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CHAPTER 6
1
Common Stock Valuation
Chapter Sections:
Security Analysis: Be Careful Out There
The Dividend Discount Model
The Two-Stage Dividend Growth Model
The Residual Income Model
The Free Cash Flow Model
Price Ratio Analysis
An Analysis of the Proctor & Gamble Company
“Value matters. You ignore value at your peril.”
Greg Ireland, mutual fund manager with over 35 years experience
Common Stock Valuation

Stock Valuation
 The process by which the underlying value of a
stock is established on the basis of its forecasted
risk and return performance
 At any given time, the price of a share of common
stock depends on investors’ expectations about
the future behavior of the security
 A fundamental assertion of finance holds that the
value of a stock is based on the present value
of its future cash flows (a.k.a. earnings)
The worth of a company is primarily based on the earnings the
company will produce in the future. But if we knew what was going
to happen in the future, it would not be called the future, would it?
2
3
Common Stock Valuation
(continued)

Stock Valuation
 “The most fundamental influence on stock prices is
the level and duration of the future growth of
earnings and dividends. [However,] future
earnings growth is not easily estimated, even by
market professionals.” – Burton Malkiel, A Random
Walk Down Wall Street
So, if someone were to ask you, “What is the most important factor in
determining the future value of a company?” In a few words, you
could say, “FUTURE EARNINGS!” (or FUTURE DIVIDENDS)
But do any of us know what is going to happen in the future? “NO!”
So is valuing stock going to be easy? “NO!”
4
Security Analysis

Security Analysis
 The process of gathering and organizing
information and then using it to determine the
value of a share of common stock

Intrinsic Value
 The underlying or inherent value of a stock, as
determined through security analysis
The question is, “What security analysis methods or measures does
one use to determine the intrinsic value of a company?”
Future dividends? Potential capital appreciation? Price/earnings
ratio? Financial ratios? Past price performance? Amount of risk?
Value is in the eye of the beholder.
5
Fundamental Analysis

Fundamental Analysis
 Examination of a firm’s accounting statements and
other financial and economic information to assess
the economic value of a company’s stock
 Examples of some of the Fundamentals:





The competitive position of the company
Growth prospects for company and its market
Profit margins and company earnings
What assets are available
The company’s capital structure
 How much debt, how much equity
Simply put, the value of a stock is influenced by the
performance of the company that issued the stock.
6
Financial Ratio Analysis

Financial Ratio Analysis
 One method of security analysis involves looking
at certain financial ratio measures
 Financial ratios give us a quick and easy method
for comparing one company to other companies
within their industry or the stock market as a whole
 The problem with financial ratios is that there is no
single financial ratio that can adequately sum up or
summarize the overall general state of affairs,
situation, predicament, etc., that a company finds
itself in
The first financial ratios we will investigate will be price ratios.
We will look at others later on.
7
Price-to-Earnings Ratio

Price-to-Earnings Ratio (Review)
 a.k.a. Price-earnings Ratio, P/E Ratio, P/E, PE
 Current Price divided by Earnings per Share

Examples:
 GM
(GM),
GD (GD), Google (GOOGL), GE (GE), GoPro (GPRO)
P/E = 6.3 P/E = 20.1
P/E = 30.5
P/E = 33.8
P/E = N/A
As of 2 Mar 2017
Current Market Price
P/E Ratio = ––––––––––––––––––––––––––––––––––––
Earnings per Share (EPS)
The most popular stock market statistic! Historically, P/E ratios were in the
5 to 12 range for mature companies and 14 to 20 range for growing
companies. Greater than 20 was unusual. In the 1990’s, it was
commonplace. Now, P/E ratios are all over the map but pretty high by
historical standards!
8
Price-to-Earnings Ratio

(continued)
Historically,
 A company’s P/E Ratio was supposed to match its
growth rate. If a company was growing at 20% per
year, then a P/E of 20 was justified. During the
Internet bubble, many companies had P/E ratios in
the hundreds
 eBay’s P/E was 10,000 for a time during the mania!
 At that P/E, it would take eBay 10,000 years to earn its price
 “Growth” stocks typically have high-P/E Ratios
 “Value” stocks typically have low-P/E Ratios
 But remember our discussion of “growth” vs “value”
 A “value” stock might not necessarily be a good value!
The P/E Ratio tells you how long it will take in years (assuming no changes
in earnings) for the company to earn back its price. A P/E of 3 will take
three years. A P/E of 20 will take twenty years.
9
Price-to-Cash Flow Ratio

