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8 -- Part 2: Stock Valuation

- We know what the future cash flows of the investment will be.
- We can use that information to value Universal Office Furnishings stock.

- Any asset that produces a stream of cash can be applied to this process.
- The investor needs to determine the amount of future cash flows, the timing of these cash flows, and the rate of return on the investment to establish the value of an asset.

- The value of common stock is determined by the amount of risk and estimated cash flows to stockholders.
- We use various types of stock valuation models to represent the elusive intrinsic value we have been looking for.
- We can use forecasted stock behavior to judge the investment merits of a particular security in this way.

- Either of two conditions would make us consider a stock a worthwhile investment candidate: 1) the expected rate of return equals or exceeds the return we feel is war ranted given the stock's risk, or 2) the justified price is equal to or greater than the current market.
- In other words, a security is a good investment if its expected return is at least as high as the return that an investor demands based on the security's risk or if its intrinsic value equals or exceeds the current market price of the security.
- Purchasing a security in circum stances is not irrational.
- The security meets our minimum standards if it gives investors the rate of return they want.

- Even though valuation is an important part of the investment process, there is no guarantee that the outcome will be the same as the projections.
- Security analysis and stock valuation models can be used to help investors better understand the return and risk of a potential transaction.

- The return that an investor requires should be related to the investment's risk.
- The level of compensation is compatible with the amount of risk involved.
- It helps determine if the expected return on a stock is satis factory.
- Because investors don't know what the cash flow of an investment will be, they should expect to earn a rate of return that reflects this.
- More investors should expect to earn if the perceived risk is greater.
- The capital asset pricing model is based on this idea.

- Two of the required inputs are available.
- You can get a stock's alpha from a variety of online and print sources.
- The risk-free rate is the current return provided by a risk-free investment.

- It is not easy to estimate the expected return on the stock market.

- A long-run average return on the stock market is used to calculate the market's expected return.
- The average return may have to be adjusted up or down depending on what investors think the market will do over the next year or so.

- The risk of a stock is captured in the CAPM.
- Universal's stock is an example of the CAPM at work.

- You won't be fully compensated for the risk if you accept a lower return.

- Several stock valuation models are used by investors.

- Some models focus on the dividends that a stock will pay over time.
- Other models emphasize the cash flow that a firm creates, focusing less on whether the company pays that cash out as dividends, uses it to chase shares, or simply holds it in reserve.

- There are other stock valuation models that use variables such as dividend yield, abnormal low P/E multiples, and even company size or market cap as key elements in the decision making process.

- We'll move on to procedures that set the price of a stock based on how it behaves relative to earnings, cash and the stock valuation model.

- Understanding valuation models will allow you to better evaluate analysts' recommendations.

- The present value of the expected cash benefits is the same as the intrinsic value of the investment.
- The future sale price of the stock is added to the cash dividends received each year.
- The value of a share of stock is equal to the present value of all future dividends it is expected to provide over an infinite time horizon.

- When an investor sells a stock from a strictly theoretical point of view, what he or she is selling is the right to future dividends.
- The current value of a share of stock is a function of future dividends, just as the future price of the stock is a function of future dividends.
- The future price of the stock will be influenced by the outlook for dividends and the required rate of return.

- Many kinds of valuation problems can be solved with the DVM in one form or another.

- If you assume the stock has a fixed stream of dividends, you can picture the dividend valuation model.
- The dividends are expected to stay the same in the future.
- The present value of annual dividends is what determines the value of a zero-growth stock.

- If analysts were really making recommendations.

- The dations were tilted toward the buy side.

- According to analysts' ratings, stocks should be free of sell recommendations.
- A hold or neutral rating for a stock could be interpreted as a buy or a sell by the investment research firm.
- When the market began, analysts missed the boat because they should have given more weight to negative ratings.

- According to a recent study, stocks that analysts told investors to sell rose 19% per annum on average from 2000 to 2004, while the price of downgrades rose just 3%.

- Conflict of interest is one explanation.
- Recommendations can signal future problems.

- Analysts follow companies that investors should pay attention to.

- Analysts are under pressure to make a positive com forecast revision.
- If an investment analyst moves a stock from sell to buy in order to please their current and prospective banking clients.
- The earnings forecast for the stock can be raised by analysts' buy recommendations, which may induce investors to trade, and those trades are more credible than a report that simply changes the generate commissions for the analysts' employers.

- Wall Street and the securities industry should use the techniques and Main Street that have been taught in this text to deal with analyst hype.

- Sell the public rather than quietly disseminated to ana ratings tend to cause stock prices to fall, while buy lysts.

- You don't expect the stock's dividend to change even though it pays $3 per share each year.

- If you paid a higher price, your rate of return would be less than 10%, and if you could acquire the stock for less, your rate of return would be more than 10%.

- The only cash flow variable used in this model is the fixed annual dividend.
- The price of the stock will fall if the required rate of return goes up to 15%.
- The simplified view of the valuation model is basically the procedure used to price.

- The zero-growth model does not take into account a growing stream of dividends.
- The dividend valuation model assumes that dividends will grow over time at a specified rate.

- The model assumes that dividends will grow at a constant rate forever, but that doesn't mean the investor will hold the stock forever.
- The investment horizon has no bearing on the computed value of a stock because the dividend valuation model makes no assumptions about how long the investor will hold the stock.
- It is irrelevant if the investor has a one-year, five-year, or ten-year expected holding period.
- Under all circumstances, the stock's computed value will be the same.

- Regardless of the intended holding period, the value of the stock will be the same.

- In practice, there are 2008 to December.
- After potentially two components that make up the total return to a stockholder: receiving the same dividends and capital gains.
- The model captures both components.

- If we assumed that investors needed a yield.
- The sum of the dividends and capital gain is what the stock would sell for.

