 dividend last year. At a constant

Answer: The value of the common stock is $24.53.

Thomas, Inc.’s return on equity is 13% and management plans to

Thomas, Inc.’s return on equity is 13% and management plans to

Answer for A: The company’s growth rate will be 2.6%

Thomas, Inc.’s return on equity is 13% and management plans to

Answer for A: The company’s growth rate will be 2.6%

Answer for A: The value of the preferred stock is $36.00.

Answer for A: The value of the preferred stock is $36.00.

You own 200 shares of Somner Resources’ preferred stock, which

You own 200 shares of Somner Resources’ preferred stock, which

Answer for A: The value of the preferred stock is $34.00.

You own 200 shares of Somner Resources’ preferred stock, which

Answer for A: The value of the preferred stock is $34.00.

Kendra Corporation’s preferred shares on trading for $25 in the market

Kendra Corporation’s preferred shares on trading for $25 in the market

Answer for A: The value of the preferred stock is $32.14.

Kendra Corporation’s preferred shares on trading for $25 in the market

Answer for A: The value of the preferred stock is $32.14.

Relative Valuation Models

Relative Valuation Models

Price multiples- disadvantages:

A privately held company is anticipating selling its first shares to the

What is the stock price using the P/E valuation method?

A privately held company is anticipating selling its first shares to the

What is the stock price using the P/E valuation method?

Assume the following:

Answer for A: The expected growth rate for dividends is 10%.

Assume the following:

Answer for A: The expected growth rate for dividends is 10%.

Assume the following:

Answer for A: The expected growth rate for dividends is 10%.

Assume the following:

a. Determine the price earnings ratio.

Answer for A: Cannot be determined.

Assume the following: