Stock Valuation and Investment Decisions Chapter 8 - Cfa
Stock Valuation and Investment Decisions Chapter 8 - Cfa
CHAPTER 8
ech stocks have been at the forefront of stock market news the
STOCK
VALUATION AND
T past few years. Often this sector, rather than blue-chip
industrials, drives the market—both up and down. Take
Qualcomm, for example; a company that is a leading developer
and supplier of digital wireless communications products and services.
It pioneered Code Division Multiple Access (CDMA) technology, a
INVESTMENT standard for the wireless communications industry. Investors in
DECISIONS Qualcomm stock have experienced a roller coaster ride recently. The
firm’s 1999 stock price started at $6.48 and soared steadily upward to
end the year when it hits $176.13—after splitting 2-for-1 in May and
L EARNING G OALS 4-for-1 in December. This represents an annual return of over 2,600%,
After studying this chapter, you the year’s best. The following year was another matter, however. Fears
should be able to: of slowing growth sent the stock price into free-fall: It plummeted
from $163.25 to $51.50, before rebounding to $82.19 at year end, for
LG 1 Explain the role that a
company’s future plays in the stock a 53% return. Even after the decline, the stock was still trading at a
valuation process and develop a fore- price/earnings ratio of about 85 in early January 2001, a substantial
cast of a stock’s expected cash flow. premium over the average P/E of 29 for the S&P 500.
Despite Qualcomm’s fluctuating stock price, investors looked with
LG 2 Discuss the concepts of
favor on the company’s earnings growth—94% from 1997 through
intrinsic value and required rates of
2000, which far outstripped the S&P 500’s 14%. The company
return, and note how they are used.
consistently met or exceeded quarterly earnings estimates, and
LG 3 Determine the underlying analysts project continued earning growth to $1.26 per share in 2001,
value of a stock using the dividend an increase of 48% over 2000.
valuation model, as well as other What do all these numbers mean in terms of the value of
present value– and price/earnings–
Qualcomm’s stock? This chapter explains how to determine a stock’s
based stock valuation models.
intrinsic value by using dividend valuation, dividend-and-earnings,
LG 4 Gain a basic appreciation price/earnings, and other models. We also look at how to value
of the procedures used to value technology stocks. Finally, we’ll review the use of technical analysis as
different types of stocks, from a way to assess the state of the market in general.
traditional dividend-paying shares
Sources: Adrienne Carter, “The Big Score,” Money Technology 2000, October 15, 2000,
to new-economy stocks with their p.60; “Morningstar Quicktake Report—Qualcomm” Morningstar.com, downloaded
extreme price/earnings ratios. from www.morningstar.com, January 15, 2001; and Qualcomm Web site,
www.qualcomm.com
LG 5 Describe the key attributes
of technical analysis, including some
popular measures and procedures
used to assess the market.
314
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Valuation: Obtaining a standard of performance that can be used to judge the investment
Obtaining a merits of a share of stock is the underlying purpose of stock valuation. A
stock’s intrinsic value provides such a standard because it indicates the future
Standard of risk and return performance of a security. The question of whether and to
Performance what extent a stock is under- or overvalued is resolved by comparing its cur-
rent market price to its intrinsic value. At any given point in time, the price of
LG 1 LG 2 a share of common stock depends on investor expectations about the future
behavior of the security. If the outlook for the company and its stock is good,
the price will probably be bid up. If conditions deteriorate, the price of the
stock valuation stock will probably go down. Let’s look now at the single most important issue
the process by which the in the stock valuation process: the future.
underlying value of a stock
is established on the basis of its
forecasted risk and return Valuing a Company and Its Future
performance.
Thus far, we have examined several aspects of security analysis: economic and
industry analysis, and the historical (company) phase of fundamental
analysis. It should be clear, however, that it’s not the past that’s important but
the future. The primary reason for looking at past performance is to gain
insight about the future direction of the firm and its profitability. Granted,
past performance provides no guarantees about future returns, but it can give
us a good idea of a company’s strengths and weaknesses. For example, it can
BLIND SPOT—As optical tell us how well the company’s products have done in the marketplace, how
networking companies caught the company’s fiscal health shapes up, and how management tends to respond
investors’ attention, their to difficult situations. In short, the past can reveal how well the company is
market value soared. In positioned to take advantage of the things that may occur in the future.
September 2000, this hype
drove the value of JDS Because the value of a stock is a function of its future returns, the
Uniphase to $96 billion, which investor’s task is to use available historical data to project key financial vari-
made it the 36th most highly ables into the future. In this way, you can assess the future prospects of the
valued company in the world. company and the expected returns from its stock. We are especially interested
Investors apparently turned a in dividends and price behavior.
blind eye to the company’s
financial results for the fiscal
year ended June 30, 2000: Its Forecasted Sales and Profits The key to our forecast is, of course, the future
revenues were $1.4 billion and behavior of the company and the most important aspects to consider in this
its losses $905 million. For regard are the outlook for sales and the trend in the net profit margin. One
about the same total market way to develop a sales forecast is to assume that the company will continue to
capitalization, you could
theoretically buy all 11 of the perform as it has in the past and simply extend the historical trend. For
following major companies— example, if a firm’s sales have been growing at the rate of 10% per year, then
the New York Times, Saks Fifth assume they will continue at that rate. Of course, if there is some evidence
Avenue, Georgia Pacific, T. about the economy, industry, or company that suggests a faster or slower rate
Rowe Price, Delta Airlines, of growth, the forecast should be adjusted accordingly. More often than not,
Tiffany & Co., Bear Stearns,
FedEx, CVS, Gap, and John this “naive” approach will be about as effective as more complex techniques.
Hancock—with aggregate Once the sales forecast has been generated, we can shift our attention to
revenues of $115 billion and the net profit margin. We want to know what kind of return on sales to expect.
$6.4 billion in profits! A naive estimate can be obtained by simply using the average profit margin
Source: Jon Birger, Pablo Galarza, that has prevailed for the past few years. Again, it should be adjusted to
Laura Lallos, and Jeanne Lee, “Best account for any unusual industry or company developments. For most indi-
Stocks & Funds: Invest the Smart
Way to Buy Tech,” Money/Tech 2000, vidual investors, valuable insight about future revenues and earnings can be
October 15, 2000, pp. 65–66. obtained from industry or company reports put out by brokerage houses, advi-
sory services (e.g., Value Line), the financial media (e.g., Forbes), and from
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The “year t” notation in this equation simply denotes a given calendar or fiscal
year in the future. It can be next year, the year after that, or any other year in
which we are interested. Let’s say that in the year just completed, a company
reported sales of $100 million, we estimate that revenues will grow at an 8%
annual rate, and the net profit margin should be about 6%. Thus estimated
sales next year will equal $108 million ($100 million 1.08). And, with a 6%
profit margin, we should expect to see earnings next year of
Future after-tax
$108 million 0.06 $6.5 million
earnings next year
Using this same process, we would then estimate sales and earnings for all
other years in our forecast period.
Forecasted Dividends and Prices At this point we have an idea of the future
earnings performance of the company. We are now ready to evaluate the
effects of this performance on returns to common stock investors. Given a cor-
porate earnings forecast, we need three additional pieces of information:
• An estimate of future dividend payout ratios.
• The number of common shares that will be outstanding over the forecast
period.
• A future price/earnings (P/E) ratio.
For the first two, unless we have evidence to the contrary, we can simply pro-
ject the firm’s recent experience into the future. Payout ratios are usually fairly
stable, so there is little risk in using a recent average figure. (Or, if a company
follows a fixed-dividend policy, we could use the latest dividend rate in our
forecast.) It is also generally safe to assume that the number of common shares
outstanding will hold at the latest level or perhaps change at some moderate
rate of increase (or decrease) that’s reflective of the past.
Getting a Handle on the P/E Ratio The only really thorny issue in this
whole process is coming up with an estimate of the future P/E ratio—a figure
that has considerable bearing on the stock’s future price behavior. Generally
speaking, the P/E ratio is a function of several variables, including:
1. The growth rate in earnings.
2. The general state of the market.
3. The amount of debt in a company’s capital structure.
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Estimating Earnings per Share So far we’ve been able to come up with an
estimate for the dividend payout ratio, the number of shares outstanding, and
the price/earnings multiple. We’re now ready to forecast the stock’s future
earnings per share (EPS), which can be done as follows:
Future after-tax
Equation 8.2 Estimated EPS earnings in year t
in year t Number of shares of common stock
outstanding in year t
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*Note: By May 2001, the average P/E ratio on the S&P 500 was down to about 23 times
earnings.
Source: Average year-end multiples derived from various sources, including Standard & Poor’s
Index of 500 Stocks and its Statistical Service—Security Price Index Record. Listed P/Es are all
year-end (December) figures, except 2000, which is as of end of the third quarter.
This formula will produce the same results as the standard EPS equation
shown first in Chapter 6 (Equation 6.1) and then again in Chapter 7. The
major advantage of this form of the equation is that it allows you to assess the
extent to which EPS is influenced by the company’s book value and (especially)
its ROE. As we saw in the previous chapter, ROE is a key financial measure,
because it captures the amount of success the firm is having in managing its
assets, operations, and capital structure. And as we see here, ROE not only is
important in defining overall corporate profitability but it also plays a crucial
role in defining a stock’s EPS.
To produce an estimated EPS using Equation 8.3, you would go directly
to the two basic components of the formula and try to get a handle on their
future behavior. In particular, what kind of growth is expected in the firm’s
book value per share, and what’s likely to happen to the company’s ROE? In
the vast majority of cases, ROE is really the driving force, so it’s important to
produce a good estimate of that variable. Investors often do that by breaking
ROE into its component parts—margin, turnover, and the equity multiplier
(see Equation 7.13 in Chapter 7).
