musings of a budding social entrepeneur

Tuesday, October 13, 2009

Chapter 7: Valuing Stocks

  1. learn how to read stock trading reports
  2. calculate the PV of a stock given forecasts of future dividends and future stock price
  3. use stock valuation formulas to infer the expected rate of return on a common stock
  4. Interpret 'priece-earnings ratios'
  5. Understand 'no free lunches' means on Wall street
 Def : Common stock - ownership shares in a publicly held corporation

LArge firms sell or issue shares of stock tot he public when they need to raise money.

Def: Primary market. Market for the sale of new securities by corporations.Fed ex and other frims sell new shares to the public only infrequentyly. These take place in the 'primary market'

Def IPO: First offering of stock to the general public.  The first time a company sells shares to the public.  Companies raise funds by selling these new shares, but the previous owners (investors, founders, employees) have to share ownership (and profits) with the new shareholders.  Current record ipo VA Linux Systems. In 1999 they shold shares at $30, but by the end of the day they had reached $239 (700% gain).

Def: secondary market. Market in which previously issued securities are traded among investors.  Exchanges are really markets for secondhand stocks. (NYSE and NASDAQ are the two main ones in US)  Every day the NYSE trades 3 billion shares with market value over $100billion.

Def P/E Ratio: Ratio of stock price to earnings per share.

What determines the value of a stock?

Def: Book value: Net worth of the firm according to the balance sheet.  = Total Equity/number of shares
Example. Fed Ex Equity on 5/31/07 was $12,656 mill.  Outstanding shares were 296 mill. book value = 12,656/296 = $42.76/share

Def: Liquidation value:  Net proceeds that could be realized by selling the firm's assets and paying off its creditors.

Market price is not the same as book or liquidation value. Investors buy shares on teh basis of present and future earning power. Two key features determine the profits the firm will be able to producer
1) the earnings that can be generated by the firm's current tangible AND intangible assets
2) the opportunities that the firm has to invest in lucrative projects that will increase future earnings.

7.3 Valuing Common Stocks

a. Valuation by Comparables - common first approach. divid stock price by measures of assets or earningsa nd see how these ratios stack up against other firsms.  See table 7-5 for examples in different industries.  Look at the industry average "price to book values" or "Price to earnings ratio" and then assume then multiply your company's book value times average ratio.

"Price to book" works best for companies with lots of fixed assets.  Not so good with companies with lots of intangibles and R&D

Price and Intrinsic Value
Just as bond values are the present value of all future coupon payments + PV of final payment,
Stock value is the present value of all future dividend payments up to the time of sale + the PV of the final selling point at the time of sale.

Intrinsic Value of Stocks is the present value of future cash flows except there's no final payment.

Say for example, you want to buy stock in Blue Skies Inc and sell it in a year, what price should you pay for it?  If the predicted stock price after 1 year is P1 and the expected dividend payout is DIV1, and the discount rate for the stock's expected cash flows is r, then...
The PV of the cash flows the investor will receive is
Vo = (DIV1+P1)/(1+r)

So if you're looking to buy a stock, you need to try to guess the intrinsic value and see what the going price is Po. If Po
If Po>Vo, then don't buy.

But how do we estimate the Future price P1?

Def - Dividend Discount Model : Discounted cash flow model which states that today's stock price equals the present value of all expected future dividends

Po = PV(DIV1, DIV2, DIV3,...DIVt, ...)
= DIV1/(1+r) + DIV2/(1+r)^2 + ... + DIVt/(1+r)^t + ...

Suppose our horizon date is H

Then the stock valuation formula using the DDM is

Po = DIV1/(1+r) + DIV2 (1+r)^2 + ... + DIVH/(1+r)^H

Which is always the same regardless of time horizon.

7.4 Simplifying the Dividend Discount model (DDM)

DDM with no growth, all earnings paid out as DIVs.  This is a special case. For example, there might be a producer in an industry that is heavily regulated and has fixed limits on annual production.

Value (or price of a share) of a No-growth stock  = Po = EPS1/r
EPS = earnings per share
In other words, the stock prices is the present value of future earnings per share.

Constant Growth Dividend Discount Model, - dividend grows at constant rate.
Version of the dividend discount model in which dividends grow at a constant rate
Po = DIV1/(r-g)
r = discount rate
g = constant growth rate

Estimating Expected Rates of Return (ERR)

In competitive markets, common stocks with the same risk are expected to have the same ERR. But how do you figure ERR? It ain't easy.

Rules of thumb
1) rewrite the constant growth DDM as
r = DIV1/Po + g
r = dividend yield + growth rate
ex. Blueskies
r = $3/$75 + .08 = 12%

Rate of Return for a particular company is determined by the rate of return offered by other equally risky stocks., not by DIV or g. DIV or g affect stock price, not rate of return.

So rate of return r for a company is based on the risk, if growth changes, stock price changes with it, not necessarily the rate of return.

NonConstant Growth (variable growth?)
Many companies grow at different rates for several years before settling down. we can't use the constant growh model to estimate value. Alternative approach see page 200

7.5 Growth Stocks and Income Stocks
"Growth stocks are ones that are expected to have capital gains. Income Stocks are ones that give cash dividends." Aha!

Def payout ratio - Fraction of earnings paid out as dividents
Def Plowback ratio - fraction of earnings retained by the firm
Def Sustainable Growth Rate : steady rate at which firm can grow; 

g = return on equity X plowback ratio

The total value of stock is equal to the value of it's assets in place (tangible/intangible) plus the present value of its growth opportunities (PVGO)

Def Present value of Growth opportunities (PVGO). Net present value of a firm's future investments.

Price to Earnings (P/E) ratio is an indicator of prospects. High P/E means that investors think that the company has good growth potential. however, if earnings are trending down, P/E will increase. Not necessarily a good sign.

7.6 No such thing as free lunches
Difference between technical analysts, and fundamental analysts. one look at numbers, the other look at trends in market/govt/society.


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