Stock Valuation Issues

1
Stock Valuation Issues

• Chapter 25

2
Introduction

• This chapter will help you decide if you wish to
  be an active or passive investor
• If markets are strongly efficient, there is no
  need to learn the security analysis tools
  presented in this chapter
• Well examine
• Inflation and stock market returns
• Financial ratios and the SP500 Index
• Industry analysis and life cycles
• Unusual stock categories
• Call option theory
• Price-to-book value ratio

3
What Stock Market Data Tells Us About Inflation

• The last 30 years represent a period of high
  inflation compared to the last 200 years
• If a government spends more than it collects in
  taxes, inflation will usually result
• Inflation is measured through a consumers price
  index (CPI)
• As inflation increases interest rates rise
  leading to a decrease in bond prices

4
What Stock Market Data Tells Us About Inflation

• Some argue inflation is good for the stock market
  because corporations increase the selling price
  of their product and their costs do not rise
• This is a fallacy because
• Consumers resist price increases
• Corporations enter long-term contracts to sell
  products at a fixed price
• GAAP do not contain inflation adjustments for
  depreciation
• Thus depreciation cash flows are inadequate for
  equipment renewal during periods of inflation

5
What Stock Market Data Tells Us About Inflation
Real returns were below average during high
inflation periods.
Average real returns are negative during
extra-ordinary inflation periods.
Stock market returns were average during moderate
inflation.
6
What Stock Market Data Tells Us About Inflation
Rapidly decelerating inflation led to the highest
real returns.
Rapidly accelerating inflation led to the lowest
real returns.
7
Two Yardsticks For Timing The Stock Market
When average cash dividend yield for SP500 rises
above 5, the market has usually fallensome
interpret this as a buy signal.
8
Two Yardsticks For Timing The Stock Market
Some believe when SP500 Index P-E ratio lt 8 (gt
19) it is a signal to buy (sell).
9
Buy-Sell Guidelines

• Prior to 1991 the guidelines were sometimes
  profitable and sometimes not
• Technology stocks violated the guidelines during
  1990s
• Most investors do not blindly follow these
  guidelines
• Some only take action if both cash dividend yield
  and P-E ratio methods suggest the same action
• But these methods are nice and simple
• Also tend to agree with valuation theories

10
Problems with Guidelines

• What if the two guidelines offer conflicting
  signals?
• Since 1992 the cash dividend yield and P-E ratios
  were affected by
• The baby boom
• Rising labor productivity due to technological
  developments
• Addition of Internet and computer stocks to
  SP500 Index
• Increased used of stock repurchases

11
Investment Implications And The Baby Boom

• A large increase in the U.S. birthrate occurred
  from 1946 to 1962
• Caused a considerable impact on resource
  allocation
• Will continue to be felt through the decades as
  baby boomers retire
• Helpful to understand the life cycle theory of
  savings

12
Life Cycle Theory of Savings

• Assumption Typical consumer is happier if
  consumption of goods is apportioned equally
  throughout ones life
• Begins when a child becomes economically
  independent
• Young consumers typically borrow
• Their desired consumption is greater than income
• As income rises, debt is repaid and savings
  accumulate
• Savings peak at retirement
• Savings diminish throughout retirement

13
Chens 1990 Forecast

• The life cycle theory of savings has implications
  for the stock market
• Zhiwu Chen linked the life cycle theory of
  savings to the baby boom
• Predicted baby boomers would allocate significant
  portion of savings to equity and traced the
  implications to the stock market

14
Chens 1990 Forecast

• Hypothesized when baby boomers reached age 49,
  they would allocate an increasing portion of
  savings to stock market
• Thus, high levels of stock market investing
  should continue until baby boomers retire
• Forecasted bullish stock market beginning ? 1995
  and lasting through 2012 (when youngest baby
  boomers reach retirement age)
• Indeed a raging bull market begin in 1995
• The 1995-1999 average annual total return of
  SP500 was 28.8
• Far greater than the 1924-1994 average annual
  return of 11.2
• A long bear market is forecasted as baby boomers
  withdraw retirement funds from 2012-2042

15
Investment Implications and Stock Buybacks

• In 1997-98 amount spent on stock repurchases by
  large public corporations exceeded amount spent
  on cash dividends by this same group
• Stock repurchases by large non-bank corporations
  was nearly 150 billion
• Cash dividends were about 115 billion
• The shrinking cash dividend yield has modified
  the role of the traditional cash dividend yield
  in equity valuation

16
Increasing Labor Productivity and Investment
Implications

• Nations labor productivity can be measured in
  output per hour of work
• Output per hour aggregate real national output
  ? aggregate hours worked by nations labor force
• During 1980s U.S. labor productivity increased by
  1-2 per year
• Capital-to-labor ratio increased
• Education of labor force improved
• Rapid emergence of new technology
• During 1990s labor productivity increased by 2-3
  per year
• Wider implementation of computers and Internet
• If prices of raw material remain constant, an
  increase in output per hour worked will lead to
  lower unit labor costs
• Increases in labor productivity are
  anti-inflationary