Price-to-Cash Flow Ratio
 Current price divided by current cash flow per share
 Cash flow often differs from earnings per share
 For several reasons – one major reason is…
 Depreciation is not an actual cash expenditure
 But there are many reasons cash flow & earnings differ
 “Good quality” versus “poor quality” earnings
Current Price
Price-Cash Flow Ratio = ––––––––––––––––––––––––––––
Cash Flow per Share
During the Internet mania, many companies were reporting
record earnings. At the same time, their cash flow was negative.
Huh? How could that be? Example: Lucent Technologies
10
Price-to-Sales Ratio

Price-to-Sales Ratio
 Current price divided by annual sales per share
 Historically, a higher Price-to-Sales Ratio suggested
a higher sales growth
 And a lower Price-to-Sales Ratio suggested a lower
sales growth
Current Price
Price-to-Sales Ratio = –––––––––––––––––––––––––––––
Annual Sales per Share
During the Internet mania, many analysts used Price-to-Sales
instead of Price-to-Earnings since most all of the new companies
never generated any earnings!
11
Price-to-Book Ratio

Price-to-Book Ratio
 Current price divided by book value
 Historically, if the Price-to-Book Ratio was greater
than 1.0, then shareholders believed that the firm
was creating value above and beyond the physical
assets of the corporation
Current Price
Price-to-Book Ratio = –––––––––––––––––––––––––––––
Book Value per Share
The Book Value of a stock is the value of the assets the company
possesses. Historically, it was fairly close to the price of the
stock. Today, it is rarely close to the price of the stock.
12
Applications of Price Ratio Analysis

To predict future stock price using price ratios,
 Multiply a historical price ratio by the expected
future value price-ratio denominator (“What? Huh?”)
 Price-to-Earnings Per Share Example
 Page 201, 7th Edition:
Intel Corp (INTC) – Price-to-Earnings (P/E) Analysis
Mid-2012 stock price
Mid-2009 EPS
5-year average P/E ratio
EPS growth rate
$26.98
$2.31
17.10 P/E
7.6%
Expected stock price = historical P/E ratio  projected EPS*
$42.50 = 17.10  $2.31  (1 + 0.076)
*projected EPS = current EPS * (100% + expected EPS growth rate)
13
Applications of Price Ratio Analysis
(continued)

Applications of Price Ratio Analysis (continued)
 Price-to-Cash Flow Per Share Example
 Page 201, 7th Edition:
Intel Corp (INTC) – Price-to-Cash Flow (P/CF) Analysis
Mid-2012 stock price
Mid-2012 CFPS
5-year average P/CF ratio
Cash Flow Per Share growth rate
$26.98
$3.65
8.00 P/CF
7.0%
Expected stock price = historical P/CF ratio  projected CFPS*
$31.24 = 8.00  $3.65  (1 + 0.070)
*projected CFPS = current CFPS * (100% + expected CFPS growth rate)
This is far from the Price-to-Earnings estimate
14
Applications of Price Ratio Analysis
(continued)

Applications of Price Ratio Analysis (continued)
 Price-to-Sales per Share Example
 Page 201, 7th Edition:
Intel Corp (INTC) – Price-to-Sales (P/S) Analysis
Mid-2012 stock price
Mid-2012 SPS
5-year average P/S ratio
Sales Per Share growth rate
$26.98
$9.99
3.00 P/S
4.5%
Expected stock price = historical P/S ratio  projected SPS*
$31.32 = 3.00  $9.99  (1 + 0.045)
*projected SPS = current SPS * (100% + expected SPS growth rate)
Very close to the Price-to-Cash-Flow prediction
15
Reality Check!

Can we reasonably assume that the formulas
on the previous slides will give us realistic
figures?
 For many companies, yes
 For many companies, no

But there are countless other factors at work
 It is like trying to predict the weather – only worse!
The major assumption of these models is that the price multiples will
remain constant. However, we are using averages without taking into
account the variances and standard deviations of the averages.
(Remember them?) Is it reasonable to expect predictions from these
models to be accurate if the variances of the averages are large?
16
Reality Check!