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Once you have projected ROE and book value per share, you can plug
these figures into Equation 8.3 to produce estimated EPS. The bottom line is
that, one way or another (using the approach reflected in Equation 8.2 or that
in Equation 8.3), you have to arrive at a forecasted EPS number that you are
comfortable with. When that’s been done, it’s a pretty simple matter to use the
forecasted payout ratio to estimate dividends per share:
The last item is the future price of the stock, which can be determined as
Pulling It All Together We’ve seen the various components that go into our
estimates of future dividends and share prices. Now, to see how they all fit
together, let’s continue with the example we started above. Using the aggregate
sales and earnings approach, if the company had 2 million shares of common
stock outstanding and that number was expected to hold in the future, then
given the estimated earnings of $6.5 million that we computed earlier, the firm
should generate earnings per share (EPS) next year of
This result, of course, would be equivalent to the firm having a projected ROE
of, say, 15% and an estimated book value per share of $21.67. According to
Equation 8.3, those conditions would also produce an estimated EPS of $3.25
(i.e., 0.15 $21.67). Using this EPS figure, along with an estimated payout
ratio of 40%, we see that dividends per share next year should equal
Estimated dividends
$3.25 .40 $1.30
per share next year
Actually, we are interested in the price of the stock at the end of our antic-
ipated investment horizon. Thus the $56.90 figure would be appropriate if we
had a 1-year horizon. However, if we had a 3-year holding period, we would
have to extend the EPS figure for 2 more years and repeat our calculations with
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the new data. As we shall see, the estimated share price is important because
it has embedded in it the capital gains portion of the stock’s total return.
*Annual rate of growth in sales Change in sales from one year to the next Level of sales in
the base (or earliest) years. For 1998, the annual rate of growth in sales equaled 34.7% (1998
sales 1997 sales)/1997 sales ($1,283.9 $953.2)/$953.2 0.3467.
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share, and so forth hold up. We see in Table 8.3 that dividends should
go up to 28 cents a share, which is a big jump. Even so, with annual div-
idends of a little over a quarter a share, it’s clear that dividends still
won’t account for much of the stock’s return. In fact, the dividend yield
in 2004 is projected to fall to just 3/10 of 1%. The returns from this
stock are going to come from capital gains, not dividends. That’s clear
when you look at year-end share prices, which are expected to more
than double over the next 3 years. That is, if our projections are valid,
the price of a share of stock should rise from around $41.50 to over
$93.00 by year-end 2004.
We now have an idea of what the future cash flows of the investment are
likely to be. We now can establish an intrinsic value for Universal Office
Furnishings stock.
Required Rate of Return One of the key elements in the stock valuation
required rate of return process is the required rate of return. Generally speaking, the amount of return
the return necessary to required by an investor should be related to the level of risk that must be
compensate an investor for the assumed in order to generate that return. In essence, the required return estab-
risk involved in an investment.
lishes a level of compensation compatible with the amount of risk involved.
Such a standard helps you determine whether the expected return on a stock
(or any other security) is satisfactory. Because you don’t know for sure what
the cash flow of an investment will be, you should expect to earn a rate of
return that reflects this uncertainty. Thus the greater the perceived risk, the
more you should expect to earn. As we saw in Chapter 5, this is basically the
notion behind the capital asset pricing model (CAPM).
Recall that using the CAPM, we define a stock’s required return as
Required Risk-free Stock’s Market Risk-free
Equation 8.6
rate of return rate beta return rate
The required inputs for this equation are readily available: You can obtain a
stock’s beta from Value Line or S&P’s Stock Reports (or from just about any
of the many Internet sites, such as Quicken.com, MSN MoneyCentral, or
Morningstar.com). The risk-free rate is basically the average return on
Treasury bills for the past year or so. And a good proxy for the market return
is the average stock returns over the past 10 to 15 years (like the data reported
in Table 6.1).
In the CAPM, the risk of a stock is captured by its beta. For that reason,
the required return on a stock increases (or decreases) with increases (or
decreases) in its beta. As an illustration of the CAPM at work, consider
Universal’s stock, which has a beta of 1.30. Given that the risk-free rate is
5.5% and the expected market return is, say, 15%, this stock would have a
required return of
I N R E V I E W
C O N C E P T S
8.1 What is the purpose of stock valuation? What role does intrinsic value play in
the stock valuation process?
8.2 Are the expected future earnings of the firm important in determining a stock’s
investment suitability? Discuss how these and other future estimates fit into
the stock valuation framework.
8.3 Can the growth prospects of a company affect its price/earnings multiple?
Explain. How about the amount of debt a firm uses? Are there any other vari-
ables that affect the level of a firm’s P/E ratio?
8.4 What is the market multiple, and how can it help in evaluating a stock’s P/E?
Is a stock’s relative P/E the same thing as the market multiple? Explain.
8.5 In the stock valuation framework, how can you tell whether a particular secu-
rity is a worthwhile investment candidate? What roles does the required rate
of return play in this process? Would you invest in a stock if all you could earn
was a rate of return that equaled your required return? Explain.
8.6 According to the Investing in Action box on page 317, what are whisper fore-
casts and how can investors use them? How accurate are whisper forecasts?
Explain.
Stock Valuation Take a look at the market and you’ll discover that investors employ a number
Models of different types of stock valuation models. Though they all may be aimed at
a security’s future cash benefits, their approaches to valuation are nonetheless
considerably different. Take, for example, those investors who search for value
in a company’s financials—by keying in on such factors as book value, debt
LG 3 LG 4 load, return on equity, and cash flow. These are the so-called value investors,
who rely as much on historical performance as on earnings projections to iden-
tify undervalued stock. Then there are the growth investors, who concentrate
solely on growth in earnings. To them, though past growth is important, the
real key lies in projected earnings—that is, in finding companies that are going
to produce big earnings, along with big price/earnings multiples, in the future.
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Zero Growth The simplest way to picture the dividend valuation model is to
assume the stock has a fixed stream of dividends. In other words, dividends stay
the same year in and year out, and they’re expected to do so in the
H O T L I N K S future. Under such conditions, the value of a zero-growth stock is
simply the capitalized value of its annual dividends. To find the
See the dividend valuation model at
capitalized value, just divide annual dividends by the required rate
www.stocksense.com/valuation.html of return, which in effect acts as the capitalization rate. That is,
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Constant Growth The zero-growth model is a good beginning, but it does not
take into account a growing stream of dividends, which is more likely to be
the case in the real world. The standard and more widely recognized version
of the dividend valuation model assumes that dividends will grow over time at
a specified rate. In this version, the value of a share of stock is still considered
to be a function of its future dividends, but such dividends are expected to
grow forever (to infinity) at a constant rate of growth, g. Accordingly, the
value of a share of stock can be found as follows:
Equation 8.8a D1
V
kg
where
D1 annual dividends expected to be paid next year (the first year
in the forecast period)
k the capitalization rate, or discount rate (which defines the
required rate of return on the investment)
g the annual rate of growth in dividends, which is expected to
hold constant to infinity
This model succinctly captures the essence of stock valuation: Increase the
cash flow (through D or g) and/or decrease the required rate of return (k), and
the value of the stock will increase. Also note that in the DVM, k defines the
total return to the stockholder and g represents the expected capital gains on
the investments. We know that, in practice, there are potentially two compo-
nents that make up the total return to a stockholder: dividends and capital
gains. As it turns out, the returns from both dividends and capital gains are
captured in the DVM. That is, because k represents total returns and g defines
the amount of capital gains embedded in k, it follows that if you subtract g
from k (k g), you’ll have the expected dividend yield on the stock. Thus the
expected total return on a stock (k) equals the returns from capital gains (g)
plus the returns from dividends (k g).
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The constant-growth DVM should not be used with just any stock. Rather,
it is best suited to the valuation of mature companies that hold established
market positions. These are companies with strong track records that have
reached the “mature” stage of growth. This means that you’re probably dealing
with large-cap (or perhaps even some mature mid-cap) companies that have
demonstrated an ability to generate steady—though perhaps not spectacular—
rates of growth year in and year out. The growth rates may not be identical from
year to year, but they tend to move within such a small range that they are seldom
far off the average rate. These are companies that have established dividend poli-
cies, particularly with regard to the payout ratio, and fairly predictable growth
rates in earnings and dividends. Thus, to use the constant-growth DVM on such
companies, all that’s required is some basic information about the stock’s cur-
rent level of dividends and the expected rate of growth in dividends, g.
One popular and fairly simple way to find the dividend growth rate is to
look at the historical behavior of dividends. If they are growing at a relatively
constant rate, you could assume that they’ll continue to grow at (or near) that
average rate in the future. You can get historical dividend data in a company’s
annual report, from various online Internet sources, or from publications like
Value Line. Given this stream of dividends, you can use basic present-value
arithmetic to find the average rate of growth. Here’s how: Take the level of
dividends, say, 10 years ago and the level that’s being paid today. Presumably,
dividends today will be (much) higher than they were 10 years ago, so, using
your calculator, find the present value discount rate that equates the (higher)
dividend today to the level paid 10 years earlier. When you find that, you’ve
found the growth rate, because in this case, the discount rate is the average
rate of growth in dividends. (See Chapter 5 for a detailed discussion of how to
use present value to find growth rates.)
Once you’ve determined the dividend growth rate, g, you can find next
year’s dividend, D1, as D0 (1 g), where D0 equals the actual (current) level
of dividends. Let’s say that in the latest year Amalgamated Anything paid $2.50
a share in dividends. If you expect these dividends to grow at the rate of 6% a
year, you can find next year’s dividends as follows: D1 D0 (1 g) $2.50
(1 .06) $2.50 (1.06) $2.65. The only other information you need is the
capitalization rate, or required rate of return, k. (Note that k must be greater
than g for the constant-growth model to be mathematically operative.)
To see this dividend valuation model at work, consider a stock that cur-
rently pays an annual dividend of $1.75 a share. Let’s say that by using the
present-value approach described above, you find that dividends are growing
at a rate of 8% a year, and you expect they will continue to do so into the
future. In addition, you feel that because of the risks involved, the investment
should carry a required rate of return of 12%. Given this information, you can
use Equation 8.8 to price the stock. That is, given D0 $1.75, g 0.08, and
k 0.12, it follows that
Stock
Year Dividend Price*
(Current year) 0 $1.75 $47.25
1 1.89 51.00
2 2.04 55.00
3 2.20 59.50
4 2.38 64.25
5 2.57 69.50
*As determined by the dividend valuation model, given
g 0.08, k 0.12, and D0 dividend level for any given
year.
