Valuing Common Stock

8 Key excerpts on "Valuing Common Stock"

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  eBook - ePub

  The AMA Handbook of Financial Risk Management

  • John Hampton(Author)
  • 2011(Publication Date)
  • AMACOM

    (Publisher)

  To minimize possible fraud . The SEC monitors corporations to reduce the chance of misrepresentation, dishonesty, and fraud connected with the sale of common stock.

  VALUATION CONCEPTS

  When an investor is evaluating the purchase of common stock to hold in an investment portfolio, she must be knowledgeable with respect to investment values. In this section, we will examine different concepts of value.

  Common Stock Values

  The value of a security may be defined as its worth in money or other securities at a given moment in time. The value of an equity security can be expressed in various terms, including:

  • Going concern value . This is applied to the common stock of a profitable and otherwise successful firm with prospects for indefinite future operations. The value is based upon future cash flows, profits, dividends, or the growth rate of the business.

  • Liquidation value . This applies to the common stock of a firm that is ceasing operations. It assumes the sale of all assets, the payment of all liabilities, and the repurchase of any preferred stock. The remaining value is the liquidation value of the common stock.

  • Market value . This is the value of stock based upon the assessment of all investors at a given moment in time. In effect, it is the current market price of the stock.

  • Book value . This is the value based on the firm’s accounting records. It is calculated by dividing the total of contributed capital and retained earnings by the number of shares outstanding.

  Intrinsic Value

  A stock’s intrinsic value is the real worth of the security when the primary factors that create value are taken into consideration. In other words, it is the market value that would be justified by an analysis of the fundamental factors of stock value. It may be based on any or all of the following:

  • Physical assets

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  eBook - ePub

  The Handbook of Traditional and Alternative Investment Vehicles

  Investment Characteristics and Strategies

  • Mark J. P. Anson, Frank J. Fabozzi, Frank J. Jones(Authors)
  • 2010(Publication Date)
  • Wiley

    (Publisher)

  What determines the market price of a share of common stock? Like anything else, price depends on what people are willing to pay. The price of a share of stock today depends on what investors believe is today’s value of all the cash flows that will accrue in the future from that share of stock. In other words, investors are not going to pay more today for a share of stock than they think it is worth—based on what they get out of it in terms of future cash flows. What people are willing to pay for a share of stock today determines its market value. This theory of stock prices makes sense. If we could accurately forecast a company’s cash flows in the future, we could determine the value of the company’s stock today and determine whether the stock is over- or under-valued by the market. But forecasting future cash flows is difficult. As an alternative, what is typically done is to examine the historical and current relation between stock prices and some fundamental value, such as earnings or dividends, using this relation to estimate the value of a share of stock.

  In this chapter and the next, we look at common stock as an investment. We explain the fundamental factors of earnings and dividends and their relations with share price as expressed in such commonly-used ratios as the price-earnings ratio and the dividend yield, where stocks are traded, the mechanics of stock trading, and trading costs. In the next chapter we focus on common stock portfolio strategies.

  EARNINGS

  A commonly used measure of a company’s performance over a period of time is its earnings, which is often stated in terms of a return—that is, earnings scaled by the amount of the investment. But earnings can really mean many different things depending on the context. If a common stock analyst is evaluating the performance of a company’s operations, the focus is on the operating earnings of the company—its earnings before interest and taxes

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  eBook - ePub

  Five Key Lessons from Top Money Managers

  • Scott Kays(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 10 Valuing Stocks Most investors utilize simplistic valuation techniques that require little time and effort. As we will see shortly, most of those methods are flawed and frequently yield inaccurate results.

  Faulty analysis can produce two types of poor investment decisions: Valuing a company too richly increases the probability you will overpay for it. Conversely, significantly undervaluing a security may cause you to pass on a compelling investment opportunity because you think its price is too high. Without a reasonable idea of what a firm is worth, obtaining a strong return from an investment becomes a matter of chance.

  Computing a stock’s fair value does not so much establish a single number that represents the company’s exact worth as it helps you determine the business’s worth to you—it tells you what you can pay for the firm and still generate the return you need. Stated differently, the intrinsic value figure places a worth on a security’s projected cash flow based on the available alternatives. Calculating stocks’ fair values also lets you compare the relative valuations of companies to each other.

