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After studying this chapter, you should be able to:

I LG l| Explain the role that a company's future plays in the stock valuation process and develop a forecast of a stock's expected cash flow.

I LG 2| Discuss the concepts of intrinsic value and required rates of return, and note how they are used.

I 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.

I LG 4| Gain a basic appreciation of the procedures used to value different types of stocks, from traditional dividend-paying shares to new-economy stocks with their extreme price/earnings ratios.

I LG 5| Describe the key attributes of technical analysis, including some popular measures and procedures used to assess the market.

I LG 6| Discuss the idea of random walks and efficient markets and note the challenges these theories hold for the stock valuation process.

Tech stocks have been at the forefront of stock market news the 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 standard for the wireless communications industry. Investors in 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 4-for-1 in December. This represents an annual return of over 2,600%, the year's best. The following year was another matter, however. Fears 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 a -53% return. Even after the decline, the stock was still trading at a price/earnings ratio of about 85 in early January 2001, a substantial premium over the average P/E of 29 for the S&P 500.

Despite Qualcomm's fluctuating stock price, investors looked with favor on the company's earnings growth—94% from 1997 through 2000, which far outstripped the S&P 500's 14%. The company consistently met or exceeded quarterly earnings estimates, and analysts project continued earning growth to $1.26 per share in 2001, an increase of 48% over 2000.

What do all these numbers mean in terms of the value of Qualcomm's stock? This chapter explains how to determine a stock's intrinsic value by using dividend valuation, dividend-and-earnings, price/earnings, and other models. We also look at how to value technology stocks. Finally, we'll review the use of technical analysis as a way to assess the state of the market in general.

Sources: Adrienne Carter, "The Big Score," Money Technology 2000, October 15, 2000, p.60; "Morningstar Quicktake Report—Qualcomm" Morningstar.com, downloaded from www.morningstar.com, January 15, 2001; and Qualcomm Web site, www.qualcomm.com

Valuation: Obtaining a Standard of Performance stock valuation the process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance.

HVESTOR FACTS

BLIND SPOT—As optical networking companies caught investors' attention, their market value soared. In September 2000, this hype drove the value of JDS Uniphase to $96 billion, which made it the 36th most highly valued company in the world. Investors apparently turned a blind eye to the company's financial results for the fiscal year ended June 30, 2000: Its revenues were $1.4 billion and its losses $905 million. For about the same total market capitalization, you could theoretically buy all 11 of the following major companies— the New York Times, Saks Fifth Avenue, Georgia Pacific, T. Rowe Price, Delta Airlines, Tiffany & Co., Bear Stearns, FedEx, CVS, Gap, and John Hancock—with aggregate revenues of $115 billion and $6.4 billion in profits!

Source: Jon Birger, Pablo Galarza, Laura Lallos, and Jeanne Lee, "Best Stocks & Funds: Invest the Smart Way to Buy Tech," Money/Tech 2000, October 15, 2000, pp. 65-66.

Obtaining a standard of performance that can be used to judge the investment 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 risk and return performance of a security. The question of whether and to what extent a stock is under- or overvalued is resolved by comparing its current market price to its intrinsic value. At any given point in time, the price of 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 will probably go down. Let's look now at the single most important issue in the stock valuation process: the future.

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