As the table shows, we can also find the expected price of the stock in the
future by using the standard dividend valuation model. To do this, we simply
redefine the appropriate level of dividends. For example, to find the price of
the stock in year 3, we use the expected dividend in the third year, $2.20, and
increase it by the factor (1 g). Thus the stock price in year
3 D3 (1 g)/(k g) $2.20 (1 0.08)/(0.12 0.08) $2.38/0.04
$59.50. Of course, if future expectations about k or g do change, the future
price of the stock will change accordingly. Should that occur, an investor could
use the new information to decide whether to continue to hold the stock.
Present value of
Present value of the price
Equation 8.9 Value of a share future dividends
of the stock at the end of
of stock during the initial
the variable-growth period
variable-growth period
Dv(1 g)
(Dv PVIFv) PVIFv
kg
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where
Note that the last element in this equation is the standard constant-growth
dividend valuation model, which is used to find the price of the stock at the
end of the initial variable-growth period.
This form of the DVM is appropriate for companies that are expected to
experience rapid or variable rates of growth for a period of time—perhaps for
the first 3 to 5 years—and then settle down to a constant (average) growth rate
thereafter. This, in fact, is the growth pattern of many companies, so the model
has considerable application in practice. (It also overcomes one of the opera-
tional shortcomings of the constant-growth DVM in that k does not always
have to be greater than g. That is, during the variable-growth period, the rate
of growth, g, can be greater than the required rate of return, k, and the model
will still be fully operational.)
Finding the value of a stock using Equation 8.9 is actually a lot easier than
it looks. All you need do is follow these steps:
1. Estimate annual dividends during the initial variable-growth period and
then specify the constant rate, g, at which dividends will grow after the
initial period.
2. Find the present value of the dividends expected during the initial vari-
able-growth period.
3. Using the constant-growth DVM, find the price of the stock at the end
of the initial growth period.
4. Find the present value of the price of the stock (as determined in step 3).
Note that the price of the stock is discounted at the same PVIF as the
last dividend payment in the initial growth period, because the stock is
being priced (per step 3) at the end of this initial period.
5. Add the two present-value components (from steps 2 and 4) to find the
value of a stock.
To see how this works, let’s apply the variable-growth model to one of our
favorite companies: Sweatmore Industries. Let’s assume that dividends will
grow at a variable rate for the first 3 years (2001, 2002, and 2003). After that,
the annual rate of growth in dividends is expected to settle down to 8% and
stay there for the foreseeable future. Starting with the latest (2000) annual div-
idend of $2.21 a share, we estimate that Sweatmore’s dividends should grow
by 20% next year (in 2001), by 16% in 2002, and then by 13% in 2003
before dropping to an 8% rate. Using these (initial) growth rates, we therefore
project that dividends in 2001 will amount to $2.65 a share ($2.21 1.20),
and will rise to $3.08 ($2.65 1.16) in 2002 and to $3.48 ($3.08 1.13) in
2003. In addition, given Sweatmore’s risk profile, we feel that the investment
should produce a minimum (required) rate of return (k) of at least 14%. We
now have all the input we need and are ready to put a value on Sweatmore
Industries. Table 8.4 shows the variable-growth DVM in action. The value of
Sweatmore stock, according to the variable-growth DVM, is just under $49.25
a share. In essence, that’s the maximum price you should be willing to pay for
the stock if you want to earn a 14% rate of return.
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Step
1. Projected annual dividends: 2001 $2.65
2002 $3.08
2003 $3.48
Estimated annual rate of growth in dividends, g, for 2004 and beyond: 8%
2. Present value of dividends, using a required rate of return, k, of 14%, during the
initial variable-growth period:
PVIF
Year Dividends (k 14%) Present Value
2001 $2.65 0.877 $2.32
2002 3.08 0.769 2.37
2003 3.48 0.675 2.35
Total .0
$ (to step 5)
7
4
3. Price of the stock at the end of the initial growth period:
D2004 D2003 (1 g) $3.48 (1.08) $3.75
P2003 $62 .50
kg kg 0.14 0.08 0.06
4. Discount the price of the stock (as computed above) back to its present value,
at k 14%:
PV (P2003) $62.50 PVIF14%, 3 yr $62.50 0.675
$42 .19 (to step 5)
5. Add the present value of the initial dividend stream (step 2) to the present value
of the price of the stock at the end of the initial growth period (step 4):
Value of Sweatmore stock $7.04 $42.19
$49
.2
3
where
Both variables in Equation 8.10 (ROE and rr) are directly related to the
firm’s rate of growth, and both play key roles in defining a firm’s future
growth. The retention rate represents the percentage of the firm’s profits that
are plowed back into the company. Thus, if the firm pays out 35% of its earn-
ings in dividends (i.e., it has a dividend payout ratio of 35%), then it has a
retention rate of 65%: rr 1 0.35 0.65. The retention rate, in effect,
indicates the amount of capital that is flowing into the company to finance its
growth. Other things being equal, the more money that’s being retained in the
company, the higher the rate of growth. The other component of Equation
8.10 is the familiar return on equity. Clearly, the more the company can earn
on its retained capital, the higher the growth rate.
Let’s look at some numbers to see how this actually works. For example,
if a company retained, on average, about 80% of its earnings and generated
an ROE of around 15%, you’d expect it to have a growth rate of around:
Actually, the growth rate will probably be a bit more than 12%, because
Equation 8.10 ignores financial leverage, which in itself will magnify growth.
But at least the equation gives you a good idea what to expect. Or it can serve
as a starting point in assessing past and future growth. That is, you can use
Equation 8.10 to compute expected growth and then assess the two key com-
ponents of the formula (ROE and rr) to see whether they’re likely to undergo
major changes in the future. If so, then what impact is the change in ROE
and/or rr likely to have on the growth rate, g? The idea is to take the time to
study the forces (ROE and rr) that drive the growth rate, because the DVM
itself is so sensitive to the rate of growth being used. Employ a growth rate
that’s too high and you’ll end up with an intrinsic value that’s way too high
also. The downside to that, of course, is that you may end up buying a stock
that you really shouldn’t.
Present value of
Equation 8.11 Present value of Present value of
the price of the stock
a share of stock future dividends
at date of sale
where
Dt future annual dividend in year t
PVIFt present-value interest factor, specified at the required rate of
return (Table A.3 in the Appendix near the end of the book)
SPN estimated share price of the stock at date of sale, year N
N number of years in the investment horizon
To see how this procedure works, consider once again the case of
Universal Office Furnishings. Let’s return to our original 3-year investment
horizon. Given the forecasted annual dividends and share price from Table
8.3, along with a required rate of return of 18% (as computed earlier using
Equation 8.6), we can see that the value of Universal’s stock is
$57.25
Here’s how it works: Using the Universal example, we know that the stock
is expected to pay per-share dividends of $0.18, $0.24, and $0.28 over the
next 3 years. At the end of that time, we hope to sell the stock for $93.20.
Given that the stock is currently trading at $41.58, we’re looking for the dis-
count rate that will produce a present value (of the future annual dividends
and stock price) equal to $41.58. That is,
We need to solve for the discount rate (the present-value interest factors)
in this equation. Through a process of “hit and miss” (and with the help of a
personal computer or hand-held calculator), you’ll find that with an interest
factor of 31.3%, the present value of the future cash benefits from this invest-
ment will equal exactly $41.58. That, of course, is our expected return. Thus
Universal can be expected to earn a fully compounded annual return of about
31%, assuming that the stock can be bought at $41.58, is held for 3 years
(during which time investors receive indicated annual dividends), and then is
sold for $93.20 at the end of the 3-year period. When compared to its 18%
required rate of return, the 31.3% expected return makes Universal look like
a very attractive investment candidate.
Equation 8.12 basically captures the P/E approach to stock valuation. That is,
given an estimated EPS figure, you decide on a P/E ratio that you feel is appro-
priate for the stock. Then you use it in Equation 8.12 to see what kind of price
you come up with and how that compares to the stock’s current price.
Actually, this approach is no different from what’s used in the market
every day. Look at the stock quotes in the Wall Street Journal. They include
the stock’s P/E and show what investors are willing to pay for one dollar of
earnings. The higher the multiple, the better investors feel about the company
and its future prospects. Essentially, the Journal relates the company’s earnings
per share for the last 12 months (known as trailing earnings) to the latest price
of the stock. In practice, however, investors buy stocks not for their past earn-
ings but for their expected future earnings. Thus, in Equation 8.12, it’s cus-
tomary to use forecasted EPS for next year.
--Gitman2002.CH08.314-368.CTP 7/19/01 12:20 PM Page 336
To implement the P/E approach, the first thing you have to do is come up
with forecasted EPS one year out. In the early part of this chapter, we saw how
this might be done (see, for instance, Equation 8.3). Given the forecasted EPS,
the next task is to evaluate the variables that drive the P/E ratio. Most of that
assessment is intuitive. For example, you might want to look at the stock’s
expected rate of growth in earnings, any potential major changes in the firm’s
capital structure or dividends, and any other factors such as relative market or
industry P/Es that might affect the stock’s multiple. You could use such inputs
to come up with a base P/E, and then adjust that base, as necessary, to account
for the perceived state of the market and/or anticipated changes in the rate of
inflation.
Along with estimated EPS, we now have the P/E we need to compute (via
Equation 8.12) the price at which the stock should be trading. By comparing
that targeted price to the current market price of the stock, we can decide
whether the stock is a good buy. For example, we would consider the stock
undervalued and therefore a good buy if the computed price of the stock were
more than its market price.