- The constant-growth model should be used with more than one stock.
- It's best suited to the valuation of mature, dividend-paying companies that have a long track record of increasing dividends.
- These are probably large-cap companies that have demonstrated an ability to 8% or they expected dividends to generate steady--although perhaps not spectacular--rates of growth year in and rise.
- The company announced a dividend increase a few years ago.
- The growth rates may not be the same from year to year, but they tend to be later in the year.

- These are companies with predictable growth in earnings and dividends.

- Between 1990 and 2015, General Mills increased its dividends by about 7% per year.
- We wouldn't expect rapid growth in the food industry.
- Food consumption is closely tied to population growth so profits in this business should grow slowly over time.

- In April 2015, General Mills was paying an annual dividend of $1.76 per share, so for 2016 investors were expecting a modest increase in General Mills dividends over the coming year to $1.88 per share.
- If the required return on General Mills stock is 10%, investors should have been willing to pay $62.67 for the stock.

- The stock's market price was a little higher than its intrinsic value.
- If the required return on General Mills shares is higher than 10% or if the long-run growth rate in dividends is less than 7%, our estimate of intrinsic value might be too high.
- One of the drawbacks to the constant growth model is that the estimate of value that it produces is very sensitive to the assumptions one makes about the required return and the dividend growth rate.

- The constant-growth DVM is used by analysts to estimate the required return on a stock.

- Basic information about the stock's required rate of return, current level of dividends, and expected rate of growth in dividends is required for use of the constant-growth DVM.
- You can assume they will grow at an average rate in the future if they are growing at a constant rate.

- The growth rate embedded in a stream of dividends can be found with the help of a calculator or spreadsheet.
- For example, if a company pays a dividend today, it should be remembered that it paid a dividend several years ago.
- Today's dividends will be higher than they were in the past if dividends have been growing steadily.
- To find the discount rate that equates the present value of today's dividend to the previous one, use your calculator.
- You've found the dividend growth rate when you find that rate.
- The average rate of growth in dividends is the discount rate.

- General Mills paid an annual dividend in 2015.
- When the annual dividend was just $0.32 per share in 1990, the company had been increasing dividends steadily.
- The discounted back 25 years of the 2015 dividend is shown in the table below.
- When the discount rate is 7 percent, the present value of the 2015 dividend is roughly the same as the 1990 one, so the growth rate in dividends from 1990 to 2015 is 7 percent.

- General Mills paid dividends at an annual rate of $1.76 per share in 2015.
- If we assume that the required return on General Mills stock is 10%, combined with an expected dividend next year of $1.88 and a projected dividend growth rate of 7%, we can make an estimate of General Mills' stock value of $62.67.

- Consider the following example to see how this works.

- On January 2, 2016 a stock will pay its annual dividend of $2.00 per share.
- Next year's dividend will be 2% more than the previous year's, because investors expect it to grow at 5% per year.

- Assume that investors need a 9% return on the stock.

- An investor can buy this stock for $52.50 on January 2 and hold it for a year.
- On January 1, the investor will receive the next dividend and then sell the stock a day later.
- We must calculate the expected stock price that the investor will receive when she sells the stock on January 2nd in order to estimate the expected return on this pur chase.

- Let's take 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 888-353-1299 She chases the stock for $52.50 at the beginning of the year.
- She gets a dividend of $2.10 per share one year later and then sells the stock for $55.125.

- The capital gain is divided by the original pur chase price.

- The required return on the stock is 9%, which is exactly what the investor expects to earn.
- The stock price increased by 5% during the year.
- The stock price increased at the same rate as the dividend payment.

- The investor earned a 4% dividend yield.

- The 9% total return includes a 5% capital gain and 4% dividend yield.

- You can estimate the stock price on January 2 of any succeeding year if you repeat this process.
- The stock's dividend yield is 4% and the stock price increases by 5% every year as shown in the table below.
- The investor in this stock earns 9% every year.

- The constant-growth dividend valuation model is an improvement over the zero-growth model.
- The model does not allow for changes in expected growth rates.
- We can use a form of the DVM that allows for variable rates of growth.
- The stock price is calculated in two stages.
- In the first stage, dividends can grow quickly but not at a single rate.
- During this initial stage, the dividend growth rate can rise or fall.
- In the second stage, the company matures and settles on a sustainable rate of growth.
- It is possible to value the stock using the constant-growth version of the DVM.

- For companies that are expected to experience rapid or variable rates of growth for a period of time--perhaps for the first three to five years--this form is appropriate.
- This is the growth pattern of many companies, so the model has a lot of practice.

- It is a lot easier to find the value of a stock using Equation 8.9.

- Find the value of the dividends expected during the initial variable growth period.

- The price of the stock at the end of the initial growth period can be found using the constant-growth DVM.

- The present value of the stock is determined by step 3.
- The discounted price of the stock is the same as the last dividend payment in the initial growth period because the stock is being priced at the end of this initial period.

- To find the value of a stock, add the two present value components.

- Let's apply the variable growth model to Sweatmore Industries.
- The dividends will grow at a variable rate for the first three years.
- The annual dividend growth rate will go down to 3% after that.
- Sweatmore's divi dends should grow by 20% next year, by 16% in 2017, and then by 13% in 2018, before dropping to a 3% rate.
- SI's investors need an 11% rate of return.

- We project that dividends in 2016 will be $2.65 a share 1$2.21, and will rise to $3.081$2.65, 1.162, and 1.132, respectively.
- We have everything we need to put a value on Sweatmore.
- The variable growth DVM is shown in the table.
- Sweatmore stock has a value of $40.19 a share.
- The maximum price an investor should be willing to pay for the stock is the rate of return.

- The application of the DVM is very simple.

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