STOCK MARKET SCHOOL

Template STOCK MARKET SPECIALIST COURSE

SUBJECT: FUNDAMENTAL ANALYSIS
TOPIC: VALUATION OF COMMON STOCKS

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COACH : Mr. Reynaldo R. Nograles

Q: Given the market price MPo of a common stock in the market, how would an investor know if this stock is worth buying or not?

A: The investor determines the INTRINSIC VALUE Po of this common stock and then compares this intrinsic value with the market price MPo. If Po>MPo => the stock is worth buying. If Po<MPo => the stock is NOT worth buying (or the investor sells the stock if he/she already has it) If Po=MPo => the investor needs some other criterion or basis for buying or not buying the stock.
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STOCK VALUATION METHODS OR METHODS OF DETERMINING THE INTRINSIC VALUE OF THE COMMON STOCK OF A COMPANY:

METHOD 1 : 1 year holding period D1 P 1 P0 1 k where : D1 estimated dividend per share to be paid at the end of the year

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Template

P1 k

estimated price of the stock at the end of the year

the desired rate of return of the investor or the ROEof the company or R f E ( RM ) - R f the risk - free rate of return the systematic risk on the common stock the expected rate of return on the PSEi

Rf E(R M )

STOCK VALUATION METHOD

(continuation)

METHOD 2 : Holding Period H years (show the time diagram on the whiteboard) D1 1 k D2 (1 k ) 2 D3 DH ... 3 (1 k ) (1 k ) H PH (1 k ) H

P0

WORKSHOP PROBLEM: (to be solved by group after the presentation):

A plans to buy ABC Corp. common stocks now. He projects that ABC would pay annual dividends of P5, P6 and P8 per share at the end of years 1, 2 and 3, respectively, and that the price of the stock at the end of year 3 would be P100 per share. A expects the rate of return on the PSEi to be 15% per year and the risk free rate to be 6% p.a. The systematic risk on the stock is 1.5. If the stocks current market price is P71 per share, a) Calculate the intrinsic value of the stock. b) Is the stock worth buying now? EXPLAIN. ANSWER: a.) P0 = P71.674
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STOCK VALUATION METHOD

(continuation)

METHOD 3 : Indefinite Holding Period (i.e., H infinitely big) If H infinitely big, the equation for P0 under METHOD 2 can be written down as : D1 1 k D2 (1 k ) 2 D3 D ... 3 (1 k ) (1 k )

P0

This is the DIVIDEND DISCOUNT MODEL or the DDM for valuin g common stocks.

STOCK VALUATION METHOD

(continuation)

N.B.: The DDM asserts that Template 1. The intrinsic value P0 of a common stock is equal to the PV of all expected future dividends into PERPETUITY.
2. The intrinsic value P0 of a common stock is determined ultimately by the DIVIDENDS that the stock would pay in the future.

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STOCK VALUATION METHOD

(continuation)
METHOD 4 : the constant Growth DDM or the GORDON - SHAPIRO Model

let D0 = the current dividend or the dividend at the end of the PREVIOUS year g = the annual growth rate of the dividends = constant from year to year D1 = D0(1 + g); D2 = D1(1 + g) = D0(1 + g)2 ; D3 = D0(1 + g)3 ; ......DH = D0(1 + g)H
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STOCK VALUATION METHOD

(continuation)

Then the DDM equation can be written as : D0(1 g)2 D0(1 g)3 D0(1 g)H P0 ... 2 3 (1 k ) (1 k ) (1 k ) H (Equation 4.1) 1 k Multiply Equation 4.1 by : 1 g D0(1 g) 1 k 1 k P0 1 g D0 D0(1 g) 1 k D0(1 g)2 D0(1 g)H 1 ... 2 (1 k ) (1 k ) H 1 ( Equation 4.2)
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STOCK VALUATION METHOD

(continuation)
Subtract Equation 4.1 from Equation 4.2 : 1 k P0 1 g 1 k 1 g P0 1 P0 D0 D0 (1 g) H (1 k) H or

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(1 g) H D0 1 (1 k) H (1 g ) H , (1 k ) H k g Po 1 g D1 k g
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when k g AND when H 1 k 1 P0 1 g or P0 D 0 or

D0

D0 (1 g ) or P0 k g

STOCK VALUATION METHOD

(continuation)

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WORKSHOP PROBLEM FOR METHOD 4( to be solved by group after the presentation):