Numbers
Group Name of Firms Selected Firms
Business information services 22 Gartner Group, Keynote Systems
Computer networks 87 Cisco Systems, Juniper Networks
Computer software 227 Microsoft, Oracle
Defense electronics 27 REMEC, Teledyne
Electrical components- 114 Intel, Xilinx
semiconductors
Electronic commerce 59 Amazon.com, eBay
Fiber optics 18 Corning, JDS Uniphase
Industrial automation/robotics 5 Gerber Scientific, Rockwell
Instrumentation—control 10 Datum, Eaton
Internet content 62 CNET, Travelocity.com
Internet services 102 America Online, CMGI
Internet software 94 Ariba, Synquest
Medical—biomedical/gene 145 Amgen, Biogen
Optical character recognition 6 PSC, Scansource
Telecommunications—wireless 57 AT&T Wireless, Vodafone
Telecommunications equipment 139 Lucent, Motorola
Telecommunications services 21 Global Crossing, RCN
market leaders with solid track records. There are probably no more than a
hundred or so firms that would fall into this category. Most of them have
normal financial and market ratios and are valued pretty much like any other
growth stock, as described earlier in this chapter.
Next are the mid-tier stocks; there are literally hundreds of these firms, such
as NVIDIA, Transwitch, and Black Box Corporation. Though many of them
may not be household names, they have been around for some time and have
demonstrated an ability to not only generate substantial revenues but also to
earn solid profits year after year. NVIDIA, for example, had sales of nearly
$650 million in 1999 and profits of over $80 million. Many of these tech stocks
have very high P/E ratios and therefore may not be compatible with standard
stock valuation models. A potential problem in valuing some of these mid-tier
firms is that they may not have highly diversified product offerings and cus-
tomer bases. Thus, a shift in industry fundamentals or technology could change
their fortunes (i.e., earnings and growth rates) dramatically.
Lower-tier tech stocks include firms like bingo.com and Laser
Corporation. Firms at this level typically have yet to generate any earnings. In
many cases, they have very little in revenues. Valuation of these firms is
extremely difficult and often amounts to little more than hunches. Indeed, these
stocks are often bought by investors who pay little attention to fundamentals
but instead rely on little more than “stories,” such as some media report that’s
related to the firm’s products, an unsubstantiated comment on the Internet, or
the advice of a friend who has suddenly become an “expert” at investing.
challenges. We’ll look at the two primary techniques used to value tech stocks:
discounted cash flow analysis and the use of price multiples. After describing
each of these methods, we will discuss a concept known as the “burn rate,”
and then conclude with an example of a tech-stock valuation.
reports the change in the firm’s cash position from one period to the next by
accounting for the cash flows from operations, investment activities, and
financing activities. Other things being equal, a higher burn rate is viewed
more negatively, and is likely to result in a lower valuation for the firm.
To illustrate the concept of the “burn rate” refer to Table 8.6, which pre-
sents a highly abbreviated statement of cash flows for U.S. Internetworking,
Inc. (USIX). This firm implements, operates, and supports packaged software
applications over the Internet. The statement of cash flows in Table 8.6 covers
the first 9 months of 2000 and the corresponding period for 1999. Let’s focus
on a few of the key cash flow items relevant to USIX’s burn rate. First, the net
cash from operations was a negative $93 million for the first 9 months of
2000. This result implies that the core business operations of the firm con-
sumed (burned) cash at the rate of about $10 million per month, largely
because of the firm’s substantial—and growing—operating loss. Second, USIX
made significant capital investment in new assets. As a result, the net cash flow
from investing also was negative, to the tune of $63 million. That represents
another significant use of cash. Indeed, the net cash burned by operations and
investing together amounted to over $150 million—or a burn rate of nearly
$17 million a month! Some would argue that a more appropriate (and more
liberal) way to estimate a firm’s burn rate would be to ignore the cash used for
investing and simply focus on the cash from operations. But that doesn’t seem
to be very realistic, because most firms do, in fact, have to make some capital
expenditures in order to continue operations. As a compromise, we won’t even
consider the cash used to meet payments on the firm’s long-term debt and
lease obligations, as that would just add another $2.5 million to the monthly
burn rate.
Examination of the firm’s financing activities gives us some idea of how
USIX met these substantial cashs outflows. In particular, the firm raised nearly
$150 million by issuing additional common stock and long-term debt. Because
USIX had approximately $81 million in cash at the end of the period, it is
likely to run out of cash in about 6 to 8 months, depending on which burn rate
you use. USIX can avoid that fate if it (1) significantly decreases its burn rate
or perhaps even begins to generate cash from operations, or (2) continues to
issue significant amounts of debt or equity. Of course, the continued ability to
raise additional capital is not guaranteed for any firm and is particularly ques-
tionable for risky tech firms.
parable firms may include some that are not truly similar to the firm being
valued. Let’s assume that we have collected data on the price/sales ratios and
other financial characteristics for five publicly traded companies in roughly the
same line of business as GASP, as shown in Table 8.8.
The sales levels of the comparable firms range from $32.2 million for
Corio to $128.8 million for Interliant. Net losses range from $164 million for
U.S. Internetworking to $44 million for Breakaway Solutions. The levels of
sales and net losses for GASP are within those ranges, although GASP had
lower sales than average ($56.5 million vs. $79.4 million) and generated less
of a loss than the average firm ($92.2 million vs. $110.4 million).
Sales $56,500
Expenses
Direct cost of services $64,700
Network and infrastructure costs 35,900
General and administrative 22,400
Sales and marketing 59,300
Depreciation and amortization 31,400
Total costs and expenses $133,700
Operating loss ($77,200)
Interest expense 15,000
Net loss ($
9
2
,2
0
0
)
Using the price/sales multiple, the simplest approach is to use the average
multiple of the comparable firms to find the value of our GASP shares. But
first we have to find sales per share for GASP. Using trailing sales, that can be
done by taking the firm’s total sales for last year and dividing it by the number
of shares outstanding. Assuming 30 million shares outstanding, GASP had
trailing sales per share of
Now, to find the value of a share of GASP stock, we simply multiply the firm’s
sales per share by the average price to sales ratio (of 3.34 times):
I N R E V I E W
C O N C E P T S
8.7 Briefly describe the dividend valuation model and the three versions of this
model. Explain how CAPM fits into the variable-growth DVM.
8.8 What is the difference between the variable-growth dividend valuation model
and the dividends-and-earnings approach to stock valuation? Which procedure
would work better if you were trying to value a growth stock that pays little or
no dividends? Explain.
8.9 How would you go about finding the expected return on a stock? Note how
such information would be used in the stock selection process.
8.10 Briefly describe the P/E approach to stock valuation and note how this
approach differs from the variable-growth DVM.
8.11 Explain how risk fits into the stock valuation process. Note especially its rela-
tionship to the investment return of a security.
8.12 Why are (some) tech stocks difficult to value? What are some of the problems
you’re likely to encounter in using the DVM or D&E approach to value tech
stocks?
8.13 Briefly describe the price/sales ratio (multiple), and explain how it is used to
value tech stocks. Why not just use the P/E or price-to-book-value multiple?
Technical Analysis How many times have you turned on the TV or radio and in the course of the
day’s news heard a reporter say, “The market was up 47 points today” or
“The market remained sluggish in a day of light trading”? Such comments
reflect the importance of the stock market itself in determining the price
behavior of common stocks. In fact, some experts believe that studying the
LG 5 market should be the major, if not the only, ingredient in the stock selection
process. These experts argue that much of what is done in security analysis is
useless because it is the market that matters, not individual companies. Others
argue that studying the stock market is only one element in the security
analysis process and is useful in helping the investor time decisions.
Analyzing the various forces at work in the stock market is known as
technical analysis technical analysis. For some investors, it’s another piece of information to use
the study of the various forces at when deciding whether to buy, hold, or sell a stock. For others, it’s the only
work in the marketplace and their input they use in their investment decisions. And for still others, technical
effect on stock prices.
analysis, like fundamental analysis, is regarded as a big waste of time. Here we
will assume that technical analysis does have some role to play in the invest-
ment decision process. We will examine the major principles of market
analysis, as well as some of the techniques used to assess market behavior.
thing investors could study was the market itself. Some investors used detailed
charts in an attempt to monitor what large market operators were doing.
These charts were intended to show when major buyers were moving into or
out of particular stocks and to provide information that could be used to make
profitable buy-and-sell decisions. The charts centered on stock price move-
ments. It was believed that these movements produced certain “formations”
that indicated when the time was right to buy or sell a particular stock. The
same principle is still applied today: Technical analysts argue that internal
market factors, such as trading volume and price movements, often reveal the
market’s future direction long before it is evident in financial statistics.
If the behavior of stock prices were completely independent of market
movements, market studies and technical analysis would be useless. But we
have ample evidence that stock prices do, in fact, tend to move
H O T L I N K S with the market. Studies of stock betas have shown that as a
It happens to every investor: You’ve been rule, anywhere from 20% to 50% of the price behavior of a
watching for signs of movement in the market stock can be traced to market forces. When the market is
and the prices suddenly fall. For suggestions
of what to do in response—other than to bullish, stock prices in general can be expected to behave
panic—see the Investing in Action box at our accordingly. When the market turns bearish, you can safely
Web site: expect most issues to be affected by the “downdraft.”
www.awl.com/gitman_joehnk Stock prices, in essence, react to various forces of supply
and demand that are at work in the market. After all, it’s the
demand for securities and the supply of funds in the market that determine
whether we’re in a bull or a bear market. So long as a given supply-and-
demand relationship holds, the market will remain strong (or weak). When the
balance begins to shift, however, future prices can be expected to change as the
market itself changes. Thus, more than anything else, technical analysis is
intended to monitor the pulse of the supply-and-demand forces in the market
and to detect any shifts in this important relationship.
FIGURE 8.1.
Some Market Statistics
Individual investors can obtain
all sorts of technical
information at little or no cost
from brokerage houses,
investment services, the popular
financial media, or the Internet.
Here, for example, is a sample
of information from the Wall
Street Journal. Note that a
variety of information about
market volume, new highs and
lows, number of advancing and
declining stocks, and market
averages is available from this
one source. (Source: Wall Street
Journal, October 10, 2000,
p. C2.)
