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Chapter 10 Charles P. Jones, Investments: Analysis and Management, Ninth Edition, John Wiley & Sons
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Fundamental Analysis
Flows
t 1
( 1 k)t
Required Inputs
Discount rate
Required rate of return: minimum expected rate to induce purchase The opportunity cost of dollars used for investment
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Required Inputs
10-5
Current value of a share of stock is the discounted value of all future dividends
D1 ( 1 kcs )
1
Pcs
D2 ( 1 kcs )
t 1 2
...
D ( 1 kcs )
Dt ( 1 kcs )
t
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Problems:
Need infinite stream of dividends Dividend stream is uncertain
Must estimate future dividends
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D0 P0 kcs
Similar to preferred stock because dividend remains unchanged
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D1 P0 k g
D1 is the expected dividend at end of the first period D1 =D0 (1+g)
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P0
D0( 1 g1 ) ( 1 k)
t
t 1
Dn( 1 gc ) 1 n k-g ( 1 k)
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Example: Valuing equity with growth of 30% for 3 years, then a long-run constant growth of 6%
k=16%
1
5.20
2
g = 30%
3
g = 6%
4
9.315
g = 30% g = 30%
6.76
8.788
P3 = 9.315 .10
Price received in future reflects expectations of dividends from that point forward
Discounting dividends or a combination of dividends and price produces same results
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Intrinsic Value
If intrinsic value >(<) current market price, hold or purchase (avoid or sell) because the asset is undervalued (overvalued)
Decision will always involve estimates
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Divide the current market price of the stock by the latest 12-month earnings Price paid for each $1 of earnings
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The higher the payout ratio, the higher the justified P/E
Payout ratio is the proportion of earnings that are paid out as dividends
The higher the expected growth rate, g, the higher the justified P/E The higher the required rate of return, k, the lower the justified P/E
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As interest rates increase, required rates of return on all securities generally increase P/E ratios and interest rates are indirectly related
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P/E multiplier remains popular for its ease in use and the objections to the dividend discount model
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Complementary approaches?
P/E ratio can be derived from the constantgrowth version of the dividend discount model Dividends are paid out of earnings Using both increases the likelihood of obtaining reasonable results
Other Multiples
Price-to-sales ratio
Ratio of a companys total market value (price times number of shares) divided by sales Market valuation of a firms revenues
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