Chapter8StockValuation143

Chapter8
StockValuation
.1

Outline

Learning Goals
I.

Valuation:ObtainingaStandardofPerformance
A) ValuingaCompanyandItsFuture
1. ForecastedSalesandProfits
2. ForecastedDividendsandPrices
a. GettingaHandleontheP/ERatio
b. ARelativePrice/EarningsMultiple
c. EstimatingEarningsPerShare
d. PullingItAllTogether
B) DevelopinganEstimateofFutureBehavior
C) TheValuationProcess
1. RequiredRateofReturn
ConceptsinReview

II.

StockValuationModels
A) TheDividendValuationModel
1. ZeroGrowth
2. ConstantGrowth
a. ApplyingtheConstantGrowthDVM

144Gitman/JoehnkFundamentalsofInvesting,NinthEdition

3. VariableGrowth
a. ApplyingtheVariableGrowthDividendValuationModel
4. DefiningtheExpectedGrowthRate
B) SomeAlternativestotheDVM
1. DividendsandEarningsApproach
2. FindingtheValueofNonDividendPayingStocks
3. DeterminingExpectedReturn
4. ThePrice/Earnings(P/E)Approach
C) OtherPriceRelativeProcedures
1. APricetoCashFlow(P/CF)Procedure
2. PricetoSales(P/S)andPricetoBookValue(P/BV)Ratios
ConceptsinReview

Chapter8StockValuation145

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
8.1 ChrisLooksforaWaytoInvestHisNewFoundWealth
8.2 AnAnalysisofaHighFlyingStock
ExcelwithSpreadsheets
TradingOnlinewithOTIS

.2

Key Concepts

1.

Theroleacompanysfutureprospectsplaysinthestockvaluationprocessandaframeworkfor
developingsuchforecasts.

2.

Developingaforecastofastocksexpectedcashflow,startingwithcorporatesalesandearningsand
thenmovingtoexpecteddividendsandshareprices.

3.

Theconceptofintrinsicvalueasastandardofperformance,anditsuseinjudgingtheinvestment
suitabilityofashareofcommonstock.

4.

Valuationofastockusingzerogrowth,constantgrowth,andvariablegrowthdividendvaluation
models.

5.

Otherstockvaluationmodels:DividendandEarningsandIRRapproaches.

6.

Pricerelativemeasures,includingprice/earnings,price/cashflow,price/sales,andprice/bookvalue.

7.

Understandingthatdifferentvaluationmodelsworkindifferentinstancesdependingonthepayment
ofdividendsandearningspersistence.

.3

Overview

Thetopicsofstockvaluationandsecurityanalysisarefurtherconsideredinthischapter.Itisbasicallya
continuationofthediscussionintheprecedingchapter.Alsoaddressedaresomemajorchangestaking
placeinthemarket,astheyaffectthevaluationprocess.
1.

Afteranalyzingacompanysperformancetodate,theinvestorprojectsthecompanysfuture
performance.Basicperformanceprojectionsarerelatedtothesalesandprofitsofthecompany,
subjecttovariouseconomicandindustryprojections.Next,estimatesoffuturedividendsandstock
pricesareobtained.Usingtheexampleinthetext,theinstructorshouldstresstheusefulnessand
limitationsofhistoricalgrowthratesinobtainingestimatesofthefuture.

146Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2.

TheP/Eratioisthenextensivelydiscussed,includingtherelationshipbetweenacompanysP/E
ratiosandthemarketsP/E.Thisratioisshowntobeafunctionofthegrowthofthefirm,therisk
associatedwiththatgrowth,andP/Eratiosinthemarketplace.

3.

Nextcomesthediscussionofvarioustypesofstockvaluationmodels.Firstpresentedisthedividend
valuationmodelasatheoreticallysoundapproachtoapplytocommonstocks.Themodelrequiresa
forecastofthenextreturn,whichisafunctionofriskandalternativereturns.Inthisregard,the
CAPMisreintroducedatthispointtoshowhowCAPMcanbeusedtoestablishtherequiredrateof
return.Threetypesofdividendvaluationmodelsareintroduced:zerogrowth,constantgrowth,and
variablegrowthmodels.

4.

ThedividendsandearningsapproachandtheP/Eapproacharethenshownasalternativestothe
dividendvaluationapproach.Thismodelisbasedonthepresentvalueofthestocksfuturecashflow,
fromdividendandcapitalgains,overafiniteholdingperiod;itcorrectssomeofthepractical
shortcomingsofthedividendvaluationmodel.Theinstructorshouldworkoutseveralvaluation
examples,includingthedividendvaluationapproach,HPR,thepresentvalueofastock,andyield.

5.

Inaddition,theinvestmentdecisionprocessisthoroughlydiscussed.Astockshouldbeconsidereda
viableinvestmentcandidatewhenintrinsicvalueresultsinarateofreturnthatmeetsorexceedsthe
investors(riskadjusted)desiredrateofreturn.

.4

Answers to Concepts in Review

1.

Thepurposeofstockvaluationistoobtainastandardofperformancethatcanbeusedtojudgethe
investmentmeritsofashareofstock.Astocksintrinsicvalueissuchastandard;itprovidesan
indicationofthefutureriskandreturnperformanceofasecurity.

2.