Last year, ABC Corporation paid out dividends of P6 per share and it is assumed that these dividends will grow annually at a constant rate of 10%. It is expected that the rate of return on the PSEi will be 20% p.a. and that the risk-free rate will be 5% p.a. If the systematic risk on ABCs common stock is 1.2 and if its current market price is P54 per share,
a.) determine the intrinsic value of the stock. b.) Is ABCs common stock worth buying? EXPLAIN. ANSWER: P0 = P50.77
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STOCK VALUATION METHOD

(continuation)
M ETHOD5 : The NAV M ethod

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Template
Net realizable value of assets liabilitie s No.of oustanding common shares

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NAV per share

N.B.: 1. This method is commonly used to value the common stocks of real estate development companies like ALI, Megaworld, FLI, etc. 2. The method is most suitable for valuing the common stocks of a company that is under LIQUIDATION.

STOCK VALUATION METHOD

(continuation)
METHOD 6 : The Price/Earnings Ratio (PER) Method P0 AVERAGE PER x EPS 0

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where: PER = price/earnings ratio = market price as of the end of a given year EPS or earnings per share at the end of that year EPS at the end of any given year= net income after tax during the given year No. of outstanding common shares as of end of that year
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STOCK VALUATION METHOD

(continuation)

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where: AVERAGE PER = the average PER of the company during the LAST SEVERAL YEARS or the PER of the SECTOR or INDUSTRY to which the company belongs
EPS0= the current earnings per share of the company or the earnings per share at the end of the PREVIOUS YEAR

N.B.: Pause for 15 seconds to allow Method 6 to sink in!

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STOCK VALUATION METHOD

(continuation)

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Notes on the PER: 1. The PER of a common stock may be interpreted as the number of pesos that the investor would be willing to pay for every peso of net income that the common stock earns. 2. The PER of a common stock is NOT CONSTANT; it changes from year to year
3. The FORWARD PER of a common stock (i.e., the stocks PER one year from now) may be obtained by dividing the stocks current intrinsic value by the estimated EPS at the end of that one year; that is,

FORWARD PER

P0 EPS1
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STOCK VALUATION METHOD

(continuation)

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4.) Under the GORDON-SHAPIRO Model, the FORWARD PER is given by

P0 EPS1 1 EPS1 D1 1 k - g EPS1 D1 / EPS1 k -g EDPR k -g
1

FORWARD PER

P0

EXPECTED DIVIDEND PAYOUT RATIO AT THE END OF THE FORWARD YEAR k -g 1 - EXPECTED PLOWBACK RATE AT THE END OF THE FORWARD YEAR k -g or FORWARD PER 1 - b1 ( Equation 4.3) k -g

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STOCK VALUATION METHOD

(continuation)

5.) After obtaining the value of the FORWARD PER from Equation 4.3, this value may be used to Template ESTIMATE the price P1 of the common stock at the end of the forward year; that is,
P 1 FORWARD PER x EPS1 1 b1 xEPS1 k g 1 b1 EPS 0 1 g k g

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STOCK VALUATION METHOD

(continuation)

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WORKSHOP PROBLEM FOR METHOD 6( to be solved by group after the presentation): ABC Corporation pays annual common stock dividends that grow or increase at a constant rate of 10% per year. During the current year, ABC paid dividends of P8 per common share. By the end of year 1, it is estimated that ABC will earn P70 per common share, 85% of which would be retained by the company. It is expected during year 1 that the rate of return on the PSEi would be 15% and that the risk-free rate would be 6% p.a. It is also known that the systematic risk on the stock is 1.5. a) Determine the intrinsic value of the stock b) If the current market price of the stock is P95 per share, is the stock worth buying now or not? c) Estimate the price of the stock at the end of year 1.