--Gitman2002.CH08.314-368.CTP 7/19/01 12:20 PM Page 347
Odd-Lot Trading A rather cynical saying on Wall Street suggests that the best
thing to do is just the opposite of whatever the small investor is doing. The
reasoning behind this is that as a group, small investors are notoriously wrong
in their timing of investment decisions: The investing public usually does not
--Gitman2002.CH08.314-368.CTP 7/19/01 12:20 PM Page 348
come into the market in force until after a bull market has pretty much run its
course, and it does not get out until late in a bear market. Although its validity
is debatable, this is the premise behind a widely followed technical indicator
theory of contrary opinion and is the basis for the theory of contrary opinion. This theory uses the
a technical indicator that uses amount and type of odd-lot trading as an indicator of the current state of the
the amount and type of odd-lot market and pending changes.
trading as an indicator of the
current state of the market and Because many individual investors deal in transactions of less than 100
pending changes. shares, their combined sentiments are supposedly captured in odd-lot figures.
The idea is to see what odd-lot investors are doing “on balance.” So long as
there is little or no difference in the spread between the volume of odd-lot pur-
chases and sales, the theory of contrary opinion holds that the market will
probably continue pretty much along its current line (either up or down).
When the balance of odd-lot purchases and sales begins to change dramati-
cally, it may be a signal that a bull or bear market is about to end. For
example, if the amount of odd-lot purchases starts to exceed odd-lot sales by
an ever widening margin, it may suggest that speculation on the part of small
investors is starting to get out of control—an ominous signal that the final
stages of a bull market may be at hand.
Charting
charting Charting is perhaps the best-known activity of the technical analyst.
the activity of charting price Technicians—analysts who believe it is chiefly (or solely) supply and demand
behavior and other market
information and then using the that drives stock prices—use various types of charts to plot the behavior of
patterns these charts form to everything from the Dow Jones Industrial Average to the share price move-
make investment decisions. ments of individual listed and OTC stocks. Just about every kind of technical
--Gitman2002.CH08.314-368.CTP 7/19/01 12:20 PM Page 350
Relative Strength
Index (compares
stock's recent gains
and losses with the
market)
Share Volume
in Millions
Exponentially
Smoothed
Moving Average
(average with
emphasis on most
recent data)
Moving Average
Convergence/
Divergence (average
that indicates trends)
indicator is charted in one form or another. Figure 8.3 shows a typical stock
chart. In this case, the price behavior of Medtronic, Inc. has been plotted,
along with a variety of supplementary technical information about the stock.
Charts are popular because they provide a visual summary of activity over
time. Perhaps more important (in the eyes of technicians, at least), they contain
valuable information about developing trends and the future behavior of the
market and/or individual stocks. Chartists believe price patterns evolve into
chart formations that provide signals about the future course of the market or
a stock. We will now briefly review the practice of charting, including popular
types of charts, chart formations, and investor uses of charts.
Bar Charts The simplest and probably most widely used type of chart is the
bar chart bar chart. Market or share prices are plotted on the vertical axis, and time is
the simplest kind of chart, on
plotted on the horizontal axis. This type of chart derives its name from the fact
which share price is plotted on
the vertical axis and time on the that prices are recorded as vertical bars that depict high, low, and closing
horizontal axis; stock prices are prices. A typical bar chart is shown in Figure 8.4. Note that on December 31,
recorded as vertical bars showing this particular stock had a high price of 29 a low of 27, and closed at 27.50.
high, low, and closing prices. Because these charts contain a time element, technicians frequently plot a
variety of other pertinent information on them. For example, volume is often
point-and-figure charts
put at the base of bar charts (see the Medtronic chart in Figure 8.3).
charts used to keep track of
emerging price patterns by
plotting significant price Point-and-Figure Charts Point-and-figure charts are used strictly to keep track
changes with Xs and Os but of emerging price patterns. Because there is no time dimension on them, they are
with no time dimension used. not used for plotting technical measures. Point-and-figure charts are unique in
--Gitman2002.CH08.314-368.CTP 7/19/01 12:21 PM Page 351
FIGURE 8.4. 40
A Bar Chart
Bar charts are widely used to
track stock prices, market
averages, and numerous other 35
technical measures.
Price ($)
30
25
20
12/31 Units of time
two other ways: First, only significant price changes are recorded on these charts.
That is, prices have to move by a certain minimum amount—usually at least a
point or two—before a new price level is recognized. Second, price reversals show
up only after a predetermined change in direction occurs. Normally, only closing
prices are charted, though some point-and-figure charts use all price changes
during the day. An X is used to denote an increase in price, an O a decrease.
Figure 8.5 shows a common point-and-figure chart. In this case, the chart
employs a 2-point box: The stock must move by a minimum of 2 points before
any changes are recorded. The chart can cover a span of one year or less if the
stock is highly active. Or it can cover a number of years if the stock is not very
active. As a rule, low-priced stocks are charted with 1-point boxes, moderately
priced shares with increments of 2 to 3 points, and high-priced securities with
3- to 5-point boxes.
Here is how point-and-figure charts work: Suppose we are at point A on the
chart in Figure 8.5. The stock has been hovering around this $40–$41 mark for
some time. Assume, however, that it just closed at $42.25. Now, because the min-
imum 2-point movement has been met, the chartist would place an X in the box
immediately above point A. The chartist would remain with this new box as long
as the price moved (up or down) within the 2-point range of 42 to 44. Although
the chartist follows daily prices, a new entry is made on the chart only after the
price has changed by a certain minimum amount and moved into a new 2-point
box. We see that from point A, the price generally moved up over time to nearly
$50 a share. At that point (indicated as point B on the chart), things began to
change as a reversal set in. That is, the price of the stock began to drift downward
and in time moved out of the $48–$50 box. This reversal prompts the chartist to
change columns and symbols, by moving one column to the right and recording
the new price level with an O in the $46–$48 box. The chartist will continue to
use Os as long as the stock continues to close on a generally lower note.
--Gitman2002.CH08.314-368.CTP 7/19/01 12:21 PM Page 352
FIGURE 8.5. X
70
A Point-and-Figure Chart X O
X O
Point-and-figure charts are
X O
unusual because they have no
X O X
time dimension. Rather, a Point B X X O X
column of Xs is used to reflect a 60
X X O X O X
general upward drift in prices, X X O X X O X O
and a column of Os is used X O X O X O X O
when prices are drifting
Price ($)
X O X O X O X
downward. X X O X O O X X X
50
X O X O X X O X X O X O X
X O X O X O X O X O X O X O
X O O X X O O O X O X
X O X O X O O X X
X O X O X O X O X
40
O X O O X O X
O X O O X
O Point A O
30
Chart Formations The information that charts supposedly contain about the
future course of the market (or a stock) is thought by some to be revealed in
chart formations. That is, chartists believe that in response to certain supply and
demand forces, emerging price patterns result in various formations that histor-
ically have indicated that certain types of market behavior are imminent. If you
know how to interpret charts (which is no easy task), you can see formations
building and recognize buy and sell signals. These chart formations are often
given some pretty exotic names, such as head and shoulders, falling wedge,
scallop and saucer, ascending triangle, and island reversal, to name just a few.
Figure 8.6 shows four formations. The patterns form “support levels” and
“resistance lines” that, when combined with the basic formations, yield buy
and sell signals. Panel A is an example of a buy signal that occurs when prices
break out above a resistance line in a particular pattern. In contrast, when
prices break out below a support level, as they do at the end of the formation
in panel B, a sell signal is said to occur. Supposedly, a sell signal means every-
thing is in place for a major drop in the market (or in the price of a share of
stock). A buy signal indicates that the opposite is about to occur.
Unfortunately, one of the major problems with charting is that the formations
rarely appear as neatly and cleanly as those in Figure 8.6. Rather, identifying
and interpreting them often demands considerable imagination.
Investor Uses Charts are merely tools used by market analysts and techni-
cians to assess conditions in the market and/or the price behavior of individual
stocks. Unlike other types of technical measures, charting is seldom done on
an informal basis. Either you chart because you believe in its value, or you
don’t chart at all. A chart by itself tells you little more than where the market
or a stock has been. But to chartists, those price patterns yield formations that,
along with things like resistance lines, support levels, and breakouts, tell them
what to expect in the future. Chartists believe that history repeats itself, so
they study the historical reactions of stocks (or the market) to various forma-
tions, and they devise trading rules based on these observations. It makes no
--Gitman2002.CH08.314-368.CTP 7/19/01 12:21 PM Page 353
Price ($)
Price ($)
Breakout
Resistance Breakout
Support
Period Period
Price ($)
Pennant
Flag
Period Period
I N R E V I E W
C O N C E P T S
8.14 What is the purpose of technical analysis? Explain how and why it is used by
technicians; note how it can be helpful in timing investment decisions.
8.15 Can the market really have a measurable effect on the price behavior of indi-
vidual securities? Explain.
8.16 What is the relative strength index (as described in the Investing in Action box
on page 345)?
8.17 What is a stock chart? What kind of information can be put on charts, and what
is the purpose of charting?
a. What is the difference between a bar chart and a point-and-figure chart?
b. What are chart formations, and why are they important?
--Gitman2002.CH08.314-368.CTP 7/19/01 12:21 PM Page 354
Random Walks If a drunk were abandoned in an open field at night, where would you begin
and Efficient to search for him the next morning? The answer, of course, is the spot where
the drunk was left the night before, because there’s no way to predict where
Markets he will go. To some analysts, stock prices seem to wander about in a similar
fashion. Observations of such erratic movements have led to a body of evi-
LG 6 dence called the random walk hypothesis. Its followers believe that price
movements are unpredictable and therefore security analysis will not help to
predict future market behavior. This hypothesis obviously has serious implica-
random walk hypothesis tions for much of what we have discussed in the last two chapters.
the theory that stock price
movements are unpredictable,
so there’s no way to know where A Brief Historical Overview
prices are headed.
To describe stock prices as a random walk suggests that price movements
cannot be expected to follow any type of pattern. Or, put another way, price
movements are independent of one another. In order to find a theory for such
behavior, researchers developed the concept of efficient markets. As we dis-
cussed briefly in Chapter 7, the basic idea behind an efficient market is that
the market price of securities always fully reflects available information. This
means that it would be difficult, if not impossible, to consistently outperform
the market by picking “undervalued” stocks.