(continued)
For the record, the price of Intel one year later
in mid-2013 was around $24
 Not so good, eh? Check out the previous editions
 3rd edition predictions: $19.61, $27.54, and $31.63
 The actual price one year later was $33.50
 4th edition predictions: $50.84, $43.49, and $40.92
 The actual price one year later was $17.50
 5th edition predictions: $25.47, $25.36, and $29.63
 The actual price one year later was $20.00
 6th edition predictions: $20.92, $20.29, and $22.71
 The actual price one year later was $20.50
The only predictions that were anywhere close to the actual prices one
year later were from the 6th edition. Does not give you much confidence
in the price models, huh? Take heart, the predictions for Disney from
the book were much closer to the actual prices. The moral?
17
Dividend Discount Models

Shares of stock are valued on the basis of the
present value of the future dividend streams
the stock is projected to produce
 a.k.a. DDMs, Dividend Valuation Models (DVMs),
Discounted Cash Flows Models
 Recall: The value of a stock is based on the
present value of its future cash flows
 Therefore, dividend discount models should be
extremely popular, right?
During the 1990’s, investors who adhered to these types of
models were considered old fashioned and outdated. But those
investors weathered the 2000-2002 downturn very well.
Dividends have become important again.
18
Dividend Discount Models
(continued)

Dividend Discount Model (Purest incarnation)
 Value of stock = present value of all expected
future dividend payments
D1
D2
D3
DT
P0 



2
3
1  k  1  k  1  k 
1  k T

Example 6.1: Page 181, 7th edition
 Three annual dividends of $100 per share
 Required rate of return = 15%
 ($100/1.15)+($100/1.152)+($100/1.153) = $228.32
But how many companies pay three annual dividends and then go
out of business?! Plus, we keep using this term “present value.”
What does it mean anyway?
19
What is “Present Value?”

Present Value
 The value today of a lump sum (or series of
payments) to be received at some future date
 It is the opposite of future value! (a.k.a. the inverse)
 Did you work on the optional future value calculations?
 Future value of $10,000 in 10 years at 8%
 $10,000 * 2.1589 = $21,589
(1 + 8%) 10 years
 Present value of $21,589 in 10 years at 8%
 $21,589 * 0.4632 = $10,000
$10,000 * 2.1589 = $21,589
1
1
(1 + 8%) 10 years
Present value and future value are just two sides of the same coin.
In finance, present value tells us what the future value is worth now.
20
Present Value & DDM

(continued)
Did the formula for the DDM scare you?
D1
D2
D3
DT
P0 



2
3
T
1  k  1  k  1  k 
1  k 
 This formula has the present value calc built into it
 We mortals simply use the Present Value tables
 Just as we used the Future Value tables in Chapter 1
 The formula becomes:
Value = Dividend1*PVM1 + Dividend2*PVM2 + Dividend3*PVM3 + etc
PVM1 is the present value multiplier for the rate of growth for one
year, PVM2 is the multiplier for two years, etc.
21
Present Value & DDM

(continued)
Let’s do the same example over again
 Using the Present Value Multipliers from the
Present Value Table on the class web site
 http://wonderprofessor.com/123s17/Chap06/Chap06_PresentValueTable.pdf
 Three annual dividends of $100 per share
 Required rate of return = 15%
Value = ($100*0.870) + ($100*0.756) + ($100*0.658)
=
$87.00 + $75.60
+
$65.80
= $228.40  $228.32 (from slide 18)
What is the present value of the future stream of dividends?
At 15%, $100 in 1 year is worth $87, in 2 years $75.60, 3 years $65.80.
The sum of the present values of the future dividend cash flows equals
our perceived value of the stock.
22
Dividend Discount Models
(continued)

Zero Growth Model (Not covered in our book)
 Assume dividends will continue at a fixed rate
indefinitely into the future
Annual dividends
 Value of stock = ───────────────
Required rate of return

Example:
 Annual dividend = $3.00 per share
 Required rate of return = 6%
 $3.00 / 6% = $50.00 per share
Does the Zero Growth Model look familiar? It is simply
another way to view Dividend Yield.
23
Dividend Discount Models
(continued)

Zero Growth Model (Not covered in our book)
 Assume dividends will continue at a fixed rate
indefinitely into the future
Annual dividends
 Value of stock = ───────────────
Required rate of return
Annual dividends
 Dividend Yield = ───────────────
Market price of stock
Investors who emphasize the Zero Growth Model are valuing
the stock almost exclusively for its dividend yield.
24
Dividend Discount Models
(continued)

