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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