  Since the cash flows of corporations drive their values, a time-tested method for determining a firm’s worth involves calculating a current value for all of its expected future income. The math used to calculate the present value of a firm’s future earnings is relatively simple, but it requires an understanding of two basic concepts: (1) the future value of a present sum of money and (2) the present value of a future income stream.

  THE FUTURE VALUE OF MONEY

  Would you rather receive $1 today or $1.10 a year from now? The answer depends on the return you can earn on $1. If you can earn 7 percent, today’s $1 would be worth $1.07 a year from now, making the guaranteed $1.10 more attractive. Conversely, if you can invest at 15 percent, taking the $1 now makes more sense.

  Let’s assume you can invest at 7 percent. The future value of $1 in one year would be $1.07. The $1 would grow to $1.14 in two years, and so on. By varying the interest rates and time periods, you can develop a future value table, such as the one found in Table 10.1

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  eBook - ePub

  Value Investing in Growth Companies

  How to Spot High Growth Businesses and Generate 40% to 400% Investment Returns

  • Rusmin Ang, Victor Chng(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  Chapter 7

  Valuation—The Fourth Piece of the Puzzle

  The Valuation of a Stock

  The fourth and final piece of the puzzle is valuation —the financial projection. This is the most important piece to access once the other three pieces have been addressed. Here, valuation is what we call the final part of assessment before buying into a stock. Needless to say, every stock has a price tag. So, at what price is a stock considered cheap? This chapter serves to answer this question.

  Though we cannot expect to buy a stock at its absolute bottom, for example, in the 2008–09 crash, when the Straits Times Index (STI) was at its lowest, at 1,500 points, and sell it at its peak in 2010, when the STI had recovered to above 3,300 points, we can avoid doing the opposite. Many investors commit the mistake of buying high, when someone they know is supposedly making a killing in the stock market, and selling low, when prices start to dive. Now that you are aware that Mr. Market is subject to mood swings, you need to know how to make full use of its irrationality, in order to purchase stocks at bargain prices and sell when others are ready to pay a premium price. In order to do this, you need to know how to calculate the intrinsic value of the company based on a certain set of assumptions. Valuation can help you achieve this, so that you can buy a growth company when it is trading at a discount from its intrinsic value.

  In relation to the valuation of a stock, there are three types of valuation methods that we often use to determine growth companies:

  1. Price-to-Earnings Ratio (PE Ratio)

  2. Price-to-Earnings to Growth Rate Ratio (PEG Ratio)

  3. Discounted Earning Model

  Now let us go through these valuation methods one by one.

  Why Earnings Are Used

  When valuing a growth company, it is best to use a metric like earnings per share instead of operation cash flow. This is because growth companies tend to spend more on development costs to expand their businesses further, causing the operation’s cash flow to be plowed back into the business. However, some companies are good at manipulating earnings when they do business on credit with debtors. Such manipulation is short term. In the long run, the company’s true colors should reveal themselves. To ensure that we have an accurate assessment of a company, it is important for us to obtain a track record that goes back a minimum of three to five years. Healthy numbers reported in the past do not imply that a company will stay healthy into the future. However, such figures are definitely easier to interpret and project into the future, as compared to a company that reports inconsistency in its revenue, net profit, and cash flow. This inconsistency makes it extremely hard to value or project the company into the future when determining its intrinsic value. Again, consistency is a key quality when comparing these numbers.

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  eBook - ePub

  An Introduction to International Capital Markets

  Products, Strategies, Participants

  • Andrew M. Chisholm(Author)
  • 2009(Publication Date)
  • Wiley

    (Publisher)

  9 Equity Fundamental Analysis

  9.1 CHAPTER OVERVIEW

  When assessing the current condition and future prospects of a company, investors, and analysts often tend to start by assessing the information contained in the financial statements. This is known as fundamental analysis. Although the analysis is typically based on current and historical data, this is normally used as a starting-off point to make forecasts about the future. This chapter looks at the key items in a company’s balance sheet and income statement (profit and loss account). It sets out the balance sheet equation and explains the concept of accruals accounting. It explores what is meant by shareholders’ equity as it appears in a balance sheet, and compares it with market capitalization. Equity analysts use a range of financial ratios to extract information about a company from its financial statements. The chapter defines the main ratios and illustrates how they are used. In attempting to value shares and make investment recommendations, equity analysts use a range of valuation multiples. This chapter looks at the most widely used, the price/earnings ratio, and explores the applications and limitations of this measure. Finally, it considers some alternative valuation tools including the price/book ratio and a measure that is now widely used by professional equity analysts, the firm value/EBITDA multiple. All of these multiples are based on accounting numbers, although EBITDA is the closest to cash flow. The following Chapter 10 explores equity valuation methodologies based on discounted cash flow techniques.