Zero Growth Model (Real-life Example)




Consolidated Edison – ED (Utility income stock)
Current market price is $77.19 per share (2 Mar 2017)
Currently paying $2.76 per year in annual dividends
The question is, “What is our required rate of return?”
 Let’s first use 8%
 Value = $2.76 / 8% = $34.50
 The stock is overpriced if our required rate of return is 8%
 What about 5%?
 Value = $2.76 / 5% = $55.20
 The stock is still too expensive if our required return is 5%
With a market price of $77.19, the stock is yielding 3.6%.
The Zero Growth Model works well for stable, income-producing stocks.
25
Dividend Discount Models
(continued)

Constant Perpetual Growth Model
 Assume dividends will continue to grow at a
specified rate perpetually into the future
Annual dividends * (1+Constant growth rate)

Value of stock = Required
───────────────────
rate of return – Constant growth rate

Example 6.3: Page 182, 6th edition





Annual dividend = $10 per share (Next year’s=$10.50)
Annual dividend growth rate = 5% per year
Required rate of return = 15%
($10 * 1.05) / (15% - 5%) = $10.50 / 10% = $105
The stock should be worth $105 per share
Good for companies with consistent dividend growth.
26
Dividend Discount Models
(continued)

Constant Perpetual Growth Model (Real-life Example)
 3M (blue chip, a.k.a. Minnesota Mining and Materials)
 Current market price is $189.89 (2 Mar 2017)
 Currently paying $4.70 annual dividends
 Assume dividends growing around 8% per year
 Our required rate of return is 13%
 ($4.70 * 1.08) / (13% - 8%) = $5.0760 / 5%  $101.52
 Not a great buy if we require 13%, huh?
 What if our required rate of return were only 10%?
 ($4.70 * 1.08) / (10% - 8%) = $5.0760 / 2%  $253.80
 What a deal!
 Note: The model is very sensitive to our choice of
our required rate of return
Do you think 3M is a good value? (Hint: How
often do you use Scotch Tape or Post-It Notes?)
27
Dividend Discount Models
(continued)

Constant Perpetual Growth Model (Real-life Example)
 McDonald’s (blue chip)
 Current market price is $128.23 (2 Mar 2017)
 Currently paying $3.76 annual dividends
 Assume dividends growing around 8% per year
 Our required rate of return is 13%
 ($3.76 * 1.08) / (13% - 8%) = $4.0608 / 5%  $81.22
 McDonald’s doesn’t quite measure up to our 13% rate
 What if our required rate of return were only 10%?
 ($3.76 * 1.08) / (10% - 8%) = $4.0608 / 2%  $203.04
 The model says McD is undervalued if we require only 10%
Do you think people around the world will ever wake up to the fact that
they are being sold an expensive and unhealthy combination of sugar,
salt, and fat? No, neither do I.
28
Dividend Discount Models
(continued)

Constant Perpetual Growth Model (Real-life Example)
 Coca-Cola (blue chip)
 Current market price is $42.47 (2 Mar 2017)
 Currently paying $1.48 annual dividends
 Assume dividends growing around 8% per year
 Our required rate of return is 13%
 ($1.48 * 1.08) / (13% - 8%) = $1.5984 / 5%  $31.97
 So much for caramel colored, fizzy sugar water!
 What if our required rate of return were only 10%?
 ($1.48 * 1.08) / (10% - 8%) = $1.5984 / 2%  $79.92
 Maybe we ought to spend more time researching KO …
In the United States, the average person drinks over 400 Cokes a year.
In China, the average is 38 per year.
In India, it is 12.
Guess which country drinks the most…
29
Dividend Discount Models
(continued)

Constant Perpetual Growth Model (Real-life Example)
 GE (blue chip)
 Current market price is $30.19 (2 Mar 2017)
 Currently paying $0.96 annual dividends
 Assume dividends also growing around 8% per year
 What if our required rate of return is 13%
 ($0.96 * 1.08) / (13% - 8%) = $1.0368 / 5%  $20.74
 Uh, GE does not look so good if we want 13%
 How about 10%?
 ($0.96 * 1.08) / (10% - 8%) = $1.0368 / 2%  $51.84
 If we are happy with 10%, GE appears to be a great deal
But this is after GE dropped its dividend down to $0.40 (from $1.24)
in 2009 after decades of growing the dividend. In 2010, they
started raising the dividend again, first to $0.48, then $0.56,
$0.60, $0.68, $0.76, $0.88, $0.92, and now to $0.96 per year.
30
Dividend Discount Models
(continued)

