This lesson takes a look at the three most popular types of stock valuation models. If you ever wondered why one stock is priced at $100 and another at $1,000 this will help explain why.
Stock Valuation Models
Hannah works for an investment firm, and one of her customers is interested in investing in an international bond fund called Challenge Funds. So, she gets to work and tries to determine the value of their stock. When buyers and sellers trade stocks, they determine the value of the stock by the price of the stock during the trade. The value of a stock is based on the status of the company, including its management, capital structure, and future earnings potential.
Let's look at the various models Hannah can use to value this stock and determine the projected return.
1. Earnings Per Share (EPS)
Hannah first looks at EPS, which tells her how profitable the company is and how much of this profit is attributed to each outstanding share of common stock. She determines EPS using this formula:
(Net Income - Dividends on Preferred Stock) / Average Outstanding Shares
Hannah starts with the net income of Challenge Funds, which is 30 million. The company pays $2 million in dividends on preferred stock. This gives the company $28 million in net income, the numerator for the EPS. Challenge Funds has 10 million shares, on average, outstanding for the year. So, the EPS is 28 / 10 = $2.8. The amount of profit associated with each outstanding share of common stock for Challenge Funds is $2.8.
2. Price to Earnings (P/E) Ratio
Hannah then looks at the P/E ratio, which is also called the earnings multiple. The P/E ratio is calculated as market value per share / earnings per share. This determines the current share price in comparison to its per-share earnings. Challenge Funds is trading at $50 per share with earnings of $2 per share for the last year. Hannah calculates a P/E ratio of $50 / $2, which is 25 times.
3. Dividend Growth Rate
Hannah decides to calculate the dividend growth rate for Challenge Funds. This is the percentage of growth associated with a stock's dividend over time. Hannah uses yearly dividend payments over the last three years for her calculation. Dividend payments equaled 1.8 in Year 1, 2.5 in Year 2, and 2.8 in Year 3. She plugs in these figures into the formula:
Dividend Growth Rate = Year X Dividend / (Year X - 1 Year Dividend) - 1
The growth rates are calculated as:
Year 1 = Not Applicable
Year 2 = 2.5/1.8 - 1 = 39%
Year 3 = 2.8/2.5 - 1 = 12%
The average for these three years is 25.5%, which is the dividend growth rate Hannah is after.
When Hannah begins calculating the CAPM, she needs to turn to a few different sources to retrieve these three elements. The risk-free rate is found by using Treasury bill (T-bill) rates. In our example, the T-bill rate is 5%. The market risk premium is the amount of return associated with the stock market. This is found by using the S&P return rate and subtracting the more stable indicator, the T-bill rate. The S&P rate is 15%, so she calculates the market risk premium as 15% - 5%, which equals 10%.
For the CAPM, Hannah also has to use what is called the stock's beta, which is a measure of the volatility of a stock against the market. For example, a stock's beta of 0 means the stock is stable, even when the S&P 500 is not. A stock's beta of 1 means that a stock is just as volatile as the market. Challenge Funds has a beta value of 0.25.
Hannah's CAPM, or expected return for the stock, is:
5% + 0.25 * 10% = 7.5%
5. Price Earnings to Growth (PEG) Ratio
Next on Hannah's list is the PEGY for Challenge Funds. This is calculated by using the P/E ratio.
Hannah uses the P/E ratio and dividend growth rate she already calculated. She needs to calculate the dividend yield by dividing Challenge Fund's dividend per share by its current price. The dividend yield is $5/$50, which is 10%. The PEGY is:
25 / (25.5 + 10) = 0.70
If the PEGY ratio is < 1.0, it is undervalued. If the PEGY ratio is > 1.0, it is overvalued. Hannah considers Challenge Funds' stock to be undervalued.
6. Sum of Perpetuities Method (SPM)
The SPM is a way to value stock that discounts future earnings, both those paid as dividends and those retained.
Hannah must determine:
(E) The company's earnings
(G) The company's dividend growth rate
(P) The value of the stock
(D) The company's dividend payment
She also needs the company's risk-adjusted discount rate (K), which she finds as the amount of interest Challenge Funds has to pay per period. This is 4%.
So, Hannah calculates the SPM as:
P=((E * G)/K2) + (D/K)
The equation becomes:
($2 * 25.5%) / 16 + ($2 / 4%) = 478,125 + 50
The value of this stock, (P), is $50.
7. Return on Invested Capital (ROIC)
Hannah next looks to the ROIC, which is a measurement of how well Challenge Funds is dedicating its capital to investments that are profitable.
ROIC = (Net Income - Dividends on Preferred Stock) / Total Capital
When Hannah puts the equation together, she gets ($30 million - $2 million) / $50 million, which equals 0.56, or 56%. This is the return on invested capital.
8. Return on Assets (ROA)
Next on Hannah's list is ROA, which will tell her how profitable Challenge Funds is in comparison to the company's total assets.
ROA is found by Net Income / Total Assets, so Hannah figures $30 million / $100 million. The ROA for Challenge Funds is 0.3, or 30%.
9. Price to Sales (P/S) Ratio
The last stock valuation model Hannah wants to review is the P/S ratio for Challenge Funds. Hanna needs the sales for the current fiscal year, which is $500 million. The P/S ratio is found using stock price per share / (net sales / share). She calculates the denominator first with $500 / 50, which is $10. The P/S ratio is $50 / $10 = $5. Investors are paying $5 for every dollar of Challenge Funds' holdings.
Stock valuation models paint a picture of the probability that investing in a company will return a dividend. Even if the picture is positive, there may be other investments more worthy of a client's dollar. These models help determine how much and when an investment should or should not be made.
The actual value of a company is determined by many factors. Using these methods allow an investor to make a methodical decision. These methods include EPS, P/E ratio, dividend growth rate, CAPM, PEG ratio, SPM, ROIC, ROA, and P/S ratio.
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