978-0134083308 Chapter 8 Solution Manual Part 1

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Chapter 2 Securities Markets and Transactions 15

Chapter 8

Stock Valuation

 Outline

Learning Goals

I. Valuation: Obtaining a Standard of Performance

A. Valuing a Company Based on Its Future

1. Forecasted Sales and Profits

2. Forecasted Dividends and Prices

a. Getting a Handle on the P/E Ratio

b. A Relative Price-to-Earnings Multiple

c. Estimating Earnings per Share

d. Pulling It All Together

B. Developing a Forecast of Universal’s Financial Performance

C. The Valuation Process

1. Required Rate of Return

Concepts in Review

II. Stock Valuation Models

A. The Dividend Valuation Model

1. Zero Growth

2. Constant Growth

a. Estimating the Dividend Growth Rate

b. Stock Price Behavior over Time

3. Variable Growth

a. Applying the Variable-Growth DVM

4. Defining the Expected Growth Rate

B. Other Approaches to Stock Valuation

1. Free Cash Flow to Equity

a. Zero Growth in Free Cash Flow

b. Constant Growth in Free Cash Flow

c. Variable Growth in Free Cash Flow

d. Using IRR to Solve for the Expected Return

2. The Price-to-Earnings (P/E) Approach

16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

C. Other Price-Relative Procedures

1. A Price-to-Cash-Flow (P/CF) Procedure

2. Price-to-Sales (P/S) and Price-to-Book-Value (P/BV) Ratios

Concepts in Review

Summary

Key Terms

Discussion Questions

Problems

Case Problems

8.1 Chris Looks for a Way to Invest His Newfound Wealth

8.2 An Analysis of a High-Flying Stock

Excel@Investing

Chapter-Opening Problem

 Key Concepts

1. The role a company’s future prospects plays in the stock valuation process and a framework for

developing such forecasts

2. Developing a forecast of a stock’s expected cash flow, starting with corporate sales and earnings

and then moving to expected dividends and share prices

3. The concept of intrinsic value as a standard of performance and its use in judging the investment

suitability of a share of common stock

4. Valuation of a stock using zero growth, constant growth, and variable growth dividend valuation

models

5. Other stock valuation models: free cash flow to equity.

6. Understanding that different valuation models work in different instances depending on the

payment of dividends and earnings persistence

 Overview

The topics of stock valuation and security analysis are further considered in this chapter. It is basically a

continuation of the discussion in the preceding chapter. Also addressed are some major changes taking

place in the market, as they affect the valuation process.

1. After analyzing a company’s performance to date, the investor projects the company’s future

performance. Basic performance projections are related to the sales and profits of the company,

subject to various economic and industry projections. Next, estimates of future dividends and stock

prices are obtained. Using the example in the text, the instructor should stress the usefulness and

limitations of historical growth rates in obtaining estimates of the future.

2. The P/E ratio is then extensively discussed, including the relationship between a company’s P/E

ratios and the market’s P/E. This ratio is shown to be a function of the growth of the firm, the risk

associated with that growth, and P/E ratios in the marketplace.

Chapter 2 Securities Markets and Transactions 17

3. Next comes the discussion of various types of stock valuation models. First presented is the

dividend valuation model as a theoretically sound approach to apply to common stocks. The model

requires an estimate of the next dividend, the growth rate, and the required rate of return, which is a

function of risk and alternative returns. In this regard, the CAPM is reintroduced at this point to show

how CAPM can be used to establish the required rate of return. Three types of dividend valuation

models are introduced: zero growth, constant growth, and variable growth models.

4. The free cash flow to equity approach and the P/E approach are then shown as alternatives to the

dividend valuation approach. The free-cash-flow-to-equity model is based on the present value of the

stock’s future free cash flows going to equity.; it corrects some of the practical shortcomings of the

dividend valuation model. The instructor should work out several valuation examples, including the

dividend valuation approach, HPR, the present value of a stock, and yield.

5. In addition, the investment decision process is thoroughly discussed. A stock should be considered

a viable investment candidate when intrinsic value results in a rate of return that meets or exceeds the

investor’s (risk-adjusted) desired rate of return.

 Answers to Concepts in Review

8.1 The purpose of stock valuation is to obtain a standard of performance that can be used to judge the

8.2 Expected earnings are indeed important in determining a stock’s investment suitability. In making an

investment decision, the investor must decide if a stock is undervalued or overvalued by comparing

8.3 Both the growth prospects of a company and the amount of debt it uses can affect the P/E ratio. As

the growth rate increases, a higher P/E ratio can be expected. Likewise, as the debt level decreases,

8.4 The market multiple is the average P/E ratio of stocks in the marketplace. It provides insight into the

general state of the market, and it gives the investor information on how aggressively the market is

pricing stocks. Over the past 20 years, average market P/E ratios have ranged from 12.2 in 1988, to

18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

8.5 Investors should be willing to purchase a stock if the computed rate of return equals or exceeds the

return the investor feels is warranted, based on the stock’s risk, or if the justified price is equal to or

greater than the current market price. The required rate of return provides a standard so that an

8.6 In general, the value of any asset is the present value of all future cash flow. For common stock, the

cash flow is dividends received each year plus the future sale price of the stock. If any future price

The constant growth dividend valuation model reduces the need to estimate all future dividends

individually by saying that the value of a share of stock is a function of dividends that are growing at

The DVM can be used to value a stock that pays a constant dividend, a stock that pays a dividend

The CAPM fits into the DVM through its effect on r, the required rate of return. The greater the

8.7 The difference between the variable growth dividend valuation model and free cash flow to equity

approach is in the determination of the future selling price of the stock. The variable growth dividend

8.8 Expected return on a stock can be found by using the (present-value-based) internal rate of return

(IRR). The expected rate of return on a stock would be the discount rate that equates the future stream

Chapter 2 Securities Markets and Transactions 19

8.9 The P/E approach is a simpler, more intuitive approach to valuing a stock. Given an estimated EPS

figure, decide on a P/E ratio that is appropriate for the stock, multiply the EPS by the P/E to

The price-to-cash-flow (P/CF) measure has been popular with investors because cash flow is felt

8.10 Price-to-sales (P/S) and price-to-book-value (P/BV) ratios are alternative price relative measures.

They are useful for valuing firms that are new or have volatile earnings streams, where the P/E

multiple approach has little value. Unprofitable firms still have sales. Both are used in a similar

Suggested Answers to Famous Failures in Finance Questions

Why do you think sell ratings tend to cause stock prices to fall, while buy ratings do not lead to stock price

increases?

Answer:

When economists attempt to explain anomalous behavior, they usually begin by looking at incentives.

Most stock analysts work for investment banking firms that are eager to retain their existing clients and

attract new ones. Although the SEC has taken steps to assure that the public has the same access to

corporate disclosures that analysts have, and some steps have been taken to assure the independence of

Taken together, the combination of incentives and probabilities leads to a sort of “grade inflation” that