Expectedearningsareindeedimportantindeterminingastocksinvestmentsuitability.Inmakingan
investmentdecision,theinvestormustdecideifastockisundervaluedorovervaluedbycomparing
thecurrentmarketpriceoftheissuetoitsintrinsicvalue.Andtheintrinsicvalueofastockdepends
onaninvestorsexpectationsaboutitsfuturecashflowsanditsrisk.Toestimatefuturecashflows,
onehastoforecastthefutureearningsofthatcompany.Thisisdonebymultiplyingforecastedsales
bytheforecastednetprofitmargin.Expectedfuturereturns(fromdividendsandcapitalgains)
dependontheseforecastedearnings,aswellasforecasteddividendpayoutratios,thenumberof
sharesoutstanding,andfutureprice/earningsratios.

3.

BoththegrowthprospectsofacompanyandtheamountofdebtitusescanaffecttheP/Eratio.As
thegrowthrateincreases,ahigherP/Eratiocanbeexpected.Likewise,asthedebtleveldecreases,
thefinancialriskinherentinthefirmdecreases,andtheP/Eratiocanbeexpectedtoincrease.Other
factorsthataffecttheP/Eratioaregeneralmarketpsychology(higherP/Eratiosaccompany
optimisticmarkets)andthelevelofdividends(ahigherP/Eratiocanbeexpectedwithhigher
dividends,solongasthefirmisalsoabletomaintainarespectablerateofgrowthinearnings).

4.

ThemarketmultipleistheaverageP/Eratioofstocksinthemarketplace.Itprovidesinsightintothe
generalstateofthemarketanditgivestheinvestorinformationonhowaggressivelythemarketis
pricingstocks.Usingthemarketmultipleasabenchmark,astocksP/Eperformancecanbe
evaluatedrelativetothemarket.TherelativeP/Eofastockisnotthemarketmultiple.Therelative
P/EisfoundbydividingastocksP/EbythemarketsP/E.

Chapter8StockValuation147

5.

Ifthecomputedrateofreturnequalsorexceedstheyieldtheinvestorfeelsiswarranted,basedonthe
stocksriskbehavior,orifthejustifiedpriceisequaltoorgreaterthanthecurrentmarketprice,the
stockunderconsiderationshouldbeconsideredaworthwhileinvestmentcandidate.Therequiredrate
ofreturnprovidesastandardsothataninvestorcandetermineiftheexpectedreturnonastockis
satisfactoryornot.Therequiredrateofreturnispositivelyrelatedtotheunderlyingriskinvolvedin
aninvestment.Thehighertherisk,thehigherthereturntheinvestorwouldexpecttheinvestmentto
generate.Theinvestorwhopicksastockwhosereturnislessthantherequiredrateofreturnhas
reallyinvestedinastockwhichisovervaluedatthecurrenttime.Thisisbecausethestockisnot
yieldingreturnscommensuratewiththeriskexposure.Sincethemarketwilllearnofsuch
overvaluationintime,marketforceswillbiddownthepriceofsuchasecurity.Theinvestorwill
incurcapitallosseswhenthestockpricedropsbelowthepurchaseprice.

6.

Ingeneral,thevalueofanyassetisthepresentvalueofallfuturecashflowbenefitsreceived.For
commonstock,thecashflowisdividendsreceivedeachyearplusthefuturesalepriceofthestock.If
anyfuturepricecanbedescribedintermsofsubsequentdividends,thenthecurrentpricecanbe
viewedasthepresentvalueofdividendsreceivedoveraninfinitetimehorizon.Thebasicdividend
valuationmodelreducestheneedtoestimateallfuturedividendsindividuallybysayingthatthe
valueofashareofstockisafunctionofdividendsthataregrowingataspecifiedrateovertime.In
thisway,eachfuturedividendcanbeexpressedasafunctionofthecurrentdividendandaspecified
rateofgrowthindividends.Thediscountrateappliedtothesefuturecashflowsisthedesiredrateof
returnoftheinvestorrelativetotheriskofthestockandtheotherreturnsavailable.
TheDVMcanbeusedtovalueastockwhichpaysaconstantdividend;anongrowingstockwhich
paysadividendthatisgrowingataconstantrateovertime;andastockwhichpaysadividendthat
growsatvariableratesovertime.
TheCAPMfitsintothevariablegrowthDVMthroughitseffectonk,therequiredrateofreturn.The
greaterthesystematicriskofaparticularinvestment,thegreatershouldbeitsrequiredrateof
return,ascomputedusingtheCAPMand,therefore,thelowerthevalueobtainedthroughthe
variablegrowthDVM.Moregenerally,theCAPMfitsintoallthreeofthedividendvaluationmodels
andhasthesameeffectdescribedabove.

7.

Thedifferencebetweenthevariablegrowthdividendvaluationmodelandthedividendsand
earningsapproachisinthedeterminationofthefuturesellingpriceofthestock.Thevariablegrowth
dividendvaluationmodelusesthefuturedividendstoderivethepriceofthestockwhilethe
dividendsandearningsmodelemploysprojectedEPSandP/Emultiplestoderivethestockprice.
Thedividendsandearningsmodelispreferabletothevariablegrowthmodelbecauseitismore
flexibleandeasiertounderstandandapply.ThismodelonlyrequirestheestimationofaP/Emultiple
inonefutureperiodasopposedtoestimatingthedividendgrowthrateoveraninfiniteperiodoftime.

8.

Expectedreturnonastockcanbefoundbyusingthe(presentvaluebased)internalrateofreturn
(IRR).Theexpectedrateofreturnonastockwouldbethediscountratethatequatesthefuturestream
ofbenefitsfromthestock(i.e.,thefutureannualdividendsandfuturepriceofthestock)toitscurrent
marketvalue.Inordertoacceptastockasaninvestmentvehicle,itsexpectedreturn(IRR)mustat
leastequalitsrequiredrateofreturn(e.g.usingCAPM).Iftheexpectedreturnonastockishigher
thanitsrequiredrateofreturn,thenitiscertainlyagoodbuy.