Constant Perpetual Growth Model (Real-life Example)
 Altria (blue chip)
 Current market price is $75.72 (2 Mar 2017)
 Currently paying $2.44 annual dividends
 Assume dividends also growing around 8% per year
 Same required rate of return of 13%
 ($2.44 * 1.08) / (13% - 8%) = $2.6352 / 5%  $52.70
 The model says it is overvalued at 13%, but not by much
 Again, how about 10%?
 ($2.44 * 1.08) / (10% - 8%) = $2.6352 / 2%  $131.76
 What a buy!
 If you conveniently ignore the fact that tobacco kills 400,000
Americans each year
Hey!
Would you buy Altria?
31
Dividend Discount Models
(continued)

Constant Perpetual Growth Model (continued)
 The Constant Perpetual Growth Model is very
sensitive to the assumed growth rate of dividends
 The recent dividend growth rates of 3M, Coke, GE,
McD’s, and Altria are all currently higher than 8%
 Coke and McD are 8.3%, Altria 9.7%, 3M 10.9%, and GE 11.7%!
 But the model does not work if the required rate of
return is equal to or less than the dividend growth
rate (You get division by zero or negative prices)
 Therefore, we should actually raise our expected rates of
returns for all of these companies!
 All are actually better buys than what the model is
telling us for our 10% or 13% rates of return
Note: These are blue chip companies with long histories of rising dividends.
But they are not alone. Check out ExxonMobil, Proctor & Gamble, United
Technologies, Honeywell, Johnson Controls, and Ford.
32
Dividend Discount Models
(continued)

Constant Growth Model
 Assume dividends will continue to grow at a
specified rate for a specified number of years
D0(1  g)
P0 
kg
Constant Perpetual
Growth Model
T

1

g

 
 
1  
1 k  



¡Aye, Paquito!
Do we have to
know how to do
this?! (No.)
Added term to account for
growth for a number of years
 This model takes the Constant Perpetual Growth
Model one step further, adding a term to account
for constant growth for a number of years
 Just as the Constant Perpetual Growth Model evolved from
the Zero Growth Model, adding an additional term to account
for the constant growth of dividends
33
Dividend Discount Models
(continued)

Two-Stage Dividend Growth Model
 a.k.a. Variable Growth Model
 Assume dividends will continue to grow at a specified rate
into the future (presumably the fast-growth stage) and then
grow at a second (presumably slower growth rate once the
company matures)
Many decades ago,
Benjamin Graham
warned against using
overly sophisticated
mathematical models
to value stocks.
This model may look very impressive, especially to those who love math, but it
has some serious problems. It is very difficult to accurately predict future
dividend growth during the initial fast growth stage of a stock. Usually
companies do not pay significant dividends while they are growing quickly.
34
Dividend Discount Models
(continued)

Observations of the Dividend Discount Models
 How do you use them for a company that isn’t
paying any dividends?
 The simple answer is, “You can’t!”
 Constant perpetual growth is usually an unrealistic
assumption (except for a very small number of companies)
 Dividend growth rates are very difficult to estimate
 With large cap, well-established companies,
historical growth rates may be useful
 But with fast growing companies in new industries, it
is almost impossible
The problems of DDMs notwithstanding, repeat after me: “The value
of a stock is based on the present value of its future cash flows.”
35
Discounted Cash Flow Model

Uses present value of expected dividends and
the present value of the expected future price
to value a share of stock
 Value of stock = present value of future dividends +
present value of the price of stock when we plan to sell
 We use the present value multipliers from the table
 Not covered specifically in our text
 But it is really just the pure form of the DDM with the
present value of the expected price of the stock as
our final cash inflow
 (P.S. It is my favorite Dividend Discount Model)
As with the other DDMs, this model is very sensitive to our
estimates and our choice of required rate of return and, hence,
can be very far off the mark.
36
Discounted Cash Flow Model
(continued)

Example 1:
 Assume it is January 1, 2017. Pretzels Unlimited is currently
selling for $22 per share and will pay $2.00 per share in dividends
in 2017. PU expects to increase their dividends to $2.20 in 2018,
$2.30 in 2019, and $2.30 in 2020. We will be selling the stock at
the end of 2020 and we expect the price to be $27 per share at
that time. Our required rate of return is 12%.

