Stock Valuation Basics



I. Careers in Finance

A career in finance can be separated into three areas – corporate finance, investment management, and retail financial services.

A career in corporate finance involves analyzing, selecting, and funding investments for financial and non-financial corporations. Positions in corporate finance include financial analysts, reporting analysts, budget analysts, and planners. A career in corporate finance requires extensive knowledge of accounting and the business and industry environment.

A career in investment management involves analyzing and selecting securities and managing the overall return and risk profile of a portfolio. Positions in investment management are often categorized and from office, middle office, and back office. The front office includes portfolio managers, traders, researchers, and sales representatives. The middle office includes risk managers, reporting analysts, and information systems analysts. The back office includes compliance analysts and general support staff of other offices. The BS in finance prepares students for all three areas. Positions in the front office are very competitive and often require excellent grades and summer internships.

A career in retail financial services involves direct interaction with the public in their need to save, invest, and borrow. Areas include retail banking, financial advising, mortgage lending, credit cards, and stock brokerage services. Starting positions include bank representatives, stock brokers, financial advisors, credit analysts, and financial analysts and consultants at banks and other financial institutions.

[pic]

II. Stock Valuation Methods

1. Technical Analysis: Use of price and volume graphs to predict stock changes.

Key Terms:

1. Momentum: Belief that stocks will continue in current price direction (up, down, sideways) because the market price does not fully reflect current events (products, profits, news).

2. Reversal: Belief that stock will change its current direction because market has overreacted to current events.

3. Support: stock price that you belief that stock cannot fall below. Some graph support levels by connecting previous lows (see graph below).

4. Resistance: stock price that you belief that stock cannot exceed. Some graph support levels by connecting previous highs.

5. Volume is the number of shares traded over a particular time period. Some suggest that increasing volumes is an indicator of momentum (continuation) and decreasing volumes is an indicator of reversal.

[pic]

Activity: Look up RIMM and AAPL stock quotes on finance.. What are the support and resistance levels? Which would you buy?

The problem with technical analysis is that there is little evidence that trading based on these principles is profitable.

2. Price Multiples: A price multiple is the stock price divided by a per share value of earnings, sales, or book “Accounting” value.

Example: The Price-Earnings Ratio (PE) is the stock price divided by the earnings per share (EPS)

[pic]

Apple PE = 142.36/5.56 = 25.6

[pic]

RIM PE = 71.29 / 3.58 = 19.9

Activity: What is RIMM and AAPL’s current PE (finance.) and which would you buy?

The problem with multiples is that it is difficult to compare stock multiples because stocks have different characteristics such as growth and risk.

3. Discounted Free Cash Flow Method: A belief that stock value should be the sum of all its expected cashflows (adjusted for time) divided by the current number of shares

Free cash flows (FCF) are the amount of cash that a company generates after all production costs and capital good expenditures (such as property, plant, equipment). One such measure of FCF for companies with no debt is:

Free Cash Flow (FCF) = Net Income – Capital Expenditure + Depreciation

Depreciation is the accounting recognition of prior year capital expenditures (aka, CAPEX). Depreciation is added to avoid the double counting of capital expenditures.

Stock Value per share is:

[pic]

If you assume FCFs grow at some constant rate, g, then the formula for growth perpetuity is

[pic]

Where g is the perpetual growth rate and r is the discount rate that should account for the riskiness of the company.

Where get g? often between -5% and long-term growth of the economy (4.5%)

Where get r? at least the return on a risk-free long term security (such as the 10-year treasury which is about 4%, see finance.bonds), plus 2 – 10%.

r estimate: 10-yr yield plus 4% for average risk stock, 8% for high risk, and 2% for low risk

Valuation Exercise for Companies with Low and Stable Growth, and No Debt

TradeStation Group (TRAD) Exercise: (finance.)

Net Income: 30.6 Million (Annual Income Statement, Net Income)

Depreciation: 4.2 M (Annual Cash Flow Statement, Depreciation and Amortization)

CAPEX: 3.7 M (Annual Cash Flow Statement, Capital Expenditures)

Shares: 42 M (Key Statistics)

Debt: 0 (Annual Balance Sheet, Long-term + Short-term Debt)

g = ? (see analyst estimate of next 5-year’s growth in yahoo)

r = ?

V =

Buy Sell of hold?

What if r off by +/- 2%

The problem with this method is that g, r, and FCF are often difficult to calculate and it does not work if g > r. Remember ENRON?

Other companies with little or no debt: BBW

Yahoo StockScreen: Low Growth Firms with No debt and Positive Cash Flows

[pic]

4. Event/News Trading: see what stocks are in the news and take a view on the outcome of some uncertain event or the markets reaction to an announced event.









Activity: What are today’s top stock events or stories and how have their prices reacted? What is your bet?

III. Free Cash Flow MODEL FOR companies with debt and low/Stable growth

A. Forecasting FREE CASH FLOWS with Debt

FCF=Net Income –CAPEX +Depr. +Interest Expense(1-Tax Rate)

and

[pic]

Note: Interest is added to FCF and debt subtracted from the valuation to value the stockholders claim to the firm. Tax is subtracted because interest payments are tax deductible.