  9.2 PRINCIPLES OF COMMON STOCK VALUATION

  Common stock (ordinary shares) provides an investor with a share in the total net assets (total assets less total liabilities) of a company plus the right to receive dividends if they are distributed. Unlike a fixed income security such as a bond there is no pre-determined return on an investment in a share. Nor is there a fixed redemption date. This makes the valuation of common stock a complex and uncertain process. There are many factors to take into account:

  • the value of the company’s assets including intangible (non-physical) resources such as brands, patents, reputation, and client relationships; • its liabilities including bank loans and money owed to trade creditors; • forecasts of future sales, costs, profits, and dividends; • the company’s business strategy, its sources of competitive advantage, its order book, the quality of the management and workforce;

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  eBook - ePub

  The Fundamental Principles of Finance

  • Robert Irons(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  Chapter 4 , we learned that the cost of debt is interest. There are two costs to stock: dividends and capital gains. So, the total yield on a stock is comprised of dividend yield and capital gains yield. Since stock returns are more volatile than interest rates, most stocks typically have required returns that are higher than the YTM on investment grade bonds. In this chapter, we learn the very basics of how to value a stock.

  The Fundamental Principles in Action

  FP1 states that an asset derives its value from the cash flows it will produce. For many stocks, the cash flows are the dividends paid to common shareholders. For stocks that do not pay dividends, the cash flow from assets (CFFA) valuation model will be discussed. FP3 indicates the inverse relationship between an asset’s yield and its market value. This is clearly reflected in the mechanics of the dividend discount model used to value a stock. FP2 asserts that risk and return are directly related, and so riskier assets require higher returns. This applies to stocks as well, and it can be seen in PR1 (relating value inversely to the discount rate). Since the required return on the firm’s stock is used as the discount rate in valuing the stock, stocks of higher risk will pay a higher discount rate, which will reduce the market value of the stocks.

  The Basics of Stocks

  As mentioned above, common stock represents ownership in the firm as well as a claim to the common dividends paid by the firm. Preferred shareholders do not have ownership claims, but they do have claims to the preferred dividends paid by the firm, and in the case of bankruptcy they get in line ahead of the common shareholders for claims against the firm’s assets. So common shareholders purchase stocks in order to obtain dividends and/or to obtain capital gains (i.e., see the stock price rise over time), while preferred shareholders purchase stocks for the security of the income (the preferred dividend is more reliable than the common dividend) and to protect their investment (by being ahead of the common shareholders in the bankruptcy line). The difference between common and preferred shareholders is the risk–return tradeoff; common shareholders want growth, both in the share price and in the annual dividend, while preferred shareholders want mainly to protect their investment. Common shareholders know that growth stocks are risky because there are a number of things, both inside and outside of the firm’s influence, that can affect the firm’s profitability (and therefore the stock’s return). The common shareholders are less risk averse and are willing to take on the risks associated with the stock’s returns in the belief that the long-run returns will be high enough to justify the risks. The preferred shareholders are (relatively) more risk averse and are willing to accept lower returns on their investment in order to avoid the risks associated with the common equity market.

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  eBook - ePub

  Islamic Capital Markets

  A Comparative Approach

  • Obiyathulla Ismath Bacha, Abbas Mirakhor(Authors)
  • 2019(Publication Date)
  • WSPC

    (Publisher)

  Chapter 9

  COMMON STOCKS AND EQUITY MARKETS

  Topics in this Chapter

  9.1.Introduction 9.2.The Evolution of Stocks 9.3.Why Companies Choose to List 9.4.Rights of Share Ownership

  9.5.Equity Ownership and Shari’ah Compliance

  9.6.The Valuation of Common Stocks 9.7.The Market Required Rate of Return 9.8.Required Return and Stock Price Dynamics Dividend Growth and the Trade-off with Capital Gains Stock Market Indices 9.9.Schools of Thought on Stock Price Behavior

  Chapter Objective

  This chapter is designed to provide readers with an in-depth introduction to common stocks, their evolution, valuation, and pricing models. Beginning with an explanation of how equity differs from debt, the function of stock markets and the terminologies used are explained. The different schools of thought on stock price behavior are also explained. On completing the unit, the reader should have a good understanding of stocks, why companies choose to list and issue stocks, what returns investors get from holding stocks, how to value stocks, and finally, the alternative explanations of stock price behavior.

