22 question exam 19 multiple choice questions 3 short answer calculation questions Ch 13 14 11 18 1 Calculate Holding Period Return Chapter 13 Slide 12 Page 408 The return on a Stock Investment comprises cash dividends and capital gains or losses Assuming 1 year holding period Expected HPR E r E D1 E P1 P o P o E D1 Expected Dividend Per Share P o Current Price of the Share E P1 Expected Price at the end of the year 2 Dividend Payout Ratio The percentage of earnings paid to shareholders in dividends The payout ratio provides an idea of how well earnings support the dividend payments More mature companies tend to have a higher payout ratio A reduction in dividends paid is looked poorly upon by investors and the stock price usually depreciates as investors seek other dividend paying stocks 3 Securities Intrinsic Value Chapter 13 Slide 14 15 Page 408 Intrinsic Value the present value of a firms expected future net cash flows discounted by the required rate of return Intrinsic Value Denoted V o of a share of stock is defined as the present value of all cash payments to the investor in the stock including dividends as well as proceeds from the ultimate sale of the stock discounted at the appropriate risk adjusted interest rate k whenever the intrinsic value or the investor s own estimate of what the stock is really worth exceeds market price the stock is considered undervalued and a good investment Market Price Consensus value of all traders Equilibrium When current Market Price will equal Intrinsic Value Trading Signals V o P o Buy V o P o Sell or Short Sell V o P o Hold as it is fairly priced Intrinsic Value V o E D1 E P1 1 k D1 dividend paid in one year P1 stock price in one year K risk adjusted required rate of return 4 Calculate Expected Market Price Per Share Market value capitalization of company shares outstanding 5 Stock Valuation Models Chapter 13 Slides 3 55 Valuation models using comparables look at the relationship between price and the various determinants of value for similar firms Balance Sheet Models Stock analyst use models to estimate the fundamental value of a corporations stock from observable market date and from the financial statements of the firm and its competitors book value Value of common equity on the balance sheet Based on historical values of assets and liabilities which may not reflect current values market value Current market value of assets minus current market value of liabilities Liquidation value Net amount realized from sale of assets and paying off all debt Replacement cost Replacement cost of the assets less the liabilities Dividend Discount Models Basic dividend discount No growth model Stocks that have earnings and dividends that are expected to remain constant over time zero growth constant growth model Stocks that have earnings and dividends that are expected to grow at a constant rate forever Price Earnings Ratios price earnings multiple commonly called P E ratio the ratio of a stock s price to its earnings per share Market Value per Share Earnings per Share EPS For example if a company is currently trading at 43 a share and earnings over the last 12 months were 1 95 per share the P E ratio for the stock would be 22 05 43 1 95 P E Ratios are functions of two factors Required Rates of Return k inverse relationship Expected Growth in Dividends direct relationship Uses Estimates intrinsic value of stocks Conceptually equivalent to the constant growth DDM Extensively used by analysts and investors Pitfalls in using P E Ratios Earnings management is a serious problem P E should be calculated using pro forma earnings A high P E implies high expected growth but not necessarily high stock returns Simplistic assumes the future P E will not be lower than the current P E If expected growth in earnings fails to materialize the P E will fall and investors may incur large losses Free Cash Flow Models alternative approach to the dividend discount model values the firm using free cash flow that is cash flow available to the firm or the equity holders net of capital expenditures capitalize or discount the free cash flow for the firm FCFF at the weighted average cost of capital and then subtract the existing market value of debt Another approach calculates the free cash flow to the equity holders FCFE and discounts the cash flows directly at the cost of equity K e useful for firms who pay no dividends for which the dividend discount model would be difficult to implement help understand sources and uses of cash in Theory free cash flow approaches should provide the same estimate of intrinsic value as the dividend growth in practice the various approaches often differ substantially 6 Components of Balance Sheet Income Statement Chapter 14 Slides 4 12 Pages 447 450 Where EBIT earnings before interest and taxes Tc the corporate tax rate NWC net working capital Income Statement Four Broad Types of Accounts Cost of Goods Sold General and Administrative Expenses Interest Expense Taxes on Earnings Common Size Income Statements allows size free comparisons through time and across companies Divide each account by net sales Eliminates size distortions Balance Sheet Assets Current Long Term Liability current and long term and stockholders equity Common size balance sheet divide each account by total assets each account presented as a percent of the total 7 Components of Dupont Model Chapter 14 Page 455 456 Slides 22 26 DuPont Model decomposition of profitability measures into component ratios analyst decompose RE into the product of a series of ratios Each component ratio is in itself meaningful and the process serves to focus the analyst s attention on the separate factors influencing performance ROE Net Profit Equity ROE Net Profit Pretax Profit 1 Tax Burden X Pretax Profit EBIT 2 Interest Burden X EBIT Sales 3 Margin X Sales Assets 4 Turnover X Assets Equity 5 Leverage Ratio 1 Tax Burden Measures the percentage of pretax profit that the firm keeps after paying taxes Ratio 2 Interest Burden Measures the percent of EBIT kept after paying interest expense if this ratio is 1 the firm has no debt Ratio 3 Operating Profit Margin measures the percentage of sales revenue that remains after subtracting cost of goods sold selling and administrative expenses and depreciation Ratio 4 Asset Turnover Ratio ATO Measures the efficiency of the firm at generating sales per dollar invested in the assets Ratio 5 Leverage Ratio measure of the percentage of debt in total