148Gitman/JoehnkFundamentalsofInvesting,NinthEdition

9.

TheP/Eapproachisasimpler,moreintuitiveapproachtovaluingastock.GivenanestimatedEPS
figure,decideonaP/Eratiothatisappropriateforthestock,multiplytheEPSbytheP/Eto
determinethestockprice,thencomparethispricetothestockscurrentprice.TheP/Eapproach
differsfromthevariablegrowthdividendmodelinthattheP/EapproachestimatesEPSanddevelops
anappropriateP/Eforthefirm.Thevariablegrowthdividendmodelonlyusesfuturedividendsand
estimatedgrowthratestodeterminethestockprice.
Thepricetocashflow(P/CF)measurehasbeenpopularwithinvestorsbecausecashflowisfeltto
provideamoreaccuratepictureofacompanysearningpower.InamannersimilartoP/Eratio
valuation,cashflowismultipliedbyaP/CFratio.Inadditiontoeaseofuse,therelativelylowlevel
oftheP/CFratio(whencomparedtotheP/Eratio),isviewedasastrength.Theobstacletousingthe
P/CFmethodisthevaryingcashflowmeasures,includingcashflowfromoperations,freecashflow,
andEBITDA.

10. Pricetosales(P/S)andpricetobookvalue(P/BV)ratiosarealternativepricerelativemeasures.
Theyareusefulforvaluingfirmsthatareneworhavevolatileearningsstreams,wheretheP/E
multipleapproachhaslittlevalue.Unprofitablefirmsstillhavesales.Bothareusedinasimilar
fashiontoestimatefuturevalues,bymultiplyingestimatedsalesorbookvaluebytherelevantratio.
Generallyspeaking,investorspreferlowP/SandP/BVratios,withdesiredP/Sratiosoflessthan2.0
andP/BVratiosoflessthan7.0.However,ifacompanyhasahighprofitmargin,itislikelytohave
highP/SandP/BVratios,also.Animportantdifferenceliesinthefactthatsalesariseinthecurrent
period,whilebookvalueisbasedontheissuanceofstockandretentionofearningssincethefirm
wentpublic.

.5

Suggested Answers to Investing in Action Questions

Ive Got a Secret: Whisper Forecasts (p. 334)

(a) Whatarewhisperforecastsandhowcaninvestorsusethem?
(b) Howaccuratearewhisperforecasts?
Answers:
(a) Whisperforecastsareunofficialearningsestimatesthatcirculateamongtradersandinvestors.They
arerumorsratherthanofficialanalystsestimates.WhispernumbersareavailableontheInternet.
Investorsshouldusewhisperforecastsonlyincombinationwithothersecuritiesanalysisand
techniques.
(b) Somestudiesshowwhisperforecaststendedtobemoreaccuratethananalystsestimates.Duringthe
20002002downturn,whispernumbersprovedtobelessaccuratethananalystsforecasts.

.6

Suggested Answers to Ethics in Investing Questions

Stock Analysts: Dont Always Believe the Hype (p. 344)

Shouldanalystsbeforbiddenfromowningthestocktheycover?
Answers:

Chapter8StockValuation149

Althoughthereisnofederalregulationforbiddingtheanalystsfromowningthestockfromcompanies
theycover,manybrokeragehouseshaveadoptedthispolicytoavoidconflictofinterestbetweenanalyst
buyandsellrecommendationsandtheirpersonaltradinginstocks.Therulesrecentlyimplementedbythe
SECrequiremoredisclosurebyfirmsandanalystsregardingstockrecommendationsandtheirholdings,
imposeblackoutperiodsonanalystspersonaltradingofstockstheycover(30daybeforeand5daysafter
theannouncement),andforbidsthepracticeoftyinganalystscompensationtotheamountofinvestment
bankingbusinesstheirfirmreceives.
Perhapsabetterpolicywouldbe(withinthelimitsimposedbytheSEC)toallowtheanalyststotrade
accordingtotheirownrecommendationsandrequirethemtodisclosethisinformationtothegeneral
public.Tofurtherdiminishthepossibilityofconflictofinterestanalystsshouldalsobebannedfrom
coveringcompanieswithwhomtheirbrokeragehousedoesinvestmentbanking.

.7

Suggested Answers to Discussion Questions

1.

Answerswillvarybystudent.

2.

(a) 1. Thevalueofagrowthstockthatpayslittleornothingindividendscouldbefoundusinga
dividendsandearnings(D&E)approach.Thedividendportionbeingminimal.
2. TheS&P500wouldbestbevaluedwithaconstantgrowthmodel,sinceabnormallygood
performancebysomecompaniescouldoffsetpoorperformanceofothers.
3. Arelativelynewcompanywhichhasabriefhistoryofearningswouldbestbevaluedusinga
price/salesratio.Sinceitisrelativelynew,thereprobablyhasnotbeenmuchofabuildupin
bookvaluethroughearningsretention.
4. Alargematurecompanyisprobablypayingadividend,howeverthatdividendmightvary
withfirmspecificevents.Hence,avariablegrowthDVMisappropriate.
5. Preferredstockhasafixeddividendpayment,makingthezerogrowthDVMappropriate.
6. Afirmwithalargeamountofdepreciationandamortizationshouldusethepricetocash
flow(P/CF)ratio,becausethismeasureaddsdepreciationandamortizationtoearningsinthe
estimationprocess.
(b) Answersvarybystudent.However,thedividendsandearnings(D&E)valuationmodel
incorporatesbothoftheseinputs.Thepricetosales(P/S)ratioisappropriateforsmallfirmsand
thosewitherraticearnings.Finally,thevariablegrowthDVMcanhandleincreasingand
decliningdividends.
(c) Again,answerswillvarybystudent.However,theinstructormaywanttopointoutthat
dividendsaretheonlycashflowbacktotheshareholder.Hence,adividendvaluationmodelis
appropriate.Sincethevariablegrowthmodelhandlesalltypesofdividendgrowthrate(negative,
zero,andpositive)itmaywellbethebest.Ifdividendsarecurrentlyhardtoestimate,onemay
havetousethedividendsandearnings(D&E)approach.

