STEPS TO ANALYZE STOCK

•Think through the "story" in detail

Why is this a potentially better stock to own than others? e.g. – Medco Health Systems – leader in pharmaceuticals delivered by mail at low cost.

•Check the financials

Analyze ratios and quality of earnings

•Compare competitors product/ financials

Will the story hold up under competition?

•Consider management

Solid record? - management turnover? Share ownership? - selling?

•Compute a price estimate for the stock

Compare to market price.

•Look at price support and resistence levels

Try to buy at support level, sell at resistance - technical analysis - next class.

•Once you buy - keep up with new information on stock

COMMON STOCK PRICING

TWO MODEL TYPES

1. Comparables models - P/ B, P / E, P/ S, P / EBITDA,P/Marketing, P / R&D

Example: Price Estimate = P/E * E where P = stock price per share

E = earnings per share

2. Discount cash flow methods

Example: Price Estimate = )(

10

gk

DV

PRICING STOCKS USING P/E & NORMAL EARNINGS

•Get industry average P/E or similar company P/E

•Estimate normal earnings per share

- Various methods - Adjust for accounting gimmicks

•Multiply P/E times normal earnings

eg. suppose normal earnings = $3/share and P/E of industry = 10

Price estimate = $3 * 10 = $30

CYCLICAL EARNINGS

7

6

5

4

3

2

1

0

Earnings Per Share

Year

78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

For price earnings ratios, use secular not cyclical earnings as a measure of normal earnings.

Hewlett-Packard Earnings Per Share

cyclical

secular trend

BOOK VALUE STOCK VALUATION

•Price/Book (P/B) is the ratio of stock price per share (P) to book value of equity per share (B). P/B is are used to compare the replacement value of a firm’s equity (its book value) to the market's valuation of its equity (stock price).

As P/B increases, this is a signal for firms to investin the industry or for new firms to enter which, ofcourse, forces P/B down.

•When P/B is very low either the industry is declining or firm is poor competitor.

If neither is true then a low P/B may signal a buying opportunity as market value returns to at least book.

•To price a stock with P/B do as we did using P/E

A. Get industry average or comparable firm P/B ratio

B. Get the firm’s book value per share

C. Multiply A and B to get stock price estimate

•What if a firm has no earnings or no book value. (e.g. small or new firms or poorly performing firms)?

- if the firm has sales then use price to sales (P/S) in the same way that you use P/E or P/B above.

VERY NEW COMPANIES MAY NOT HAVE MUCH IF ANY SALES

Here you can use price to cost ratios or price toresearch and development ratios. These methodsare much less reliable. For such companies youmust rely mostly on the value of their share of thepotential market and have faith in management

(andpray a lot).

DISCOUNTED CASH FLOW MODELS

BASIC

where V0 is the stock value (price estimate),

D = dividends and k = required rate of return

QUESTION: Why are high growth stocks usually riskier than low growth stocks?

ANSWER: Their dividends come far into the future - more uncertainty.

)1(...

)1()1()1( 33

221

0 k

D

k

D

k

D

k

DV

CONSTANT GROWTH MODEL - DERIVED FROM BASIC MODEL

This model only works precisely if a. k > g where g=growth in dividends

b. Dividends grow at a constant rate

It is still a good approximation

EXAMPLE: D0 = 1.80, g = .055, k = .11

gk

D

gk

gDV

100

)1(

$34.50.055 .11

(1.055) 1.80V0

You can use negative growth in the model but it reduces value.

HOW TO GET INPUTS

• Dividends in present year - D0

• Dividend growth - estimate from past dividends

Or use formula if no dividends availableg = growth = ROE * (1 - Div. payout ratio)

Use the industry payout ratio or the expected future payout ratio if the company pays no dividends.

• Required return

CAPM - k = Rf + B(Rm - Rf)

or k = R bond + equity premium.

MORE COMPLEX GROWTH MODEL

One that allows three growth rates, an initial rate for, say, 5 years, intermediate rate for 10 years, and an average rate for mature firms into infinity.

The more complex the model, the more inputs you need and the more assumptions have to be made. A manageable model is the two-stage growth model.

TWO-STAGE GROWTH MODEL

Two stages of growth

gi = initial (usually higher) growth rate which lasts for n years (say 5 years).

g = stable long-term growth at about the economy’s average that is assumed to last from the end of the initial growth period for ever after.

With two stages, the simple model above becomes

nn

i

n

ni

i

kgk

D

gk

k

ggD

V)1)(()(

)1(

)1(1)1(

1

0

0

There are some simplifying assumptions for this model that are not completely realistic.

The same k is used for the initial growth stage and the stable growth stage. One might expect that there will be more risk involved during the initial growth stage and thus it should carry a larger k.

The model assumes that growth changes abruptly in year nand that growth is constant at gi for the initial stage and at g for the stable stage. It is also unclear what n should be. We will use n=5 since it is difficult to predict growth after 5 years.

EXAMPLE

Redo previous example with two stage growth.

D0 = 1.80, gi = initial growth =.10, g = .05, k =.11

Dn+1 = D6 = 1.80(1 + gi )5 (1 + g) = 1.80(1 + .10)5 (1 + .05) = 3.04

83.3807.3076.8)11.1)(05.11(.

04.3

)10.11(.

)11.1()10.1(

1)10.1(80.1

5

5

5

0

V

The Two-Stage model still can not handle more than two growth rates. To do this, one needs to figure the actual dividends based upon various growths over a period and then discount the dividends along with the terminal price calculated using the simple growth model. That is:

where D1 = D0(1 + g1), D2 = D1(1 + g2), and so forth.

The problem with this approach is that it may require many calculations depending upon how many different growth rates are required – Spreadsheet Helpful – see Amazon.

nn

nn

kgk

D

k

D

k

D

k

D

k

DV

)1)(()1(...

)1()1()1(1

33

221

0

REDO PREVIOUS EXAMPLE

D0 = 1.80, k = .11g1 = .12, g2 = .10, g3 = .08g = growth = .05 - long-term growth

D1 = 1.80(1 + g1 ) = 1.80(1 + .12) = 2.02D2 = D1(1 + g2 ) = 2.02(1 + .10) = 2.22D3 = D2(1 + g3 ) = 2.22(1 + .08) = 2.40Dn+1 = D4 = D3(1 + g) = 2.40(1 + .05) = 2.52

08.36)11.1)(05.11(.

52.2

)11.1(

40.2

)11.1(

22.2

)11.1(

02.23320

V