  9.1.Introduction

  Investment in the form of equity is very different from investment in debt instruments. As explained in Chapter 5 on bonds, debt financing is fixed in claim and time. Equity, on the other hand, represents ownership and is therefore residual in claim and has no fixed time (maturity) — i.e., equity is perpetual. By residual in claim, we mean that an equity-holder has a claim on all assets that have not been mortgaged or pledged in any way. Whereas collateralized debt would constitute a claim on a specific asset(s), equity represents a claim on all assets of the firm and not specific ones. To understand what all these means, let us look at an example in Box 9.1 .

  Box 9.1. Illustration: A Common Stock Purchase

  Suppose Ali buys stocks in Malaysia Airlines (MAS) at RM5.00 each for a total investment of RM5,000 (1,000 shares), Ali now becomes a shareholder in MAS. As a shareholder, Ali is essentially a co-owner of MAS. Ali co-owns MAS together with the thousands of other shareholders who have also invested in MAS shares. The size or proportion of Ali’s ownership of MAS will depend on the size of Ali’s holding relative to the total number of outstanding stocks. If, for example, MAS has a total of 100,000 shares outstanding, then Ali’s stake is 1% of MAS. If, on the other hand, MAS has one million shares outstanding, then Ali’s stake is 0.01% or a tenth of 1%. To understand why equity is a perpetual claim, unlike a bond which has no maturity, Ali’s stake in MAS remains for as long as he holds the shares in the company.

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  eBook - ePub

  Quantitative Financial Analytics

  The Path to Investment Profits

  • Edward E Williams, John A Dobelman;;;(Authors)
  • 2017(Publication Date)
  • WSPC

    (Publisher)

  The basic procedure for evaluating equity securities begins very much like the one recommended for bond analysis. First, aggregate economic projections are made. Next, a comprehensive evaluation of the industry in question is prepared. Finally, the future earnings position of the firm is forecasted as far as possible into the future. Probability estimates are attached where appropriate to such significant variables as sales, pertinent cost figures, and most importantly, net income. Because a major element of the cash return generated by a common stock is the dividend it pays, a careful projection of the future dividend policy of the firm must be made. Ratio analysis can be a very useful supplement to the forecasting procedures. Various profit, turnover, and return-on-investment ratios may be computed for the firm in past years and for other comparable enterprises in the industry. These ratios may be used as performance criteria in evaluating the future prospects for the firm.

  Dollar returns from common stocks are derived from two sources; (1) the dividends paid by the firm, and (2) the price appreciation of the security. The ability of a firm to pay dividends, of course, depends upon its earning power. A firm that generates only a negligible return on its asset investment will obviously be in no position to pay dividends. Nevertheless, even firms that obtain very good returns on investment sometimes elect not to pay large dividends. Such firms may be able to benefit stockholders more by retaining earnings and reinvesting in profitable assets. This procedure will produce higher earnings in the future and improve the long-run dividend paying potential of the firm. When a firm retains earnings for reinvestment in profitable projects, it improves its long-run earnings stream. This improvement should be reflected in the price of the firm’s shares. Thus, by retaining earnings, the firm may in effect raise the price of its stock.

  Common shares may be categorized by the above characteristics. The shares of firms that do not generate large returns on their investment in assets but that pay out in cash dividends most of what they do earn are called income shares. These stocks sell almost entirely on a pure dividend yield basis, because appreciation from retained earnings is limited. Income stocks may be above-average-risk securities issued by declining firms that have exhausted their most profitable reinvestment opportunities. Many fire and casualty insurance, undiversified tobacco equities, etc., would be included in this group. On the other hand, income stocks may also be lower-than-average-risk securities issued by firms that have their return on investment regulated by government. These equities, which are usually stable and relatively safe even during periods of recession, may retain earnings and show capital appreciation. Nevertheless, their growth rates are constrained by the regulated rate of return that they are allowed to earn on plant and equipment. The best examples of the low-risk income shares are those of American public utilities. Shares that are stable and relatively recession-proof are also called defensive shares. All defensive shares are not income stocks, however. Food and drug companies are considered to be defensive securities, and their dividend yields are generally low. Their shares also have growth potential. Gold mining and distillery stocks are also typically classified as defensive stocks, and many of these securities (particularly the gold mining shares) pay no dividends at all.

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