17
Industry Analysis

• Industries are usually defined by a single
  product
• Thus, all companies within an industry usually
  profit or lose in tandem
• Therefore, it is worthwhile to examine an
  industrys prospects before bothering to examine
  specific firms within an industry

18
Product Life Cycle
19
Product Life Cycle

• Industrys life cycle determined by type of
  product
• Example Musical groups vs. Coca-Cola
• Coca-Cola has been in product maturation stage
  for over 100 years
• Life cycle model is important to many security
  analysts
• Must determine stage the industry, product or
  firm is in

20
Financial Analysis of an Industry

• Many different sources compile industry data
  useful to investors
• Standard Poors Corporation
• Moodys Investors Services
• Trade associations
• Government
• Standard Poors provides stock price indexes on
  numerous U.S. industries and also offers balance
  sheets, income statements, and financial ratios
  for
• 87 Industrial
• 13 Technology
• 4 Transportation
• 2 Utility
• 10 Financial

21
Valuing Internet Stocks

• A bull market for technology stocks existed
  during the latter half of the 1990s
• Can be attributed to
• Interest rates decreasing sharply during 1980s
  and 1990s
• Led to lower discount rates and higher present
  values
• Equity risk premiums declined due to long
  economic expansion and lower investor
  risk-aversion
• Led to even lower discount rates
• Earnings grew at fast pace
• Baby boomers and stock repurchases increased
  demand for equities
• Labor productivity increased in last half of 1990s

22
Valuing Internet Stocks

• By year 2000 the P-E ratio of SP500 was 2 times
  as high as normal and cash dividend yield was ½
  normal rate
• Suggests that stock market was over-priced
• Internet stocks were ridiculously over-priced
  using these investment gauges
• In January 2000 SP500 Index fell 5.0
• The SP Computer Software Index fell 17.5 during
  same period

23
Clicks vs. Bricks

• Are technology companies fundamentally different
  form the bricks-and-mortar (BM) blue chips?
• BM forecast sales by extrapolating historical
  sales
• Internet companies try to create growth by
  inventing new/improved products
• BM attempt to increase profit by cutting costs
• Internet companies raise prices to meet growing
  demand

24
Clicks vs. Bricks

• BM are burdened by fixed interest expense on
  debt
• Internet companies may have zero debtraise
  capital by issuing stock and paying stock
  dividends
• BM reward employees by increasing pay (and
  thereby increasing fixed costs)
• Internet companies offer stock options (with no
  increase in fixed costs)
• BM typically fight to maintain market share
• Internet companies strive to dominate market

25
Winner Take All

• A few Internet sites are very popular with many
  visitors, but many sites have few visitors
• A few websites enjoy huge market prices, but most
  are not worth much
• Popular websites become even more popular
• Prices of most popular website companies are bid
  up

26
Power Law Estimates

• The following power law equation does a good job
  of explaining total market capitalizations for
  over 100 Internet companies

• Power law equation explained over half the
  variation in total market capitalization of major
  Internet firms
• Explains relative prices fairly well, but offers
  no indication as to whether stock prices are too
  high or low

27
Example Power Law Equation

• Example In 1999 AOL was the 1 ranked Internet
  firm in terms of size
• The power law equation for AOL is

• Model predicts that Yahoo (2nd ranked in size)
  would be worth 49.65 as much as AOL
• Yahoo was actually worth less than forecasted

28
Slippery Slopes Around Winners Peak

• In 1997 Amazon.com, Inc. went public at 1.50 a
  share
• By 1999 Amazon traded at over 100 a share

29
Slippery Slopes Around Winners Peak

• While Amazons stock price rose, their losses
  increased.

30
Slippery Slopes Around Winners Peak

• Investors bid up Amazons price because they
  thought profits would eventually follow the
  losses
• Firms sales were rising
• If Amazons sales decline, etc., the stock price
  will drop very quickly
• A winners position is not easy to maintain
• If, for instance, the 1 ranked firm slipped into
  the 2nd position, the power law equation says its
  value will drop by half

31
P-E Ratios for Internet Stocks

• It is difficult to use ratios such as the P-E and
  cash dividend yield if firm pays no dividends or
  has earnings less than zero
• Chip Morrisportfolio manager of T. Rowe Price
  Science and Technology Funduses the practical
  price/earnings ratio to estimate value of tech
  stocks

32
P-E Ratios for Internet Stocks
33
Valuing Common Stock as a Call Option

• If a firms total liabilities gt total assets,
  creditors receive assets as partial payment
• Stockholders get nothing
• Can be equated to a call option model
• Creditors own the company and sell a call option
  on firms assets to stockholders
• Exercise price equals par value of firms debt
• If stockholders exercise option, they call in
  total assets but must pay all companys
  liabilities to keep assets
• If assets lt liabilities, option expires worthless
• Shareholders forfeit all claim on bankrupt firm
  to creditors