Random Walks The first evidence of random price movements dates back to
the early 1900s. During that period, statisticians noticed that commodity
prices seemed to follow a “fair game” pattern. That is, prices seemed to move
up and down randomly, giving no advantage to any particular trading strategy.
Although a few studies on the subject appeared in the 1930s, thorough exam-
ination of the randomness in stock prices did not begin until 1959. From that
point on, particularly through the decade of the 1960s, the random walk issue
was one of the most keenly debated topics in stock market literature. The
development of high-speed computers has helped researchers compile con-
vincing evidence that stock prices do, in fact, come very close to a random
walk.
weak form (EMH) Weak Form The weak form of the EMH holds that past data on stock prices
form of the EMH holding that are of no use in predicting future price changes. If prices follow a random
past data on stock prices are of walk, price changes over time are random. Today’s price change is unrelated
no use in predicting future prices.
to yesterday’s or to that of any other day, just as each step by a drunk is unre-
lated to previous steps. If new information arrives randomly, then prices will
change randomly.
A number of people have asserted that it is possible to profit from “runs”
in a stock’s price. They contend that when a stock’s price starts moving up, it
will continue to move up for a period of time, developing momentum. If you
can spot a run, then, on the basis of past prices alone, you can develop a
trading strategy that will produce a profit. The results from much careful
research suggest that momentum in stock prices does exist, and if investors
quickly trade at the beginning of the run, large profits can be made. But there’s
a problem: In addition to spotting a run (no easy task), an investor would have
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to make numerous trades; when commissions are factored in, the person most
likely to make a profit is the broker. Many other trading rules have been tested
to determine whether profits can be made by examining past price movements,
and there is very little, if any, evidence that a trading rule based solely on past
price data can outperform a simple buy-and-hold strategy.
semi-strong form (EMH) Semi-Strong Form The semi-strong form of the EMH holds that abnormally
form of the EMH holding that large profits cannot be consistently earned using publicly available informa-
abnormally large profits cannot tion. This information includes not only past price and volume data but also
be consistently earned using
publicly available information. data such as corporate earnings, dividends, inflation, and stock splits. The
semi-strong information set includes all of the information publicly considered
in the weak form, as well as all other information publicly available. Tests of
the semi-strong form of the EMH are basically concerned with the speed at
which information is disseminated to investors. The research conclusions of
research tests support the position that stock prices adjust very rapidly to new
information and therefore support the semi-strong form of the EMH.
Most tests of semi-strong efficiency have examined how a stock price
changes in response to an economic or financial event. A famous study
involved stock splits. A stock split does not change the value of a company, so
the value of the stock should not be affected by a stock split. The research indi-
cated that there are sharp increases in the price of a stock before a stock split,
but the changes after the split are random. Investors, therefore, cannot gain by
purchasing stocks on or after the announcement of a split. To earn abnormal
profits they would have to purchase before the split is announced. By the time
of the announcement, the market has already incorporated into the price any
favorable information associated with the split.
Other studies have examined the impact of major events on stock prices.
The overwhelming evidence indicates that stock prices react within minutes, if
not seconds, to any important new information. Certainly, by the time an
investor reads about the event in the newspaper, the stock price has almost
completely adjusted to the news. Even hearing about the event on the radio or
television usually allows too little time to complete the transaction in time to
make an abnormal profit.
strong form (EMH) Strong Form The strong form of the EMH holds that there is no information,
form of the EMH that holds that public or private, that allows investors to consistently earn abnormal profits.
there is no information, public or It states that stock prices immediately adjust to any information, even if it isn’t
private, that allows investors to
earn abnormal profits available to every investor. This extreme form of the EMH has not received
consistently. universal support.
One type of private information is the kind obtained by corporate insiders,
such as officers or directors of a corporation. They have access to valuable infor-
mation about major strategic and tactical decisions the company makes. They
also have detailed information about the financial state of the firm that may not
be available to other shareholders. Corporate insiders may legally trade shares
of stock in their company, if they report the transactions to the Securities and
Exchange Commission (SEC) each month. This information is then made public,
usually within several weeks. It should not be surprising to learn that most
studies of corporate insiders find that they consistently earn abnormally large
profits when they sell their company stock. They are able to sell stock holdings
before major announcements are made to the public and can thereby profit from
the stock price adjustment that comes quickly after important news is released.
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Possible Implications
The concept of an efficient market holds serious implications for investors. In
particular, it could have considerable bearing on traditional security analysis
and stock valuation procedures. Some, in fact, contend that investors should
spend less time analyzing securities and more time on such matters as reducing
taxes and transaction costs, eliminating unnecessary risk, and constructing a
widely diversified portfolio. Make no mistake about it: Even in an efficient
market, all sorts of return opportunities are available. But to proponents of
efficient markets, the only way to increase returns is to invest in a portfolio of
higher-risk securities.
Implications for Technical Analysis The most serious challenge the random
walk evidence presents is to technical analysis. If price fluctuations are purely
random, charts of past prices are unlikely to produce significant trading
profits. In a highly efficient market, shifts in supply and demand occur so
rapidly that technical indicators simply measure after-the-fact events, with no
implications for the future. But if markets are less than perfectly efficient,
information may be absorbed slowly, producing gradual shifts in supply and
demand conditions—and profit opportunities for those who recognize the
shifts early. Although the great bulk of evidence supports a random walk,
many investors follow a technical approach because they believe it improves
their investment results.
So Who Is Right?
Some type of fundamental analysis probably has a role in the stock selection
process, for even in an efficient market, there is no question that stock prices
reflect a company’s profit performance. Some companies are fundamentally
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strong and others fundamentally weak, and investors must be able to distin-
guish between the two. Thus some time can profitably be spent in evaluating
a company and its stock to determine, not if it is undervalued, but whether it
is fundamentally strong.
The level of investor return, however, is more than a function of the fun-
damental condition of the company; it is also related to risk exposure.
Fundamental analysis can help assess risk exposure and identify securities that
possess risk commensurate with the return they offer.
The extent to which the markets are efficient is still subject to consider-
able debate. At present, there seems to be a growing consensus that although
the markets may not be perfectly efficient, evidence suggests that they are at
least reasonably efficient.
In the final analysis, the individual investor must decide on the merits of
fundamental and technical analysis. Certainly, a large segment of the investing
public believes in security analysis, even in a market that may be efficient. What
is more, the principles of stock valuation—that promised return should be
commensurate with exposure to risk—are valid in any type of market setting.
I N R E V I E W
C O N C E P T S
8.18 What is the random walk hypothesis, and how does it apply to stocks? What
is an efficient market? How can a market be efficient if its prices behave in a
random fashion?
8.20 What are the implications of random walks and efficient markets for technical
analysis? For fundamental analysis? Do random walks and efficient markets
mean that technical analysis and fundamental analysis are useless? Explain.
Summary LG 1 Explain the role a company’s future plays in the stock valuation process and develop a
forecast of a stock’s expected cash flow. The final phase of security analysis involves an
assessment of the investment merits of a specific company and its stock. The focus here
is on formulating expectations about the company’s prospects and the risk and return
behavior of the stock. In particular, we would want some idea of the stock’s future
earnings, dividends, and share prices, because that’s ultimately the basis of our return.
LG 2 Discuss the concepts of intrinsic value and required rates of return, and note how they
are used. Information such as projected sales, forecasted earnings, and estimated divi-
dends are important in establishing intrinsic value. This is a measure, based on
expected return and on risk exposure, of what the stock ought to be worth. A key ele-
ment is the investor’s required rate of return, which is used to define the amount of
return that should be earned given the stock’s perceived exposure to risk. The more risk
in the investment, the more return one should require.
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LG 3 Determine the underlying value of a stock using the dividend valuation model, as well
as other present value– and price/earnings–based stock valuation models. The dividend
valuation model derives the value of a share of stock from the stock’s future growth in
dividends. Another popular valuation procedure is the dividends-and-earnings
approach, which uses a finite investment horizon to derive a present value–based “jus-
tified price.” There’s also the price/earnings approach to stock valuation, which uses
projected EPS and the stock’s P/E ratio to determine whether a stock is fairly valued. At
times, investors find it more convenient to deal in terms of expected returns than in
dollar-based justified prices. To do so, one would find the fully compounded rate of
return by solving for the discount rate in the present value–based stock valuation model.
LG 4 Gain a basic appreciation of the procedures used to value different types of stock, from
traditional dividend-paying shares to new-economy stocks with their extreme
price/earnings ratios. Various forms of the dividend valuation model work fine for com-
panies that pay dividends. For those that pay little or nothing in dividends, the dividend-
and-earnings and P/E approaches are used. But even these procedures often don’t work
well with many of the new-economy tech stocks, which may not have dividends, may
not even have profits, and may sell at astronomical P/E ratios. To value these stocks, we
use the discounted cash flow approach (which is like the D&E approach except that
value is based solely on the estimated future price of the stock) or some type of price
multiple (usually, the price/sales multiple). Though far from perfect, these procedures at
least enable investors to get a rough idea of the value of these high-flying tech stocks.
LG 5 Describe the key attributes of technical analysis, including some popular measures and
procedures used to assess the market. Technical analysis is another phase of the analyt-
ical process. It deals with the behavior of the stock market itself and the various economic
forces at work in the marketplace. A number of tools can be used to assess the state of
the market, including market measures like volume of trading, breadth of the market,
short-interest positions, odd-lot trading, and relative strength. Some investors use
charting to assess the condition of everything from the overall market to specific stocks.
LG 6 Discuss the idea of random walks and efficient markets, and note the challenges these
theories hold for the stock valuation process. In recent years, both technical and fun-
damental analysis have been seriously challenged by the random walk and efficient
market hypotheses. Indeed, considerable evidence indicates that stock prices do move
in a random fashion. The efficient market hypothesis is an attempt to explain why
prices behave randomly. The idea behind an efficient market is that available informa-
tion is always fully reflected in the price of securities, so investors should not expect to
outperform the market consistently.
