Contemporary Investments: Chapter 14

Chapter 14 FUNDAMENTALS OF COMMON

STOCK VALUATION

• What is intrinsic value (IV)?

• What is the dividend discount model (DDM)?

• What is the earnings model (EM)?

• How does an investor conduct fundamental analysis on a company stock?

Contemporary Investments: Chapter 14

FUNDAMENTALS OF COMMON STOCK VALUATION-Cont.

• How can an investor value a stock with nonconstant growth?

• How is the market-to-book ratio (MV/BV) used for investment purposes?

• What are the pros and cons of using the price/earnings multiple, or P/E ratio?

Contemporary Investments: Chapter 14

Intrinsic Value

• Definition of an intrinsic value– What affects intrinsic value– How to invest based on intrinsic value

• Undervalued

• Overvalued

Contemporary Investments: Chapter 14

Four intrinsic valuation models• Dividend Discount Model (DDM)

• Earnings Model (EM)

• P/E Ratio

• MV/BV Ratio

Contemporary Investments: Chapter 14

Dividend Discount Model (DDM)

• Develop the intrinsic value, Vs0

• Two implications

• The general Dividend Discount Model– An example: Lone Star Steakhouse

(STAR)

Contemporary Investments: Chapter 14

Figure 14.1 – General Rule for Fundamental Analysis

Contemporary Investments: Chapter 14

Figure 14.2 – Summary of the STAR Example

Contemporary Investments: Chapter 14

Trading rule for fundamental analysis

• Undervalued

• Overvalued

Contemporary Investments: Chapter 14

Earnings Model (EM)

• Lone Star Steakhouse: An Earnings Model example

• The no-growth example

• The constant-growth example

Contemporary Investments: Chapter 14

Implications for growth companies

• Discussion of the five implications

• Contrast growth company with a growth stock

Contemporary Investments: Chapter 14

Fundamental Analysis in Practice

• Estimate Growth, g– historical dividend trend growth rate

– historical EPS trend growth rate

– growth rate g = ROE x b

• Estimate the required rate of return, ERs

• Estimate DIV1

Contemporary Investments: Chapter 14

Figure 14.3 – Value Line Report for Lone Star Steakhouse (STAR)

Contemporary Investments: Chapter 14

Caveats for DDM

• DDM is very sensitive to changes in g

• The market risk premium, (ERM-RF) is difficult to determine

• ROE1 is a book value and is an average of many project returns

Contemporary Investments: Chapter 14

Nonconstant-Growth Model

• Value the nonconstant-growth phase via an example

• Value of the constant-growth phase• Intrinsic value of a two-phase

nonconstant growth stock• General formula for nonconstant-growth

model• Three-phase nonconstant-growth model• Estimating the nonconstant and constant

growth rates

Contemporary Investments: Chapter 14

Market-to-Book Ratio (MV/BV)

• Define Market-to-Book Ratio (MV/BV)

• Why it may discover undervalued stocks

• Beware of MV/BV

Contemporary Investments: Chapter 14

Price/Earnings (P/E) Ratio

• Define Price/Earnings (P/E) Ratio

• Interpret P/E ratios

• Determining value from P/E

• What about low P/Es?

• Implications for investors

Contemporary Investments: Chapter 14

Two alternative ways to use P/E

• Holt’s alternative use of P/E• Firms that pay no dividends or when

g > ERs• Implications for investors using

fundamental analysis• A growth company may not

necessarily be a good investment• Use P/E and MV/BV with caution