3.

Alldecisionsaremadeinlightoffutureconsequences.Shareholderinvestmentdecisionsarebased
uponthefuturecashinflowsarisingfromtheirinvestment.Newfirmspecificevents(i.e.,anticipated
patentapproval,facilitycompletion),newindustryrelatedevents(i.e.,anticipatedcompetition,
potentialofstrikes)andchangesinmacroeconomicconditions(i.e.,inflation,disposableincome)will
impactfuturesales,profitsandtheabilitytopaydividends.
Theintrinsicvalueofastockisaninversefunctionoftherequiredrateofreturn.Thehigherthe
requiredrateofreturn,thelessashareholderiswillingtopayforanygivencashflowstream.For
instance,theintrinsicvalueofa$1.00constantdividendpayment,whentherequiredrateofreturnis
eightpercentis$12.50.Iftherequiredrateofreturnrisestotenpercent,theintrinsicvaluedrops
to$10.

150Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.8
1.

Solutions to Problems
(a) Estimatednetearnings EstimatedsalesExpectednetprofitmargin
$75,000,0000.05
$3,750,000

Chapter8StockValuation151

(b) First,wemustfindestimatedEPS:
EstimatedNetEarnings
ExpectedSharesOutstanding
$3, 750, 000
EstimatedEPS
$1.50
2,500, 000
EstimatedEPS

EstimateddividendspershareEstimatedEPSExpectedpayoutratio
$1.500.5$0.75
(c) ExpectedpriceEstimatedEPSExpectedP/Eratio
$1.5024.5$36.75
(d) ExpectedHoldingPeriodReturn:
Futuredividend
Futuresaleprice
Currentstock
receipts

ofstock

price
HPR
Currentstockprice
$0.75 $36.75 $25.00
HPR
$25.00
50%
2.

GrowthRate:EndingSales/BeginningSalesFVIFX%,3years
$83,650,000/$55,000,0001.521
FVIF1.521at15%in3yearrow
Salesin2003$83,650,0001.15$96,197,500
NetProfitMarginin2003:8%
NetProfitin20040.08$96,197,500$7,695,800

3.

EPSROEBookValuepershare
BookValuepershare$500/100$5.00
EPS0.15$5$0.75

4.

DividendpershareEPSPayoutratio
EPSROEBookValuepershare
BookValuepershare$500/100$5.00
EPS0.15$5$0.75
Dividend$0.750.3333$0.25

5.

GrowthrateROERetentionRate
Retentionrate1Payoutratio
PayoutRatio$0.20/$2.0000.10
RetentionRate10.100.90or90%
Growthrate0.150.900.135or13.5%

152Gitman/JoehnkFundamentalsofInvesting,NinthEdition

6.

Totaldebt$75M/0.10$750,000,000
GrowthROERetentionRate.RetentionRate1.Growth15%.
Withaconstantequitymultiplier,debtandequitywilleachincreaseby15%,sonewdebt
$750,000,0001.15$862,500,000.
Interestrate0.10(0.250.10)0.075.
InterestExpense0.075$862,500,000$64,687,500

7.

(a) Theintrinsicworth(orjustifiedprice)isequaltothepresentvalueofexpecteddividendsand
futurepricediscountedattherequiredrateofreturn(10percenthere).
Intrinsicvalue PV(dividends) PV(futureprice)
Intrinsicvalue $5(0.909)* $5(0.826)* ($75 $5)(0.751)*
=$68.76
*Presentvalueinterestfactorsfor10%and1,2,3years,respectively.
(b) Expectedreturncanalsobecalculatedusingthepresentvaluebasedinternalrateofreturn
(IRR):
($5 PVIFIYR ) ($5 PVIF2YRS ) ($5 PVIF3YRS )
($75 PVIF3YRS ) $50
Therateofreturnwhichdiscountsfuturecashflowssuchthattheirsumequalsthecurrentstock
priceis23%.Hencetheexpectedreturnofthestockis23%.
Nomatterhowyoulookatit,Education,Inc.shouldbeviewedasaviableinvestmentcandidate.
Ithasajustifiedprice($68.76)thatfarexceedsthestockscurrentprice($50),suggestingthat
thestockisundervalued(solongasCharlenesexpectationsareright),anditsyield(23%)is
faraboveCharlenesrequiredrateofreturn
(10%).

8.

TheintrinsicvalueofAmalgamatedAircraftParts,Inc.canbecalculatedusingthedividend
valuationmodel:
Valuepershare

$1.50
$1.50

$16.67
0.16 0.07 0.09

where16%isthedesiredrateofreturnand7%isthedividendgrowthrate.
9.

IntrinsicvalueAnnualDividend/RequiredRateofReturn$2/0.12$16.67
Eddyshouldnotbuythestock,asitisoverpricedbasedonhisvaluation.