Discussion LG 1 Q8.1 Using the resources available at your campus or public library, select a com-
Questions pany from Value Line that would be of interest to you. (Hint: Pick a company that’s
LG 2 been publicly traded for at least 10 to 15 years, and avoid public utilities, banks, and
other financial institutions.) Obtain a copy of the latest Value Line report on your
chosen company. Using the historical and forecasted data reported in Value Line, along
LG 3 with one of the valuation techniques described in this chapter, calculate the maximum
(i.e., justified) price you’d be willing to pay for this stock. Use the CAPM to find the
required rate of return on your stock. (For this problem, use a market rate of return of
12%, and for the risk-free rate, use the latest 3-month Treasury bill rate.)
a. How does the justified price you computed above compare to the latest
market price of the stock?
b. Would you consider this stock a worthwhile investment candidate? Explain.
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LG 5 Q8.2 Briefly define each of the following, and note the conditions that would suggest
the market is technically strong.
a. Breadth of the market.
b. Short interest.
c. The relative strength index (RSI).
d. Theory of contrary opinion.
e. Head and shoulders.
LG 6 Q8.3 A lot has been written and said about the concept of an efficient market. It’s
probably safe to say that some of your classmates believe the markets are efficient and
others believe they are not. Have a debate to see whether you can resolve this issue (at
least among yourselves). Pick a side, either for or against efficient markets, and then
develop your “ammunition.” Be prepared to discuss these three aspects:
a. Exactly what is an efficient market? Do such markets really exist?
b. Are stock prices always (or nearly always) correctly set in the market? If so,
does that mean there’s little opportunity to find undervalued stocks?
c. Can you find any reason(s) to use fundamental and/or technical analysis in
your stock selection process? If not, how would you go about selecting stocks?
LG 4 Q8.4 The burn rate is a concept that is often employed to help investors gain insights
about performance of tech stocks, especially relatively new high-tech firms (those that
have recently gone public). Define the burn rate, and explain how it is used in the val-
uation of tech stocks. Is it used to actually put a value on tech stocks. Explain.
a. Take another look at Table 8.6. Using the 1999 statement of cash flows, find
the monthly burn rate based on net cash flows from operations. (Remember
that the statements cover only 9 months.) What is the monthly burn rate if
you include the net cash flows from both operations and investing? If the firm
had $150 million cash on hand, how long would it take to run out of cash at
these burn rates? What can the firm do to avoid running out of cash?
Problems LG 1 P8.1 An investor estimates that next year’s sales for New World Products should
amount to about $75 million. The company has 2.5 million shares outstanding, gener-
ates a net profit margin of about 5%, and has a payout ratio of 50%. All figures are
expected to hold for next year. Given this information, compute the following.
a. Estimated net earnings for next year.
b. Next year’s dividends per share.
c. The expected price of the stock (assuming the P/E ratio is 24.5 times earnings).
d. The expected holding period return (latest stock price: $25/share).
LG 2 P8.2 Charlene Lewis is thinking about buying some shares of Education, Inc. at $50
per share. She expects the price of the stock to rise to $75 over the next 3 years. During
that time she also expects to receive annual dividends of $5 per share.
a. What is the intrinsic worth of this stock, given a 10% required rate of return?
b. What is its expected return?
LG 1 P8.3 Amalgamated Aircraft Parts, Inc. is expected to pay a dividend of $1.50 in the
coming year. The required rate of return is 16%, and dividends are expected to grow
at 7% per year. Using the dividend valuation model, find the intrinsic value of the com-
pany’s common shares.
LG 3 P8.4 Assume you’ve generated the following information about the stock of
Bufford’s Burger Barns: The company’s latest dividends of $4 a share are expected to
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grow to $4.32 next year, to $4.67 the year after that, and to $5.04 in year 3. In addi-
tion, the price of the stock is expected to rise to $77.75 in 3 years.
a. Use the dividends-and-earnings model and a required rate of return of 15%
to find the value of the stock.
b. Use the IRR procedure to find the stock’s expected return.
c. Given that dividends are expected to grow indefinitely at 8%, use a 15%
required rate of return and the dividend valuation model to find the value of
the stock.
d. Assume dividends in year 3 actually amount to $5.04, the dividend growth
rate stays at 8%, and the required rate of return stays at 15%. Use the divi-
dend valuation model to find the price of the stock at the end of year 3.
[Hint: In this case, the value of the stock will depend on dividends in year 4,
which equal D3 (1 g).] Do you note any similarity between your answer
here and the forecasted price of the stock ($77.75) given in the problem?
Explain.
LG 3 P8.5 Let’s assume that you’re thinking about buying stock in West Coast
Electronics. So far in your analysis, you’ve uncovered the following information: The
stock pays annual dividends of $2.50 a share (and that’s not expected to change
within the next few years—nor are any of the other variables). It trades at a P/E of 18
times earnings and has a beta of 1.15. In addition, you plan on using a risk-free rate
of 7% in the CAPM, along with a market return of 14%. You would like to hold the
stock for 3 years, at the end of which time you think EPS will peak out at about $7
a share. Given that the stock currently trades at $70, use the IRR approach to find
this security’s expected return. Now use the present-value (dividends-and-earnings)
model to put a price on this stock. Does this look like a good investment to you?
Explain.
LG 3 P8.6 The price of Consolidated Everything is now $75. The company pays no divi-
dends. Ms. Bossard expects the price 3 years from now to be $100 per share. Should
Ms. B. buy Consolidated E. if she desires a 10% rate of return? Explain.
LG 3 P8.7 This year, Shoreline Light and Gas (SLL&G) paid its stockholders an annual divi-
dend of $3 a share. A major brokerage firm recently put out a report on SLL&G stating
that, in its opinion, the company’s annual dividends should grow at the rate of 10% per year
for each of the next 5 years and then level off and grow at the rate of 6% a year thereafter.
a. Use the variable-growth DVM and a required rate of return of 12% to find
the maximum price you should be willing to pay for this stock.
b. Redo the SLL&G problem in part (a), this time assuming that after year 5,
dividends stop growing altogether (for year 6 and beyond, g 0). Use all the
other information given to find the stock’s intrinsic value.
c. Contrast your two answers and comment on your findings. How important is
growth to this valuation model?
LG 3 P8.8 Assume there are three companies that in the past year paid exactly the same
annual dividend of $2.25 a share. In addition, the future annual rate of growth in div-
idends for each of the three companies has been estimated as follows:
Assume also that as the result of a strange set of circumstances, these three companies
all have the same required rate of return (k 10%).
a. Use the appropriate DVM to value each of these companies.
b. Comment briefly on the comparative values of these three companies. What is
the major cause of the differences among these three valuations?
LG 3 P8.9 New Millenium Company’s stock sells at a P/E ratio of 21 times earnings. It is
expected to pay dividends of $2 per share in each of the next 5 years and to generate
an EPS of $5 in year 5. Using the dividends-and-earnings model and a 12% discount
rate, compute the stock’s justified price.
LG 3 P8.10 A particular company currently has sales of $250 million; these are expected to
grow by 20% next year (year 1). For the year after next (year 2), the growth rate in
sales is expected to equal 10%. Over each of the next 2 years, the company is expected
to have a net profit margin of 8% and a payout ratio of 50%, and to maintain the
number of shares of common stock outstanding at 15 million shares. The stock always
trades at a P/E ratio of 15 times earnings, and the investor has a required rate of return
of 20%. Given this information:
a. Find the stock’s intrinsic value (its justified price).
b. Use the IRR approach to determine the stock’s expected return, given that it
is currently trading at $15 per share.
c. Find the holding period returns for this stock for year 1 and for year 2.
LG 2 LG 3 P8.11 Assume a major investment service has just given Oasis Electronics its highest
investment rating, along with a strong buy recommendation. As a result, you decide to
take a look for yourself and to place a value on the company’s stock. Here’s what you
find: This year, Oasis paid its stockholders an annual dividend of $3 a share, but
because of its high rate of growth in earnings, its dividends are expected to grow at the
rate of 12% a year for the next 4 years and then to level out at 9% a year. So far, you’ve
learned that the stock has a beta of 1.80, the risk-free rate of return is 6%, and the
expected return on the market is 11%. Using the CAPM to find the required rate of
return, put a value on this stock.
LG 3 P8.12 Consolidated Software doesn’t currently pay any dividends but is expected to
start doing so in 4 years. That is, Consolidated will go 3 more years without paying
any dividends, and then is expected to pay its first dividend (of $3 per share) in the
fourth year. Once the company starts paying dividends, it’s expected to continue to
do so. The company is expected to have a dividend payout ratio of 40% and to main-
tain a return on equity of 20%. Based on the DVM, and given a required rate of
return of 15%, what is the maximum price you should be willing to pay for this
stock today?
LG 3 P8.13 Assume you obtain the following information about a certain company:
LG 3 P8.14 You’re thinking about buying some stock in Affiliated Computer Corporation
and want to use the P/E approach to value the shares. You’ve estimated that next year’s
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earnings should come in at about $4.00 a share. In addition, although the stock nor-
mally trades at a relative P/E of 1.15 times the market, you believe that the relative P/E
will rise to 1.25, whereas the market P/E should be around 181⁄2 times earnings. Given
this information, what is the maximum price you should be willing to pay for this
stock? If you buy this stock today at $87.50, what rate of return will you earn over the
next 12 months if the price of the stock rises to $110.00 by the end of the year?
(Assume that the stock doesn’t pay any dividends.)
LG 3 P8.15 AviBank Plastics generated an EPS of $2.75 over the last 12 months. The com-
pany’s earnings are expected to grow by 25% next year, and because there will be no
significant change in the number of shares outstanding, EPS should grow at about the
same rate. You feel the stock should trade at a P/E of around 30 times earnings. Use
the P/E approach to set a value on this stock.
LG 4 P8.16 World Wide Web Wares (4W, for short) is an online retailer of small kitchen
appliances and utensils. The firm has been around for a few years and has created a
nice market niche for itself. In fact, it actually turned a profit last year, though a fairly
small one. After doing some basic research on the company, you’ve decided to take a
closer look. You plan to use the price/sales ratio to value the stock, and you have col-
lected P/S multiples on the following Internet retailer stocks:
Pick three of these firms to use as your set of comparables, and compute the
average P/S ratio of those three firms. Given that 4W had sales last year of $40 million
and has 10 million shares of stock outstanding, use the average P/S ratio you computed
above to put a value on 4W’s stock.