Data Sources:

NI: Annual Income Statement or Cash Flow Statement

CAPEX: Annual Cash Flow Statement

Depreciation: Annual Income Statement or Cash Flow Statement

Debt: Short-term + Long-term debt from Balance Sheet or Yahoo Key Statistics

Interest Expense: Annual Income Statement

Tax: 40% is a good estimate of the sum of local, state, and federal taxes.

r: 10-year Treasury Yield (finance.yahoo/bonds) + 2 – 10 depending on risk

g: estimate of long-term perpetual growth (often between -2% to 4.5%), look at prior.

Shares: Shares Outstanding from Yahoo Key Statistics

Exercise: Value WMT

IV. Free Cash Flow Estimation MODEL FOR companies with debt and low/Stable growth (Version 2)

[pic]

FCF=Net Income –CAPEX +Depr. +Interest Expense(1-Tax Rate)

1. Next Year Net Income = Next Year Sales x Net Profit Margin

2. Sales can be estimated by multiplying last period sales x (1+expected growth rate)

Next Year Sales = Prior Year Sales x (1 + growth)

3. CAPEX + Depreciation can assume to grow at the same rate as sales.

Version 2 Valuation Formula

[pic]

Getting Information in yahoo:

1. Prior Year Sales: Key Statistics (Revenue, ttm “Trailing Twelve Months”)

2. Sales Growth: Judgment using prior growth (key Stat), prior growth (key stat), economy, industry, and company factors.

3. Profit Margin: Judgment using prior (key stat), industry costs and prices, and company factors.

4. CAPEX: Use prior CAPEX + Depreciation from annual cash flow statement and grow at g%.

5. See prior pages for g, r, and shares (be sure to keep all numbers in billions, millions, or thousands – especially shares)

Activity: What is WMT stock worth using this method?

building a general “one-STAGE” model

Build an excel model that allows you to enter information for any stock.

[pic]

Activity: Value WMT, AMZN, YUM, MCD

V. building a general “Multi-STAGE” Valuation model

[pic]

VI. Loan and Credit Card Payments

A. Auto Loan Payment Calculator USING EXCEL PMT()

PMT(rate,nper,pv,fv,type)

For a more complete description of the arguments in PMT, see the PV function.

Rate   is the interest rate for the loan.

Nper   is the total number of payments for the loan.

Pv   is the present value, or the total amount that a series of future payments is worth now; also known as the principal.

Fv   is the future value, or a cash balance you want to attain after the last payment is made. If fv is omitted, it is assumed to be 0 (zero), that is, the future value of a loan is 0.

Type   is the number 0 (zero) or 1 and indicates when payments are due.

|Set type equal to |If payments are due |

|0 or omitted |At the end of the period |

|1 |At the beginning of the period|

Exercise: Go to and SEArCH NEW CAR by Make and Model and calculate its COST. Calculate the Monthly Payment Assuming you make a $1,000 down PAYMENT. Use a 4-yr Loan and You can get the current auto loan rates at .

B. CREDIT CARD PAYMENT Calculator

The average college student graduates with $3,200 in credit card debt. Assuming an 18% annual interest rate compute the number of months and total cost it will take to payoff the loan.

a standard credit payment is the maximum of $10 or (1% of principal plus the finance charge)

[pic]

VII. YUM Earnings estimate

YUM annonces earnings after the market close today.

go the and yahoo and look up yum estimates for bottom line (EPS) and top line (Revenue).

VIII. Valuation assignment and pitch

Each group of 3 students will analyze and value a group of stocks.

Rank the following industry groups from the best to the worst performer in the next couple years. Think about what global, economic, social or industry trends favor or hurt these industries.

Restaurants/Specialty Eateries (in Services Sector)

Apparel Stores (in Services Sector)

Department/Discount Stores (in Services Sector)

Grocery/Drug Stores (in Services Sector)

Broadcasting/CATV Systems (in Services Sector)

Consumer Goods Sector

Health Care Sector

Technology Sector

1. Value at least one stock per team member in your top ranked industry using the multistage growth model.

2. Select the best buy and sell recommendation using the valuation and an insight about the company or industry.

3. Create a stock pitch

Finding Stocks using Yahoo Stock Screener:

Restaurants (FCF, Profit Margin, and Sales Growth > 0)

[pic]

IX. PowerPOINT and PRESENTATION (5 minutes per group)

[pic]

Presentation Essentials:

1) State Your Thesis Clearly (“XYZ stock is A Buy because of 1, 2, 3”)

2) Support: Support your thesis with logical arguments, evidence, models, etc.

3) Know your Audience: Anticipate concerns or questions

X. Demonstration of Automated Valuation Model

[pic]

Note: In this valuation model, FCF = NI + Net CAPEX (CAPEX + Depr + working capital) + Interest Expense.

XI: Other Topics

1. Calculating Discount Rates using the Capital Asset Pricing Model (CAPM)

r = Risk-Free Rate + Beta x (Market Risk Premium)

where

Risk-Free Rate = 10-Year Treasury Yield

Beta= Measure of Company Risk (See Yahoo Key Statistics)

Market Risk Premium= Expected Return of Stock Market over Treasuries

2. Options

3. Exchange Traded Funds

4. International Investments and Exchange Rates

5. Valuing IPOs

-----------------------

Support

Resistance

[pic]

[pic]

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download