10. ValueNextYearsDividends/(RequiredRateofReturnConstantRateofDividendGrowth)
GrowthRateindividends12%($2.12/$2.001.255;FVIF12%,2periods1.254)
Value(1.12x$2.51)/(0.140.12)$2.81/0.02$140.56

Chapter8StockValuation153

11. (a) ValueofStock4.32xPVIF15%,1yr.+4.67PVIF15%,2yrs.

+(5.04+77.75)xPVIF15%,3yrs.
4.32(0.870)+4.67(0.756)+82.79(0.658)
$61.76
(b) Expectedreturncanalsobecalculatedusingthepresentvaluebasedinternalrateofreturn
(IRR):
($4.32PVIF1YR)+($4.67PVIF2YRS)+($5.04
PVIF3YRS)
+($77.75PVIF3YRS)$61.76
Therateofreturnwhichdiscountsfuturecashflowssuchthattheirsumequalsthecurrentstock
priceis15%.Thisisalsotherequiredrateofreturnusedinparta.Hence,theanswertothe
followingitemhasbeenverified.
(c) Usingthedividendvaluationmodel:
Valueofstock

$4.00(1.08) $4.32

$61.71
15 0.08
0.07

where15%isthedesiredrateofreturnand8%isthedividendgrowthrate.
(d) Thedividendinyear4willbe$5.04(1.08)$5.44.
Thepriceinyear3willbe

$5.44
$77.71
0.15 0.08

Lookingattheinformationgivenintheproblem,theabovevalueisveryclosetothe$77.75
givenasthepriceofthestockinyear3.(Thedifferencecanprobablybeattributedtorounding
errors.)Sincethecashflowmodelissimplyanextensionofthedividendvaluationapproach,
whentheunderlyingassumptionsaboutgrowthratesandrequiredratesofreturnarethesame(as
theyarehere),thetwomodelswillgivethesameresults.

12. Tofindtheexpectedreturnonthissecurity,weneedtofindtheexpectedfuturepriceofthestock:

FuturepriceofthestockFutureEPSExpectedP/Emultiple
$7.00x18$126.00

Expectedreturncanbecalculatedusingthepresentvaluebasedinternalrateofreturn(IRR):
($2.50PVIF1YR)+($2.50PVIF2YRS)+($2.50PVIF3YRS)
+
($126PVIF3YRS)$70
Therateofreturnwhichdiscountsfuturecashflowssuchthattheirsumequalsthecurrentstockprice
is24.63%.ThisistheexpectedrateofreturnonWestCoastElectronics.

154Gitman/JoehnkFundamentalsofInvesting,NinthEdition

RequiredReturn
Riskfreerate+[Stocksbeta(MarketreturnRiskfreerate)]
7+[1.15(14.07.0)]
7+[1.157]
7+8.05
15.05;use15%

Chapter8StockValuation155

Usingthepresentvaluemodel,thisstockcouldcarryapriceof:
StockPrice(Value)PV(dividends)+PV(futurepriceofthestock)
($2.50)(0.870)*+($2.50)(0.756)*
+(2.50+$126.00)(0.658)*
$88.62
*15%presentvalueinterestfactors
Yes,thestocklookslikeitwouldmakeagoodinvestment.Ithasajustifiedpricethatsaboveits
currentmarketprice,anditsexpectedreturnexceedstherequiredrateofreturn.
13. Onemayevaluatethissituationusingjustifiedprice(intrinsicvalue).Inthiscasewecanignore
dividends;assuch,wecanfindthepresentvalueofthefuturepriceofthestock,usingadiscountrate
of10percent:
IntrinsicvaluePresentvalueofthefuturepriceofthestock
$100(0.751)*
$75.10
*Interestfactorfor10%,3years
Sincethisisslightlygreaterthanthecurrentmarketpriceof$75,itisasatisfactoryinvestmentit
earnstherequired10percentrateofreturn.
Theexpectedreturncanbecomputedusingthebasicpresentvalueequationandthepresentvalue
interestfactortables:
PresentvalueFuturevaluePVIF
$75$100PVIF
SolvingtheequationforPVIF:
PVIF$75/$100.750
Wecannowlookinapresentvalueinterestfactortable(suchastheoneinAppendixA,
TableA.3)fora3yearinterestfactorequal(orclose)to0.750.(ThetimehorizonforMs.Bs
investmentis3years).Lookingacrossthe3yearrowoffactors,wefindafactorof0.751underthe
10%column;thus,thisinvestmentpromisesareturnofjustover10%.
14. (a)
ProjectedAnnualDividends
Year
0
1
2
3
4
5
6

Dividends
$3.00
3.30(g10%)
3.63(g10%)
3.99(g10%)
4.39(g10%)
4.83(g10%)
5.12(g6%)

Estimatedannualgrowthrateforyear6andbeyond:6%

156Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Step1:Presentvalueofdividendsusingarequiredrateofreturnof12%:]
Year
1
2
3
4
5

Dividend
s
3.30
3.63
3.99
4.39
4.83

PVIF,
12%
0.893
0.797
0.712
0.636
0.567
Total

Present
Value
$2.95
2.89
2.84
2.79
2
.74
$14.21

Step2:Priceofstockattheendofyear5:
P5

D6
$5.12
$5.12

$85.33
k g 0.12 0.06 0.06

Step3:Presentvalueofthestockprice:
PV $85.33 PVIF12%,5yrs.
$85.33 0.567
$48.38
Step4:
ValueofSLL&Gstock $14.21(Step1)+$48.38(Step3)
$62.59
Therefore,$62.59isathemaximumpriceyoushouldbewillingtopayforthisstock.
(b) Sinceg0foryear6andbeyond,dividendsforyear6willbethesameasthedividendforyear
5;i.e.,$4.83.Wejustneedtoredosteps2and3tofindtheintrinsicvalueofthestock:
Step2:Priceofstockattheendofyear5:
P5