ANSWERS: P0 = P92.632; P1 =P110.526

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STOCK VALUATION METHOD

(continuation)

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METHOD 7 : The ENTERPRISE MULTIPLE (EM) Method Enterprise Value or EV EBITDA

ENTERPRISE MULTIPLE

EM

where: EV = Market Capitalization + LT debts Cash equivalents Marketable or Tradeable Securities or Investments

Market Capitalization = current market price of the common stock x No. of outstanding common shares
EBITDA = Earnings before INTEREST, TAXES, DEPRECIATION and AMORTIZATION

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STOCK VALUATION METHOD

(continuation)

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NOTES ON METHOD 7 (EM Method):

1) The method takes into account the LT debts of the company
2) The method is more appropriate for comparing companies having operations in different countries because it does not consider the distorting effects of international taxation policies and depreciation practices 3) The method can be used even for companies that incur and report net losses 4) A LOW EM compared to other companies in the same industry indicates that the company is UNDERVALUED which can be a basis for BUYING THE company.
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STOCK VALUATION METHOD

(continuation)

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INTERMISSION (before going to METHOD 8): DETERMINING THE WEIGHTED AVERAGE COST OF CAPITAL or WACC OF A COMPANY
STEP 1: Obtain the cost KPS of preferred stocks, the cost KCS of common stocks and the cost KLTD of LT debts.

STEP 2: Calculate the WACC using as weights the proportions of preferred stocks, common stocks and LT debts to the TOTAL CAPITAL of the company; i.e., WACC = WPSKPS + WCSKCS + WLTDKLTD (1-CITR)
N.B.: 1. WPS, WCS AND WLTD should be in decimals and their sum should be equal to 1; i.e., WPS + WCS+ WLTD = 1 2. The values of KPS, KCS, KLTD may be left in PERCENTAGES. 3. CITR = the corporate income tax rate of the company
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DETERMINING THE COST OF PREFERRED STOCK (KPS)

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DPS K Template PS N PS

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WHERE: DPS = the annual AMOUNT of dividend PER SHARE on the preferred stock
NPS = the NET PROCEEDS PER SHARE from the sale of the preferred stock = selling price per share of the preferred stock underwriting or flotation expense per share

DETERMINING THE COST OF COMMON STOCK (KCS)

1.) Method A : Using the CAPM : K CS k R f E ( RM ) - R f 2.) Method B : Using the GORDON - SHAPIRO equation : D1 P0 k -g Solving for k : D1 k g P0

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REPLACING P0 by the current market price (MP0 ) of the stock : k KCS D1 MP0 g

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STOCK VALUATION METHOD

(continuation)
METHOD 8 : The DISCOUNTED OPERATING FREE CASH FLOW (DOFCF) Method : STEPS : 8.1) STEP 1 : Obtain the market value VT of the

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ENTIRE company or enterprise by discountin g the ANNUAL OPERATING FREE CASH FLOWS or OFCF' s using the company's WACC as the discount rate; that is, OFCF1 OFCF2 1 WACC (1 WACC ) 2 OFCF .... (1 WACC ) OFCF3 (1 WACC ) 3
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VT

STOCK VALUATION METHOD

(continuation)

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WHERE: OFCFt = the EXPECTED operating free cash flow at the end of the year t = the amount of cash flow available to investors (i.e., the shareholders and the providers of LT debts or creditors) after the company has set aside all amounts or monies needed for operation and to pay for the companys investments in fixed assets and current assets.
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METHOD 8: THE DISCOUNTED OPERATING

FREE CASH FLOW METHOD (CONTINUATION)

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In practice, VT is obtained by using an equation which is homologous to the GORDON-SHAPIRO MODEL equation for obtaining the intrinsic value Po. This equation for VT is

VT

OFCFO (1 g ) WACC g

Where: OFCFo = the opeating free cash flow at the end of the current year. g = the constant annual growth rate of the 26 OFCFs

METHOD 8: The DISCOUNTED OPERATING FREE CASH FLOW Method (continuation)

8.2) STEP 2: Determine the market value VLTD of all the companys LT debts. 8.3) STEP 3: Determine the market value VPS of the companys preferred stocks 8.4) STEP 4: Obtain the market value VCS of the companys common stocks; i.e., VCS = VT VLTD VPS

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8.5) STEP 5: Determine the intrinsic value P0 of the companys common stocks; i.e., V
Po =
CS

No. of outstandin g common shares

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STOCK VALUATION METHOD

(continuation) WORKSHOP EXERCISE FOR METHOD 8:

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The end-of-year operating free cash flow for the CURRENT YEAR of ABC Corporation is 600,000Php and this cash flow is projected to GROW AT A CONSTANT RATE of 3% p.a. The market value of all the companys LT debts is 3.1MPhp while the market value of its preferred stocks is 800,000Php. The companys WACC is 9% p.a. If the company issued 1M outstanding common shares, find the intrinsic value per share of these common stocks. (Answer: 6.40Php)
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