Valuing Common Stock
Investment Snapshot
* Abuyer of Cisco stock at $20 per share is optimistic about
the appreciation of the price, whereas the seller of Cisco
stock at $20 thinks that the stock is fully valued.
* D. R. Horton, the home builder, traded at a valuation of
four times its earnings, whereas Google traded at 54
times its earnings.
* Bank of America has a dividend yield of around 4 percent,
whereas Apple Computer does not pay a dividend.
What is the value of common stock?
We all hate to pay too much when we buy something. Similarly, the
same standard of valuation applies to stock investments. You need
to determine the underlying or intrinsic value of a stock to determine
whether that stock is undervalued, fairly priced, or overvalued.
For stocks, this is not easy. The intrinsic value is the fair
value of the stock based on the risk and the amount and timing of
future cash flow, in other words, the present value of the stream of
receipts from a stock.
Theoretically, the value of a stock is equal to the discounted
future cash flow of both dividends and the sale price of the stock.
Neither the receipt of nor the amount of the dividends is guaranteed
for common stockholders, and uncertainty exists about the
amount of the future sale price. There are a number of different
metrics with which to find the intrinsic value of a stock that make
various assumptions about the amount of future dividends and the
growth rate of the company.
The amount of dividends paid to shareholders is based largely
on two factors:
* The company’s profitability
* The decision by the company’s board of directors to declare
and pay dividends rather than retain the profits of the
company
Many profitable companies decide not to pay dividends even
though they are profitable and can sustain the payment of dividends,
for example, Cisco and Oracle. These companies have large
amounts of cash on their balance sheets, but they have chosen to
retain their profits and reinvest them to accumulate future profits.
Consequently, companies fuel their own growth by retaining profits
and reinvesting them in future business projects. Generally, when a
company’s earnings increase, the increase is reflected in a higher
price for the company’s stock.
Other sources of value to shareholders besides the payment
of dividends and increasing retained earnings are the repurchase of
stock by a company and the reduction of its debt. A repurchase of
its own shares by a company reduces the number of its shares outstanding,
and if earnings increase or stay the same, earnings per
share increase. Many analysts base their buy, hold, and sell ratings
of companies on the growth of earnings per share.
Not all stock buybacks by companies increase shareholder
wealth. Amgen announced in February 2006 that it would sell $4
billion of convertible debt, with $3 billion of the proceeds to be
used to fund the buyback of its stock. This action caused Amgen’s
stock price to fall from $71 to $66 per share because more debt
results in greater interest expense, which decreases earnings.
Consequently, when a company reduces its debt, interest payments
are decreased, which increases earnings. The result is an increase in
earnings per share. In reality, the decision to increase or reduce
debt is not as clearcut with regard to earnings because earnings per
share can be increased using debt financing as long as the company
can earn a return that is greater than the cost of the debt.
Investors buy and value stocks based on their expectations of
receiving dividends and/or capital appreciation. In other words,
the total return for a stock is composed of the dividend received
and the appreciation in the value of the stock price. If a company
can increase its earnings, dividends can be increased over time,
which produces greater total returns for investors. An investor’s
expected rate of return for a stock is the sum of the dividend yield
plus the expected growth rate. For example, suppose that a stock
pays a dividend yield of 3 percent and is expected to grow at
10 percent for the year; then its expected rate of return is 13 percent.
If an investor’s required rate of return for stock investments is less
than 13 percent, the stock provides a superior return. On the other
hand, a required rate of return of greater than 13 percent would
make this stock an inferior investment. The required rate of return
has two components: the risk-free rate you can earn on Treasury
bills plus a risk premium associated with the stock and the market.
A riskier stock would require a higher risk premium, and if the
risk-free rate increases, an investor would require an appropriate
increase in the rate of return.
Two basic approaches to stock valuation are discussed in this
chapter:
* Discounted cash flow method
* Relative valuation methods
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