Stock Valuation Models: Types & Overview Video

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  • 0:02 Stock Valuation Models
  • 0:34 EPS & P/E Ratio
  • 1:55 Dividend Growth Rate & CAPM
  • 4:08 PEG Ratio & SPM
  • 6:03 ROIC, ROA, & P/S Ratio
  • 7:34 Lesson Summary
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Lesson Transcript
Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

In this lesson, we'll learn how to use stock valuation models to determine whether to invest in a company. We'll also review a hypothetical company using various stock valuation formulas.

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.

4. Capital Asset Pricing Model (CAPM)

The formula for CAPM uses three figures:

Market Risk-Free Rate + Market Risk Premium * Stock Beta

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.

The formula is:

PEGY = P/E Ratio / Dividend Growth Rate + Dividend Yield

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