Sources and Measures of Stock Market Value

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Sources and Measures of Stock Market Value

• By Joe Blades

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An Evil Omen Returns

• In 1958 interest rates on long term government
  bonds exceeded dividend yields on common stocks.
• History of the correlation of long term bonds and
  dividend yield rates from 1871 to 2001
• Note graph

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Dividend vs. Long Term Bond
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Rationale

• What happened to the trend?
• After 1958 market went upward as dividend yields
  slowly decreased.
• What would have happened to the value investor in
  1958?

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Valuation of Cash Flows from Stocks

• The very basic sources of stock value are the
  dividends and earnings of a firm. (if a stock
  offers no dividends then what do they do with
  those retained earnings)
• Stocks have value based on potential cash flows
  for the investor.
• These cash flows can come from many different
  sources (dividends, potential for retained
  earnings, capital gains form sale of stock)

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Valuation of Cash Flows continued

• The value of any asset is determined by
  discounting the value of all future cash flows.
• Cash you receive in the future is not worth as
  much as cash you receive at the present.
• Three main reasons for discounting1. Time
  Preference 2. Productivity 3. Inflation 4.
  Volatility of Future.

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Sources of Shareholder Value

• Payment of cash dividends
• Repurchase of shares
• Retirement of debt
• Investment in securities, capital projects, or
  other firms
• Retained earnings (if used wisely) (also tax
  benefits)

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Reason for Retained Earnings

• If a company is retaining earnings and not paying
  a dividend what are they doing ?
• Is it more beneficial to retain earnings or pay a
  regular dividend ?

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The P/E Ratio

• The most fundamental yardstick for valuing stocks
  
• Measures how much an investor will pay for a
  dollars worth of current earnings
• Influenced by numerous factors (interest rates,
  risk attitudes of investors, taxes, and
  liquidity)
• Can be misleading in the short term, but is
  proven as a long term predictor.

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P/E ratios of the market

• Sharp drops in earnings will drive up P/E ratios
  and is ultimately positive.
• Surges in stock price affect P/E upward but is
  ultimately negative.

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Historical P/E Graph
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Earnings Definitions

• Can be misleading
• Reporting earnings, Operating earnings, Bottom-up
  earnings, etc.
• The earnings number can be quite different
  depending on the number that is used.

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Book Value and Market Value

• Book value is simple Assets Liabilities
• Market value takes into account the changes in
  cost over time.
• Plot of land example

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Basic Fed Model

• Bonds are the chief alternative to stocks
• Return on bonds (interest yield)
• Return on stocks (earnings yield)
• What happens when earnings yield falls below
  interest yield?

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Recent history of the market

• 1982-1999
• great bull market (Tech Boom)
• 2000
• crash of the tech boom
• 2001
• more market turmoil with terrorist attacks
• 2002 - present
• battling back with another bull market