34
Conflicts of Interest

• Conflicts of interest exist between stockholders
  and bondholders
• Protective provisions of bond indenture
• Generally state that bonds coupon interest
  payments will be made on scheduled dates
• If scheduled payment is missed, bondholders can
  force firm into bankruptcy
• Bondholders are essentially exercising an option
  to call in assets before principal payment is due
• Bondholders gain control over corporation
• Offers evidence that shareholders have an
  American call option (not a European one)

35
Springdale Corporation Hypothetical Valuation
Case

• Springdale issues 30 million of mortgage bonds
  to finance plant and equipment purchases
• Offers 50 million in assets as collateral
• All debt have same maturity date
• No cash dividends can be paid until all debts are
  repaid

If Assets gt than Debt, shareholders will benefit
from paying D dollars to bondholders. If assets
lt D, share-holders will let option expire
worthless.
36
Springdale Corporation Hypothetical Valuation
Case

• Option theory suggests the following equation for
  calculating stock price when debt comes due
• Intrinsic value of stock Max 0, Assets Debt
  ? of outstanding common shares
• The value of the firms mortgage bonds is
• Min Debt, Assets

37
Springdale Corporation Hypothetical Valuation
Case

• If Springdales assets remain valued at 50
  million, changes in the value of the firms
  equity will be offset by equal and opposite
  changes in debt values
• Because A L E or
• Total Assets Aggregate debt owed to creditors
  Total equity of corporation
• Also, options have time value

38
Option Pricing Theory

• Option theory can also be used to gain insight on
• Pure speculations
• Firms near bankruptcy
• Firms currently being reorganized
• Leveraged buy-outs
• Management buy-outs
• Merged firms
• Emerging new firms
• Patents
• New technologies

39
Example Valuing a Patent

• Your corporation is offered a patent by a
  computer science professor on computer software
• Patent owner has right to develop and distribute
  product monopolistically
• What is this patent worth?
• Patent is call option on underlying software
  product
• Exercise price represents total initial
  investment
• Cost of patent, product development, marketing
  and legal costs
• Life of patent is 20 years (U.S. Patent Office)
• Probability distribution of expected cash flows
  from project will have big impact on value of
  option

40
Example Valuing a Patent
41
Price/Book Value Ratio

• Book value per share
• Total Assets Total Liabilities ? of
  outstanding common stock shares
• Determined by economic events and accounting
  conventions
• Compared to market value
• Determined by markets assessment of earning
  power
• Some argue that if market price of stock lt
  (significantly gt) book value, stock is
  underpriced (over-priced)
• Can be measured by using Price/Book Value ratio

42
Price/Book Value Ratio

• Price/Book Value (PBV) ratio
• Market price per share ? Book value per share
• In 1990 Fama and French, Pontiff and Schall, etc.
  suggested that PBV ratio has explanatory power
  over stock prices and returns
• Fama and French grouped assets into portfolios
• Kim argues that using individual assets rather
  than portfolios offers several advantages
• Additional work has cast doubt on use of PBV ratio

43
Analysis of PBV Ratio

• The basic DDM is

• But given that Div1 can be calculated as
• Payout ratio x EPS0 x (1g)
• The DDM can be rewritten as

44
Analysis of PBV Ratio

• Since EPS0 ROE x Book value per share, this can
  be rewritten as

• The PBV ratio can be obtained by dividing both
  sides by BV0

• If everything else remains the same, the higher
  ROE, the higher PBV

45
Over- and Under-Priced Stocks

• This explains why firms with high (low) ROEs have
  stock prices in excess of (below) book values
• Consider the following

• If a firm has high PBV ratio coupled with low ROE
• May be overpriced
• Remembermarket places more emphasis on expected
  earnings than historical earnings (EPS0)

46
Tobins Q Ratio

• Tobin offers a ratio similar to the PBV ratio
• Tobins Q Market value of firms assets ?
  Replacement value of firms assets in place
• Useful in a highly inflationary environment
• Useful when technological advances have decreased
  cost of replacing existing assets

47
The Bottom Line

• Inflation tends to have a negative impact on
  stock prices and returns in short-run
• In long-run inflation has no lasting impact
• Baby boomers are thought to have had an impact on
  the stock market and are expected to continue to
  do so
• Large influx of funds into market until baby
  boomer reach retirement years
• The life cycle of an industry is important in
  anticipating future developments

48
The Bottom Line

• A winner-take-all environment exists in the
  Internet business
• High start-up costs and low per unit costs
• Prices of Internet companies may be bid up by
  investors expectations of future profits
• Call option model can be used to price unusual
  equity positions
• Book values can help determine the value of an
  inactively traded company
• If an actively-traded company has a stock price
  far below its book value, it may be underpriced
• If price is much greater than book value, it may
  be over-priced