D6
$4.83
$4.83

$40.25
k g 0.12 0 0.12

Step3:Presentvalueofthestockprice:
PV(P5 ) $40.25 PVIF12%,5yrs.
$40.25 0.567
$22.82
Sincethepresentvalueofthefirstfiveyearsofdividendsisthesameasin(a),above,the
intrinsicvalueofthestockis:
Intrinsicvalue$14.21+$22.82$37.03
(c) Theintrinsicvalueofthestockin(a)ismuchhigherthanthatcomputedin(b).In(a),dividends
aregrowingat6%peryearbeyondyear5,whilein(b),thedividendsdonotgrowafteryear5.
Thedividendvaluationmodelisverysensitivetothegrowthrateindividends;thehigherthe
rateofgrowthindividends,thehighertheintrinsicvalueofthestock.

Chapter8StockValuation157

15. (a) ValuationusingtheDVM:

Intrinsicvalue

D (1 g)
D1
0
kg
kg

BuggiesAreUs:
Intrinsicvalue

$2.25(1+0)
$22.50
0.10 0.06

SteadyFreddie,Inc.:
Intrinsicvalue

$2.25(1+.06) $2.385

$59.63
0.10 0.06
0.04

GangBusterGroup:
Step1:Presentvalueofdividendsusingarequiredrateofreturnof10%:
Year
1
2
3
4

Dividends
$2.53
2.85
3.20
3.60

PVIF,10%
PresentValue
0.909
$2.30
0.826
2.35
0.751
2.40
0.683
2
.46
Total
$9.51

Step2:Priceofstockattheendofyear4:
D5
D4 (1 g)

kg
kg
$3.60(1 0.06) $3.82

$95.50
0.10 0.06
0.04

P4

Step3:Presentvalueofthestockprice:
PV $95.50 PVIF10%,4yrs.
$95.50 0.683
$65.23
Step4:Valueofstock$9.51(Step1)+$65.23(Step3)$74.74
(b) TheintrinsicvalueofGangBustersis$74.74,comparedto$59.63forSteadyFreddieand$22.50
forBuggiesAreUs.Thedifferenceinthevaluesiscausedbythedifferenceindividendgrowth
rates.TheBuggiesAreUsdividendsdonotgrow,resultinginaverylowintrinsicvalueforits
stock.ThedividendsofSteadyFreddie,inc.,growataconstantrateof6%forever,whereas
GangBustersdividendsgrowatapproximately12%forthefirst4yearsand6%fromyear5into
thefuture.ThishighergrowthindividendsintheearlieryearscausesGangBusterGrouptobe
worthmuchmorethanSteadyFreddie.

158Gitman/JoehnkFundamentalsofInvesting,NinthEdition

16. Tocomputethejustifiedprice,oneneedsexpecteddividendsandtheexpectedfutureprice.Expected
annualdividendsaregivenat$2pershare.Theexpectedpriceisestimatedbymultiplyingthe
expected$5inearningspersharebytheexpectedpriceearningsratioof14:
Expectedpriceinyearfive21$5$105
Thejustifiedpriceequalsthepresentvalueofthedividendsandfuturepricediscountedatthe
requiredrateofreturn,12percent:
Justifiedprice
($2)(0.893)* ($2)(0.797)* ($2)(0.712)* ($2)(0.636)* ($2 $105)(0.567)*
$66.75
*Presentvalueinterestfactorsfor12%
17. Tosolvethisproblem,firstcomputefuturesales,profits,dividends,andshareprice.
FutureSales:
Year1:$250million1.20$300million
Year2:$300million1.10$330million
FutureProfits:
Year1:$300million.08$24million
Year2:$330million.08$26.4million
FutureEPS:
Year1:$24million/15million $1.60
Year2:$26.4million/15million $1.76
FutureDividends:
Year1:$1.60.50$0.80
Year2:$1.76.50$0.88
FutureSharePrice:
Year1:$1.6015$24.00
Year2:$1.7615$26.40
Nowwecanfindthestocksintrinsicvalue,approximateyield,andHPRs.
(a) Intrinsicvalue/justifiedprice:
Intrinsicvalue presentvalueoffuturedividendsandshareprice
($0.80 0.833) ($0.88 0.694) ($26.40 0.694)
$19.60
(b) CalculatetheIRR:
($0.80PVIF1)+($0.88PVIF2)+($26.40PVIF2)$15.00
IRR37.50%

Chapter8StockValuation159

(c) Holdingperiodreturns:
$0.80 $24.00 $15.00
65.3%
$15.00
$0.88 $26.40 $24.00
HPR(Year2)
13.7%
$24.00
HPR(Year1)

18. (i)

CAPM:

Requiredrateofreturnriskfreerate+stocksbetamarketreturnriskfreerate
6%+[1.80(11%6%)]
6%+9%15%
(ii) Valuethestockusingthevariablegrowthdividendmodel:
D1D0(1+g)$3(1.12)$3.36
D2D1(1+g)$3.36(1.12)$3.76
D3D2(1+g)$3.76(1.12)$4.21
D4D3(1+g)$4.21(1.12)$4.72
Valueofstock(D1PVIF1)+(D2PVIF2)+(D3PVIF3)+(D4PVIF4)+PVIF4
D4 (1 g)
kg
($3.36PVIF15%,1)+($3.76PVIF15%,2)+($4.21PVIF15%,3)
$4.72(1.09)
+($4.72PVIF15%,4)+PVIF4
0.15 0.09
2.92+2.84+2.77+2.70+(0.57285.7549.05)
$60.28
19. (i)

Findthegrowthrateindividends:
g ROE thefirm'sretentionrate,rr
rr 1 dividendpayoutratio
g 0.20 (1 0.4)
g 0.12or12%

(ii)

Usetheconstantgrowthratedividendmodel:
D4 (1 g)
Valueofthestockinfouryears
kg
$3.00(1.12)
0.15 0.12
$112.00

(iii) Valueofstocktoday:
$112.00PVIF15%,4Presentvalue
$112.000.572$64.06

160Gitman/JoehnkFundamentalsofInvesting,NinthEdition

20. Inordertovaluethiscompany,youfirstneedtodeterminethefirmsROE,thenthegrowthratein
dividends,andfinallythedividendpayment.
(i)

ROE

NetIncome
$3,750,000

0.15or15%
TotalEquityValue $25,000,000

(ii)

growthrateROErr
0.15(10.40)
0.09or9%
(iii) dividendEPSpaymentratio
$5.00.040
$2.00
Valueofthestock

D0 (1 g) $2.00(1.09)

$72.67
kg
0.12 0.09

21. (a) UsingtheP/Eapproach:

stockprice EPS P/Eratio( MarketP/E RelativeP/E)
$4.00 (18.5 1.25)
$4.00(23.125)
$92.50
(b) (11087.50)/87.5025.7%
22. UsingtheP/Eapproachtovaluethestock:
Valueofthestock EPS P/E
1.25(2.75) 30
$103.125
23. Themostlogicalapproachbasedonthedatapresentedistovaluethestockbasedonamultipleof
sales.Marketvaluesarefairlyconsistentat10%ofsales,soagoodestimatewouldbe$1.00per
share.If,however,Newcoisexpectedtogrowmuchfasterthanitscompetitors,thenthepriceshould
beadjustedupwardforthegrowth.
24.

Amazing.com
ReallyCooking.com
Fixtures&AppliancesOnline

4.5
4.1
3.8
12.4/34.13averagepricetosalesratio
Giventrailingsalesof$40millionandsharesoutstandingof10million
$40million/10million$4.00sales/share
Tofindthevalueofashare,multiplythesalespersharebytheaveragepricetosalesratio
$4.004.13$16.52

Chapter8StockValuation161

.9

Solutions to Case Problems

Case 8.1Chris Looks For a Way to Invest His New Found Wealth
Thiscaseallowsthestudenttoestimatethefuturepriceandapproximateyieldofastock.Withthis
information,thestudentmustanalyzetheriskandrecommendwhetherornotthestockisagood
investment.
(a) 1.

Sales
Netprofitmargin(20%)
Netprofit
DividedbyNumberofshares
Earningspershare($)

($inmillions)
Year
1
2
3
$22.5
$35.0
$50.0
0.20
0.20
0.20
$4.5
$7.0
$10.0
(2.5million)
$1.80
$2.80
$4.00

162Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2. Estimatedprice(year3)estimatedP/EestimatedEPS
40$4.00$160.00
3. Expectedreturncanalsobecalculatedusingthepresentvaluebasedinternalrateofreturn(IRR):
($160P VIF3YR ) $70.00
PVIF3YR 70.000 /160
0.437
Therateofreturnwhichdiscountsfuturepricesuchthatitequalsthecurrentstockpriceis32%.
4. Chrisfacesaconsiderableamountofbothintrinsicandmarketrisk.Chrismustconsiderthe
possibilitythatthefirmwillnotreachexpectedsalesgoals,and/orthatthenetprofitmargins
maydecline.Ifthemarketfalls,P/Eratiosfallaswell;iftheP/Eisonly15timesearningsin
threeyearsforexample,thestockwillsellfor$60.00,andtheyieldwillbe:
(60 PVIF3YR ) $70.00
PVIF3YR 70.000 / 60
1.167
Therateofreturnwhichdiscountsfuturepricesuchthatitequalsthecurrentstockpriceis
negative.Thepricedeclines.
5. BecauseChrisexpectsthestocktoyield32percent,heshoulddecidewhetherthisreturnisat
leastequaltohisdesiredrateofreturn.Thedesiredrateofreturn,ofcourse,isanestimatehe
mustmakeafterstudyingtheriskcharacteristicsofthestock.Ifhisdesiredrateofreturnisless
thanorequalto32percent,Chrisshouldconsiderthestocktobeaworthwhileinvestment
candidate.
(b) 1. Chrishasadoptedaspeculativeinvestmentstrategy,anditmaynotmeethisinvestmentneeds.
Hehasnoneedforcurrentincome,buthedoesneedastoreofvalueandcapitalappreciation.
Thespeculativeprogramheisfollowing,ifcorrectlymanaged,mayenablehimtohititbig.
However,thisstrategy,beinghighlyrisky,mayalsoleavehimwithlittletoshowforhis
successfulyears.Thespeculativestrategyisusuallyfollowedbyveryactiveinvestors,andChris
isnotlikelytohavetimetomanagehisportfolioonadailybasis(evenwithahighlyregarded
BeverlyHillsbrokertohelp).
2. Onemightsuggestheputalargepartofhisearningsintomoreconservative(butstill
appealing)growthstocks,andmovetowardalongtermgrowthstrategy,whilekeepingasmaller
portionofhisportfolioinspeculativeissues.ThiswouldallowChristomeethisneedswhilestill
providingthepotentialofthebigscorefromspeculativeissues.Thischangelowershisrisk,
andalthoughChrisearnsenoughtoacceptsomerisks,itisprobablybettersuitedtothetimeand
talentChriscandevotetohisinvestments.
3. Yes,therearemanyforeignstocksandnationfundsthatoffersubstantialgrowthopportunities
andhence,thepotentialforcapitalappreciation.WiththeavailabilityofADRsformanypopular
foreignstocks,tradingforeignsecuritiesisaseasyastradingU.S.stocks.Also,byinvestingin
foreignstock,Chriscanachieveahigherlevelofdiversificationandtherebyreducetheriskof
hisportfolio.