Now repeat the valuation process, but this time use all five of the companies to
compute the average P/S ratio. Then use the P/S ratio to value 4W’s stock. If you had
to put a value on 4W stock, what would it be? Explain. If the stock were trading at $15
a share right now, would you buy it? Explain.
Case Problem 8.1 Chris Looks for a Way to Invest His Newfound Wealth
LG 1 Chris Norton is a young Hollywood writer who is well on his way to television super-
stardom. After writing several successful television specials, he was recently named the
head writer for one of TV’s top-rated sitcoms. Chris fully realizes that his business is a
fickle one and, on the advice of his dad and manager, has decided to set up an invest-
ment program. Chris will earn about a half-million dollars this year. Because of his age,
income level, and desire to get as big a bang as possible from his investment dollars, he
has decided to invest in speculative, high-growth stocks.
Chris is currently working with a respected Beverly Hills broker and is in the
process of building up a diversified portfolio of speculative stocks. The broker recently
sent him information on a hot new issue. She advised Chris to study the numbers and,
if he likes them, to buy as many as 1,000 shares of the stock. Among other things, cor-
porate sales for the next 3 years have been forecasted as follows:
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Sales
Year (in millions)
1 $22.5
2 35.0
3 50.0
The firm has 2.5 million shares of common stock outstanding. They are currently
being traded at $70 a share and pay no dividends. The company has a net profit rate
of 20%, and its stock has been trading at a P/E of around 40 times earnings. All these
operating characteristics are expected to hold in the future.
Questions
a. Looking first at the stock:
1. Compute the company’s net profits and EPS for each of the next 3 years.
2. Compute the price of the stock 3 years from now.
3. Assuming that all expectations hold up and that Chris buys the stock at $70,
determine his expected return on this investment.
4. What risks is he facing by buying this stock? Be specific.
5. Should he consider the stock a worthwhile investment candidate? Explain.
b. Now, looking at Chris’s investment program in general:
1. What do you think of his investment program? What do you see as its
strengths and weaknesses?
2. Are there any suggestions you would make?
3. Do you think Chris should consider adding foreign stocks to his portfolio?
Explain.
Sales
Year (in millions)
1997 $10.0
1998 12.5
1999 16.2
2000 22.0
2001 28.5
Wilt is concerned with the future prospects of the company, not its past. As a
result, he pores over the numbers and generates the following estimates of future per-
formance:
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Questions
a. Determine the average annual rate of growth in sales over the past 5 years.
(Assume sales in 1996 amounted to $7.5 million.)
1. Use this average growth rate to forecast revenues for next year (2002) and the
year after that (2003).
2. Now determine the company’s net earnings and EPS for each of the next 2
years (2002 and 2003).
3. Finally, determine the expected future price of the stock at the end of this 2-
year period.
b. Because of several intrinsic and market factors, Wilt feels that 25% is a viable
figure to use for a desired rate of return.
1. Using the 25% rate of return and the forecasted figures you came up with in
question (a), compute the stock’s justified price.
2. If C&I is currently trading at $32.50 per share, should Wilt consider the
stock a worthwhile investment candidate? Explain.
c. The stock is actively traded on the Nasdaq National Market and enjoys consider-
able market interest. Recent closing prices are shown in the accompanying table.
1. Prepare a point-and-figure chart of these prices (use a 1-point system—that is,
make each box worth $1).
2. Discuss how these and similar charts are used by technical analysts.
3. Cite several other types of technical measures, and note how they might be
used in the analysis of this stock.
W8.1 Check out the dividend valuation model (zero growth, constant growth, and non-
constant growth) at www.bluebloodcells.com/fun/cs4262/div.html. Using the constant-growth
model, a dividend D0 of 2, an expected growth rate, G, of 15%, a number of years t of 4, and a
required equity return, Ke, of 18%, calculate the market price of the stock.
W8.2 ASK Research at www.askresearch.com has one of the best and fastest charting tools.
It will provide you with several technical indicators, company news, and portfolio tracking. The
pages will automatically refresh themselves with latest quotes and charts. Assume that you are a
day trader, and follow the market activity. For example, click on [Nasdaq Composite Index]
and compare the Intraday Chart with the On-Balance Volume. Is there a correlation between
the movements of the two lines?
W8.3 10K Wizard at www.10kwizard.com provides real-time online access and full text
search of EDGAR, thus providing a link to SEC filings. You can view the latest SEC filings of
more than 68,000 companies and search historical filings, from the start date of each company’s
existence, by keywords, phrases, and names. For example, select [Computer/Office Equipment]
in the [Industry] box, and type ORCL in the [Ticker] box. This will retrieve a list of recently
filed forms for Oracle. Click on the first [10-Q Quarterly report] form. What were Oracle’s
reported earnings per share? What was its comprehensive income?
W8.4
a. NAIC Investor’s Tool Kit at www.better-investing.org/computer/toolkit.html provides what
you need to analyze and evaluate common stocks for your portfolio. Investor’s Toolkit
PRO adds the portfolio management tools you will want later to optimize the performance
of your portfolio.
b. Validea at www.validea.com allows you to analyze an individual stock. Check the “buzz”
on your stock by entering ticker symbol ORCL, and click on the [Go] button. Check [Guru
Analysis] on this stock by clicking on it. Analyze the report cards from the All Star Gurus.
What factors do they consider? How might these opinions influence your estimate of the
stock? Check the [Media Buzz] for the stock. What does it report?
W8.5 Find the stock analyzer at www.decisionpoint.com. Click on [Chart Spotlite] for quick
technical analysis of the selected stock, market index, and market indicator charts. New charts are
featured weekly. Select the article [VXN:New Volatility Index] for the Nasdaq 100 Index for the
latest available date. What does the index measure? How does volatility correlate with performance?
W8.7
a. See how to value stocks at www.fool.com/school/howtovaluestocks.htm
b. See Internet stock valuation techniques at the following sites:
www.acusd.edu/~mpraum/internetvalue.html
www.timeinc.net/fortune/year.in.review/1998/internetstock.html
www.techweek.com/articles/5-3-99/stockwat.htm
www.awl.com/gitman_joehnk
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C FA E X A M Q U E S T I O N S
Investing in Common Stocks
Following is a sample of 12 Level-I CFA exam questions that deal with many of the
topics covered in Chapters 6, 7, and 8 of this text, including the use of financial ratios,
various stock valuation models, technical analysis, and efficient market concepts.
(Note: You will find the term, “dividend discount model” used in many of the ques-
tions below; read that as “dividend valuation model,” as these two terms have the same
meaning).
1. Assume that at the end of the next year, Company A will pay a $2.00 dividend per
share, an increase from the current dividend of $1.50 per share. After that, the dividend
is expected to increase at a constant rate of 5%. If you require a 12% return on the
stock, what is the value of the stock?
a. $28.57.
b. $28.79.
c. $30.00.
d. $31.78.
2. The constant-growth dividend discount model will not produce a finite value for
a stock if the dividend growth rate is:
a. above its historical average.
b. below its historical average.
c. above the required rate of return on the stock.
d. below the required rate of return on the stock.
3. Which of the following assumptions is NOT required by the constant-growth div-
idend discount model?
a. Dividends grow at a constant rate.
b. The stock is sold at some future date.
c. The dividend growth rate continues indefinitely.
d. The required rate of return is greater than the dividend growth rate.
4. The constant-growth dividend discount model would typically be most appro-
priate in valuing the stock of a:
a. new venture expected to retain all earnings for several years.
b. rapidly growing company.
c. moderate growth, “mature” company.
d. company with valuable assets not yet generating profits.
5. In applying the constant-growth dividend discount model, lowering the market
capitalization rate will cause a stock’s intrinsic value to:
a. decrease.
b. increase.
c. remain unchanged.
d. decrease or increase, depending upon other factors.
6. A company’s current ratio is 2.0. If the company uses cash to retire notes payable
that are due within one year, would this transaction most likely increase or decrease the
current ratio and total asset turnover ratio, respectively?
Current Ratio Asset Turnover Ratio
a. Increase Increase
b. Increase Decrease
c. Decrease Increase
d. Decrease Decrease
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C FA E X A M Q U E S T I O N S
7. Two companies are identical except for substantially different dividend payout
ratios. After several years, the company with the lower dividend payout ratio is most
likely to have:
a. lower stock price.
b. higher debt/equity ratio.
c. less rapid growth of earnings per share.
d. more rapid growth of earnings per share.
8. A share of stock is expected to pay a dividend of $1.00 one year from now, with
growth at 5 percent thereafter. In the context of a dividend discount model, the stock
is correctly priced today at $10. According to the single stage, constant growth divi-
dend discount model, if the required return is 15 percent, the value of the stock two
years from now should be:
a. $11.03.
b. $12.10.
c. $13.23.
d. $14.40.
9. Company B paid a $1.00 dividend per share last year and is expected to continue
to pay out 40% of its earnings as dividends for the foreseeable future. If the firm is
expected to generate a 10% return on equity in the future, and if you require a 12%
return on the stock, what is the value of the stock?
a. $12.50.
b. $13.00.
c. $16.67.
d. $17.67.
10. A stock is not expected to pay dividends until three years from now. The dividend
is then expected to be $2.00 per share, the dividend payout ratio is expected to be 40
percent, and the return on equity is expected to be 15 percent. If the required rate of
return is 12 percent, the value of the stock today is closest to:
a. $27.
b. $33.
c. $53.
d. $67.
11. A basic assumption of technical analysis in contrast to fundamental analysis is
that:
a. financial statements provide information crucial in valuing a stock.
b. a stock’s market price will approach its intrinsic value over time.
c. aggregate supply of and demand for goods and services are key determinants of
stock value.
d. security prices move in patterns, which repeat over long periods.
12. The semi-strong form of the efficient market hypothesis asserts that stock prices:
a. fully reflect all historical security market information.
b. fully reflect all public information.
c. fully reflect all relevant information from public and private sources.
d. may be predictable.