Chapter 10

Fundamental Analysis Approaches

Present value approach

1 Capitalization of expected income

2 Intrinsic value based on the discounted value of the expected stream of cash flows

Multiple of earnings (P/E) approach

• Stock worth some multiple of its future earnings

Present Value Approach (Capitalization of Income)

Intrinsic value of a security is

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Ke = appropriate discount rate

In using model, to estimate the intrinsic value of the security must:

2 Discount rate (Capitalization Rate, Required Rate of Return)

1 Required rate of return: minimum expected rate to induce purchase given the level of risk

2 The opportunity cost of dollars used for investment

3 Expected cash flows and timing of cash flows

1 Stream of dividends or other cash payouts over the life of the investment

2 Dividends paid out of earnings and received by investors

1 Earnings important in valuing stocks

3 Retained earnings enhance future earnings and ultimately dividends

1 If use dividends in PV analysis, don’t use retained earnings in the model

• Retained earnings imply growth and future dividends • Compared computed price to actual price

Dividend Discount Model

Current value of a share of stock is the discounted value of all future dividends

Problems:

1 Need infinite stream of dividends

1 Dividends received 40-50 years in the future are worth very little in present value with the discount rate is sufficiently high (12%, 14%, 16%)

2 Dividend stream is uncertain

• Dividends not guaranteed

• Declared by Board of Directors

1 Must estimate future dividends

3 Dividends may be expected to grow over time

• Must model expected growth rate of dividends and the growth rate need not be constant

Dividend Discount Model-Zero Growth

Assume no growth in dividends

Fixed dollar amount of dividends reduces the security to a perpetuity

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Kp = appropriate discount rate

Similar to preferred stock because dividend remains unchanged

Dividend Discount Model-Constant Growth-Gordon Model

Assumes a constant growth in dividends

Dividends expected to grow at a constant rate, g, over time

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where

• g: growth rate

• ke: required return

3 Ke > g

4 D1 is the expected dividend at end of the first period

5 D1 =D0 (1+g)

Implications of constant growth

1 Stock prices grow at the same rate as the dividends (g)

1 Problem: what if higher growth in price than dividends or visa versa

2 Stock total returns grow at the required rate of return

1 Growth rate in price plus growth rate in dividends equals k, the required rate of return

3 A lower required return or a higher expected growth in dividends raises prices

Reasons for Different Values of Same Stock

• Each investor may use their individual k

• Each investor has their own estimate of g

Dividend Discount Model-Multiple Growth

Multiple growth rates: two or more expected growth rates in dividends

1 Ultimately, growth rate must equal that of the economy as a whole

1 The company/industry is maturing and when it reaches maturity –grows at the rate of the economy

2 Assume growth at a rapid rate for n periods followed by steady growth

Multiple growth rates approach:

1 First present value covers the period of super-normal (or sub-normal)...