Case 8.2An Analysis of a High-Flying Stock

Chapter8StockValuation163

Thiscaseenablesthestudenttogeneratefutureearningsandpershareperformance;inaddition,the
studentisaskedtousetheforecastsinestablishinganintrinsicvalueforthestock,andinmakingan
investmentdecision.Finally,thestudentisgivensomerecentpriceinformationandaskedtodosome
charting,andconsidertheroleoftechnicalanalysisintheinvestmentdecision.
(a) Averagegrowthrate:
Years
00to01
01to02
02to03
03to04

GrowthRate
(12.510.0)/10.00.250
(16.212.5)/12.50.296
(22.016.2)/16.20.358
(28.522.0)/22.00.296

0.25 0.296 0.358 0.296

30%
4
Note:Withmoreadvancedstudents,thecompoundannualratemaybeintroducedhereasamore
precisemeasure.Herethetwoareequivalent,butwhentheannualratesdiffergreatly,thearithmetic
averagemayyieldlargeerrors.
Compoundgrowthrate:
Arithmeticaverage

28.510.0(FVIF),givenn4years.
NowsolveforFVIF:
2.85FVIF
Lookingacrossthe4yearrow,weseethatFVIF2.85fori30%
1. Usingagrowthrateof30%,wehave:
Salesnextyear(2005) 2004sales(1+30%growthrate)
$28.5million1.30
$37.05million
Salesin2006
2005sales(1+30%)
$37million1.30
$48.1million

164Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2. Earningsin2005

Earningsin2006

EPS:2005
EPS:2006
3. P/Eratiofor2006
SharePrice,2006

SalesProfitmargin
$37,000,0000.12
$4,440,000
SalesProfitmargin
$48,100,0000.12
$5,772,000
$4,440,000
$0.89

5,000,000

$5,772,000
$1.15
5,000,000

50(givenintheproblem).
502006EPS50$1.15
$57.50pershare

(b) 1. Justifiedprice Presentvalueofdividendsandfutureprice

Therefore,justifiedprice(0.050.800)*+(0.050.640)*
+(57.500.640)*
$36.87
*Presentvalueinterestfactorsfor25%.
2. Sincethemarketpriceofthestock($32.50)iswellbelowthisjustifiedprice,Wiltshouldconsider
thestockaworthwhileinvestmentcandidate.Clearly,hewillbeearningmorethanhis25percent
desiredrateofreturn.

.10 Outside Project

Chapter 8Trying Your Hand at Technical Analysis
Generally,technicalanalystsbelievethatbystudyingpastmarketprices,itispossibletoforecastfuture
prices,atleastintheshortrun.Peoplewhoareprofessionaltradersalsospeakofasensetheyacquireof
commonstocktradingpatternsforparticularcompanies.Thesepatternsmaybetheresultofmany
influences:thetypeofinvestorswhotradethestock;theparticularactionofthestocksspecialist;whether
thecompanyiscyclical,growthoriented,defensive,orincomeoriented;thecurrentcourseofthemarket;
andothervariables.Thisprojectwillhelpyouacquirethissenseofthemarketforcommonstocks.
Thisprojectrequiresyoutoprepareabarchartofthedailyhigh,low,andclosingpricesfortwostocks.
Youwillneedsomegraphpaper(thefinerthelines,thebetter).Youwanttoputatleasttwoorthree
monthsofdataononepage.Inpractice,themoreconsecutivedataononepage,theeasieritistointerpret
theprices.Next,obtainsomehistoricalandcurrentpricedata.OneobviousplacetolookisTheWall
StreetJournal;buthopefully,yourlibrarywillhavetheStandard&PoorsDailyStockPriceRecord.
ThesebookscontaindailystockpricesforanentirequarterforcompaniestradedontheNYSE,AMEX,
andOTC.Obtaintherequiredinformation(dailyhigh,low,andclosingprices)foraperiodof3to
6months;confineyourdatagatheringtothemostrecenttimeperiod.

Chapter8StockValuation165

Onceyouvecollectedthedata,makethegraph.Thenobserveandstudythepricetrendsandpatternsyou
justgraphed.Notehowvolatiledailypricesare.Lookforsimilaritiesinthepatternsorforunusualprice
changes.Ifyouwanttoexpandtheproject,plottheDowJonesIndustrialAverage(usejustthedaily
closingfigures)duringtheperiodandnotehowthestockpricechangesarecorrelatedwiththeDJIA.
Thereisalotofinformationonapricechart.Remember,somepeopleseethisinformationasvery
valuableandsomebelievemarketsaresoefficientthatwhatyouhavegraphedisoflittleornovalue.
Whatisyouropinion?