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 strong and others fundamentally weak, and investors must be able to distinguish 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 fundamental 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 considerable 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.

IN REVIEW

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

8.19 Explain why it is difficult, if not impossible, to consistently outperform an efficient market.

a. Does this mean that high rates of return are not available in the stock market?

b. How can an investor earn a high rate of return in an efficient market?

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

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.

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 dividends 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 element 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.

LG 6

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 "justified 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.

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 companies 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.

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 analytical 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.

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 fundamental 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 information is always fully reflected in the price of securities, so investors should not expect to outperform the market consistently.

Discussion Questions

Q8.1 Using the resources available at your campus or public library, select a company from Value Line that would be of interest to you. (Hint: Pick a company that's 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 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.

dUE]

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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.

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?

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 valuation 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

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, generates 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).

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?

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 company's common shares.

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 r I

urn grow to $4.32 next year, to $4.67 the year after that, and to $5.04 in year 3. In addition, 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 dividend 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 X (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.

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.

P8.6 The price of Consolidated Everything is now $75. The company pays no dividends. 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.

P8.7 This year, Shoreline Light and Gas (SLL&G) paid its stockholders an annual dividend 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 of10% peryear 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?

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 dividends for each of the three companies has been estimated as follows:

Buggies-Are-Us

Steady Freddie, Inc.

Gang Buster Group

g = 0%

g = 6%

Year 1

$2.53

(i.e., dividends

(for the

2

$2.85

are expected

foreseeable

3

$3.20

to remain at

future)

4

$3.60

$2.25/share)

Year 5 and

beyond: g = 6%

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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?

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.

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.

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.

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 maintain 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?

P8.13 Assume you obtain the following information about a certain company:

Total assets Total equity Net income EPS

Dividend payout ratio Required return

$50,000,000 $25,000,000 $ 3,750,000 $5.00 per share 40% 12%

Use the constant-growth DVM to place a value on this company's stock.

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

earnings should come in at about $4.00 a share. In addition, although the stock normally 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 18/2 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.)

P8.15 AviBank Plastics generated an EPS of $2.75 over the last 12 months. The company'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.

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 collected P/S multiples on the following Internet retailer stocks:

Company P/S Multiples

Amazing.com 4.5

PotsAnPans Online 12.2

Furnishings.com 1.3

ReallyCooking.com 4.1

Fixtures & Appliances Online 3.8

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.

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