Several sites that we discussed in earlier chapters contained financial calculators. By inputting the required data, users can determine if it is better to buy or lease a car, calculate returns, and determine how much money they will have if funds are invested at a certain rate of return over time.
Summary • As an investor, you want to select investments that will provide a rate of return that compensates you for your time, the expected rate of inflation, and the risk involved. To help you find these investments, this chapter considers the theory of valuation by which you derive the value of an investment using your required rate of return. We consider the two investment decision processes, which are the top-down, three-step approach and the bottom-up, stockpicking approach. Although it is recognized that either process can provide abnormal positive returns if the analyst is superior, we feel that a preferable approach is the top-down approach in which you initially consider the aggregate economy and market, then examine alternative global industries, and finally analyze individual firms and their stocks.
• We apply the valuation theory to a range of investments, including bonds, preferred stock, and common stock. Because the valuation of common stock is more complex and difficult, we suggest two alternative approaches (the present value of cash flows and the relative valuation approach) and several techniques for each of these approaches. Notably, we do not believe that these are competitive approaches but suggest that both approaches be used. Although we suggest using several different valuation models, the investment decision rule is always the same: If the estimated intrinsic value of the investment is greater than the market price, you should buy the investment; if the estimated intrinsic value of an investment is less than its market price, you should not invest in it.
• We conclude with a review of factors that you need to consider when estimating the value of stock with either approach—your required rate of return on an investment and the growth rate of earnings, cash flow, and dividends. Finally, we consider some unique factors that affect the application of these valuation models to foreign stocks.
Questions 1. Discuss the difference between the top-down and bottom-up approaches. What is the major assumption that causes the difference in these two approaches?
2. What is the benefit of analyzing the market and alternative industries before individual securities?
3. Discuss why you would not expect all industries to have a similar relationship to the economy. Give an example of two industries that have different relationships to the economy.
4. Discuss why estimating the value for a bond is easier than estimating the value for common stock.
5. Would you expect the required rate of return for a U.S. investor in U.S. common stocks to be the same as the required rate of return on Japanese common stocks? What factors would determine the required rate of return for stocks in these countries?
6. Would you expect the nominal RFR in the United States to be the same as in Germany? Discuss your reasoning.
7. Would you expect the risk premium for an investment in an Indonesian stock to be the same as that for a stock from the United Kingdom? Discuss your reasoning.
8. Would you expect the risk premium for an investment in a stock from Singapore to be the same as that for a stock from the United States? Discuss your reasoning.
9. Give an example of a stock where it would be appropriate to use the reduced form DDM for valuation and discuss why you feel that it is appropriate. Similarly, give an example and discuss a stock where it would not be appropriate to use the reduced form DDM.
10. Give an example of and discuss a stock that has temporary, supernormal growth where it would be appropriate (necessary) to use the modified DDM.
11. Under what conditions will it be ideal to use one or several of the relative valuation ratios to evaluate a stock?
12. Discuss a scenario where it would be appropriate to use one of the present value of cash flow techniques for the valuation.
13. Discuss why the two valuation approaches (present value of cash flows and the relative valuation ratios) are competitive or complementary.
Problems 1. What is the value to you of a 9 percent coupon bond with a par value of $10,000 that matures in
10 years if you want a 7 percent return? Use semiannual compounding.
2. What would be the value of the bond in Problem 1 if you wanted an 11 percent rate of return?
3. The preferred stock of the Clarence Radiology Company has a par value of $100 and a $9 dividend rate. You require an 11 percent rate of return on this stock. What is the maximum price you would pay for it? Would you buy it at a market price of $96?
4. The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you expect BBC to earn $11 and continue its payout ratio. Assume that you expect to sell the stock for $132 a year from now. If you require 12 percent on this stock, how much would you be willing to pay for it?
5. Given the expected earnings and dividend payments in Problem 4, if you expected a selling price of $110 and required an 8 percent return on this investment, how much would you pay for the BBC stock?
6. Over the long run, you expect dividends for BBC in Problem 4 to grow at 8 percent and you require
11 percent on the stock. Using the infinite period DDM, how much would you pay for this stock?
7. Based on new information regarding the popularity of basketball, you revise your growth estimate for BBC to 9 percent. What is the maximum P/E ratio you will apply to BBC, and what is the maximum price you will pay for the stock?
8. The Shamrock Dogfood Company (SDC) has consistently paid out 40 percent of its earnings in dividends. The company's return on equity is 16 percent. What would you estimate as its dividend growth rate?
9. Given the low risk in dog food, your required rate of return on SDC is 13 percent. What P/E ratio would you apply to the firm's earnings?
10. What P/E ratio would you apply if you learned that SDC had decided to increase its payout to 50 percent? (Hint: This change in payout has multiple effects.)
11. Discuss three ways a firm can increase its ROE. Make up an example to illustrate your discussion.
12. It is widely known that grocery chains have low profit margins—on average they earn about 1 percent on sales. How would you explain the fact that their ROE is about 12 percent? Does this seem logical?
13. Compute a recent five-year average of the following ratios for three companies of your choice (attempt to select diverse firms):
a. Retention rate b. Net profit margin c. Equity turnover d. Total asset turnover e. Total assets/equity
Based on these ratios, explain which firm should have the highest growth rate of earnings.
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