Value of stock = present value of future dividends
+ present value of price of stock when you plan to sell
Value = ($2.00*0.893)+(2.20*0.797)+(2.30*0.712)+(2.30*0.636)
+ ($27.00*0.636) =
= [ $1.786 + $1.7534 + $1.6376 + $1.4628 ] + $17.172 =
= $6.6398 + $17.172 = $23.8118  $23.81
If our required rate of return is 12%, this is a pretty good stock to buy.
37
Discounted Cash Flow Model
(continued)

Example 1:
 Pretzels Unlimited in Table Format
12%
Years
Cash Flows
PVM
2017
$2.00
0.893
$1.786
2018
$2.20
0.797
$1.7534
2019
$2.30
0.712
$1.6376
2020
$2.30
0.636
$1.4628
2020
$27.00
0.636
$17.172
Total Present Value:
Discounted Cash Flows
$23.8118  $23.81
Here is the problem in spreadsheet format. I think it is much
easier to comprehend and calculate in this format, yes?
38
Discounted Cash Flow Model
(continued)

Example 1 (Simplified):
 Pretzels Unlimited in a More Simplified Table Format
12%
PVM
Discounted Cash
Flows
Years
Cash Flows
2017
$2.00
0.893
$1.786
2018
$2.20
0.797
$1.7534
2019
$2.30
0.712
$1.6376
2020
$2.30 + $27 = $29.30
0.636
$18.6348
Total Present Value:
$23.8118  $23.81
Adding the dividend and the stock price in the last year saves us a
couple of manual calculations but more importantly, it also allows us
to use a special spreadsheet function to calculate …
39
Discounted Cash Flow Model
(continued)

Internal Rate of Return (a.k.a. IRR)
 The Internal Rate of Return is a measure of what
rate of return we expect to get from a series of
cash flows, including positive and negative flows
 Someday, when you take an upper-level or
graduate finance or investment class, you will learn
how to manually compute Internal Rate of Return
 Hopefully, you will not have a sadistic professor who will
require you to calculate it manually more than once!
 We are simply going to enter the numbers into a
spreadsheet formula and press , okay?
In other words, we required a 12% rate of return from Pretzels Unlimited,
but what do our numbers tell us will be our expected rate of return?
40
Discounted Cash Flow Model
(continued)

Internal Rate of Return (a.k.a. IRR), continued
 The spreadsheet formula is:
 =IRR(values,approximate-rate-of-return) where
 values is the block of cells containing the cash flows, both
positive and negative, and
 approximate-rate-of-return is our guess as to what the
Internal Rate of Return will be
Year
Cash Flows
Comments
$ (22.00)
Our initial outlay is $22.00 – enter any outflows as negative numbers
2017
$
2.00
$2.00 dividend – enter cash inflows as possible numbers
2018
$
2.20
$2.20 dividend
2019
$
2.30
$2.30 dividend
2020
$ 29.30
$2.30 dividend + $27.00 proceeds from sale of stock
14.51%
Internal Rate of Return =IRR(B2:B5,0.12)
Let’s take a look at the example spreadsheet on the class web page …
41
Discounted Cash Flow Model
(continued)

Example 2:
 Genes ’R’ Us (symbol GRUS) is currently selling for $21 per share.
It pays no dividend. We believe that GRUS will sell for around $50
per share in five years. Our required rate of return is 13%. How
can we determine if this is a good investment?

With no dividends, which model can we use?
 The Discounted Cash Flow Model can still be used!

Value of stock = present value of future dividends
+ present value of price of stock when you plan to sell
Value = $0.00 (from dividends) + ($50.00*0.543) = $27.13
Unlike the other DDM’s, the Discounted Cash Flow Model can still be
used if there are no dividends. Very cool!
42
Other Valuation Models

Residual Income Model
 Similar to the Constant Perpetual Growth Model but
instead uses earnings in place of dividends
 Allows us to value a company that is not paying
dividends

Free Cash Flow Model
 Takes the Residual Income Model one step further
by taking into account non-cash expense items
such as depreciation
We will skip these for now and maybe come back to them later.
I think you have enough on your plate for now, yes?
43
Sources of Information

