 Explain the role that a company’s future

plays in stock valuation.

 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
 The single most important issue in the stock
valuation process is what a stock will do in
the 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
 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
 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
 Future after-tax Estimated sales Net profit margin
 
earnings in year t for year t expected in year t

 Example: Assume last year’s sales were $100

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

Future after-tax
 $108 million  0.06  $6.5 million
earnings next year
 Future after-tax
Estimated EPS earnings in year t

in year t Number of shares of common stock
outstanding in year t
 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%.

Estimated EPS $6.5 million

  $3.25
next year 2 million
Estimated dividends Estimated EPS Estimated
 
per share in year t in year t payout ratio
 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%.

Estimated dividends
 $3.25  .40  $1.30
per share next year
 Estimated P/E ratio is function of several
variables, including:
› Growth rate in earnings
› General state of the market
› Amount of debt in a company’s capital structure
› Current and projected rate of inflation
› Level of dividends
 Estimated share price Estimated EPS Estimated P/E
 
at end of year t in year t ratio

 Example: Assume estimated EPS are $3.25 and the

estimated P/E ratio is 17.5 times.
Estimated share price
 $3.25  17.5  $56.88
at the end of next year
 To estimate the stock price in three years, extend the
EPS figure for two more years and repeat the
calculations.
 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
 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
 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

Value of a Annual dividends


share of stock Required rate of return
 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
Value of a Next year's dividends

share of stock Required rate Constant rate of

of return growth in dividends
 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
Present value of
Present value of the price
Value of a share future dividends
  of the stock at the end of
of stock during the initial
the variable-growth period
variable-growth period