Okay, Paiano, this is all great, but just where
are we supposed to get all this historical
information, anyway? And just who decides
what next year’s earnings per share, sales
per share, cash flow per share, dividends per
share, etc., etc., etc. are going to be, let alone
the expected price of a stock in 3 to 5 years?!
 Before the Internet (BI?), this information was not
readily available
 Normally, you would ask your broker for it
 Or you would use one of the securities industry’s
trusted information sources
 Traditionally, the most respected source was …
44
The Value Line

Still one of the most respected and trusted
sources of data and analysis
 Traditionally, it was often the only source many
investors used for data and analysis
 Along with the company’s materials
 Expensive ($598 per year, www.valueline.com), but can be
obtained for free at various libraries (See class web site)
I am a big fan of Value Line, especially their Timeliness and Safety
indicators.
One study (which ignored transaction costs and tax consequences) only
used their Timeliness indicator. It showed how you would have beaten
the market handsomely over a twenty year period by just buying and
selling stocks as they received and lost their #1 Timeliness designation.
45
The Value Line

(continued)
Can you find…









The Value Line indicators?
The future price projections?
The historical data?
The cash assets, receivables, inventory, and
other assets?
The description and analysis of the business?
The historical annual rates?
The insider and institutional buying & selling?
The amount of debt and number of shares
outstanding?
The company’s financial strength, stability, price
growth, and earnings predictability ratings?
Value Line Example: McGraw-Hill, Page 206 (6th edition)
46
The Value Line
(continued)
47
The Value Line
(continued)
48
The Value Line

(continued)
Let’s put The Value Line to the test
 In late 2009, the price of McGraw-Hill was $28.73
 Their price prediction for early 2013 was in the
range from around $48 to $68
 On February 15th, 2013, McGraw-Hill’s price closed
at $44.95
 Not too bad, eh? Actually, pretty darned good!
 When they made this prediction at the end of 2009,
the stock market had rallied from the depths of the
2008/2009 crisis but many people were still
predicting the end of the world
 By the way, some of them are still predicting the end of the world
Now let’s look at The Value Line prediction for McGraw-Hill
from the 4th edition
49
The Value Line
(continued)
50
The Value Line
(continued)
51
The Value Line

(continued)
How did they do in mid-2005?
 Their price prediction for late 2009 was in the
range from around $66 to around $82
 Aye! McGraw-Hill’s price was hovering around $24
in late 2009
 What happened?
 It reached $70 in mid-2007 and started falling as the
credit markets started reacting to the home
mortgage loan crisis
 McGraw-Hill owns Standard & Poors (Uh, you’ve heard of them)
 It then plummeted as the home mortgage loan crisis
spread to the entire financial sector in 2008 & 2009
 Their mid-2007 prediction from the 5th edition of
the text was even uglier!
But what about their early-2003 prediction from the 3rd edition?
52
The Value Line
(continued)
53
The Value Line
(continued)
54
The Value Line

(continued)
In early 2003, The Value Line predicted that
the price of McGraw-Hill would be around $90
to $110 in 2005 & 2006
 (Why so much higher? McGraw-Hill split their
stock 2 for 1. You have to divide these prices by 2
to compare them to the previous two predictions.)
 Hurray for The Value Line!
 They were bang on the money! McGraw-Hill
reached the $120 level by the end of 2006
 ($60 split adjusted)
I get a kick when some investors trash The Value Line. They make
mistakes, too, just like everybody else. But I would sure love to see how
those investors’ long-term results stack up against the long-term results
of The Value Line! Who do you think would have the better results?
55
The Bottom Line

Once we have finished all our valuation
calculations, what should we do? Should we
really place much value in our predictions?
The answer is, “NO!” Rather, we should…
 Hurl them into the vast ocean along with the ashes
of our dead pets and relatives
 Shred them into millions of little pieces and use
them as confetti at our next party
 Burn them in a huge bonfire as we dance naked
under the full moon
We do these calculations to simply tilt the odds in our favor. Instead of
placing any significance in our predictions, after we have finished, we
should ignore them and ask ourselves a very simple question:
Do I want to own this company?
CHAPTER 6 – REVIEW
56
Common Stock Valuation
Chapter Sections:
Security Analysis: Be Careful Out There
The Dividend Discount Model
The Two-Stage Dividend Growth Model
The Residual Income Model
The Free Cash Flow Model
Price Ratio Analysis
An Analysis of the Proctor & Gamble Company
Next week: Chapter 17, Projecting Cash Flow and Earnings
(Ratio Analysis)