Price - Earnings Meinod Valuation per share = Expected Earnings of Firm ger share Consider a firm that is expected to generate earnings of $3 per share next year. If the mean ratio of share price to expected earnings of competitors in the same industry is 15, then the valuation of the firm's shares is Valuation per share Expected earnings of fim per share x Mean industry PE ratio 8x5 = . Dividend Discount Model oO > present value of the stocks future dlividends Price = y oe ce (te) ne gaee joe gent? v a Da De + Par Tun yr med iaineyy Dy * dividend in period * += period k= discount rote, To illustrate how the dividend discount modet can be used to value a stock, consider a stock that is ‘expected to pay a dividend of $7 per share annually forever. This constant dividend represents a perpe> (Ruty, oran annuity that lasts forever, Hence the present value of the cash flows (dividend payments) to investors in this example is the present value of a perpetuitys/Assuming|that'the\required'rate‘of Feturn(k)'on the stock of concemis 14 percent the present¥vale (PV) ofthe future dividends is te ao sen Antnenee = $7/014 perperual $50 per share . Unfortunately, the valuation of most stocks is not ths simple because thir dividends are sot expected to remain constant freer, IAEA ERPS FONSI SCORSBUT however, the stock can be valued by applying the constant- growth dividend discount model: PUG SOCK IA/KEG] —> constant cate tbe pa over she OUI fi te lividend is expected PV of stock — $7/(0.14 - 0.04) = $10 per sharediviclencks [dividends : EC1+G) Forcasted earnings in n years E - existing earnings G ~ growth rate a - number of years If investors expect that the earnings per share will grow by 2)percent annually and expect to sell the firm's stock in three years, the earnings per share in three years are forecast to be Earnings in three years = $12 x (1 +- 0.02)? = $12 1.0612 The forecasted earnings per share can be multiplied by the PE ratio of the firm's industry to fore- ‘cast the future stock price. If the mean PE ratio of all other firms in the same industry is 6, the stock price in three years can be forecast as follows: ——Fiaice, ua ‘This forecasted stock price can be used along with expected ddividends/and the investor's required Fate [of return to value the stock today, If the firm is expected to pay a dividend of $4 per share ‘over the next three years and if the investor's required rate zent, then the pres- cent value of expected cash flows to be received by the invest 4 sacs) $3.08 + $270 + $51.5 . In this example, the present value of the cash flows the present value of dividends to be received over the three-year investment horizon, which is $9.29 per share ($3.51 + $3.08 + $2.70), and (2) the present value of the forecasted price at which the stock can be sold at the end of the three-year investment horizon, which is $51.55 per share. Capital asset Pricing Model Ry = Ry +B) CR RED Stock Risk ge (SPoINV) +O INV Inv = itil javestment D - dividends SP - selling price of stockStock Valuation Practice Problems The Bulldog Company paid $1.5 of dividends this year. If its dividends are expected to row at a rate of 3 percent per year, what is the expected dividend per share for Bulldog five years from today? The current price of XYZ stock is $25 per share. If XY2's current dividend Is $1 per share and investors’ required rate of return is 10 percent, what is the expected growth rate of dividends for XYZ, based on the constant growth dividend valuation model? 3. Consider each of the following stocks, and solve for the missing element: Current Expected Required Value of years growthin rateof a share Stock dividend dividends return of stock nN $1.00 * x 8 x 6% $26,000 c $1.00 1x $21,000 ° $0.75 x S7.430 E $1.10 “ 10% 1. Risk-Adjusted Return Measurements Assume the following information over a five-year period: m Average risk-free rate % 6% @ Average return for Crane stock % 11% @ Average return for Load stock % 14% m Standard deviation of Crane stock returns % 2% @ Standard deviation of Load stock returns % 4%@ Beta of Crane stock % 0.8 @ Beta of Load stock % 1.1 Determine which stock has higher risk-adjusted returns according to the Sharpe index. Which stock has higher risk-adjusted returns according to the Treynor index? Show your work. 2. Measuring Expected Return Assume Mess stock has a beta of 1.2. If the risk-free rate is 7 percent and the market return is 10 percent, what is the expected return of Mess stock? 3. Using the PE Method You found that Verto stock is expected to generate earnings of $4.38 per share this year and that the mean PE ratio for its industry is 27.195. Use the PE valuation method todetermine the value of Verto shares. 4. Using the Dividend Discount Model Suppose that you are interested in buying the stock of a company that has a policy of paying a $6 per share dividend every year. Assuming no changes in the firm's policies, what is the value of a share of stock if the required rate of return is 11 percent? 5. Using the Dividend Discount Model Micro, Inc., will pay a dividend of $2.30 per share next year. If the company plans to increase its dividend by 9 percent per year indefinitely, and you require a 12 percent return on your investment, what should you pay for the company’s stock? 6. Using the Dividend Discount Model Suppose you know that a company just paid an annual dividendof $1.75 per share on its stock and that the dividend will continue to grow at a rate of 8 percent per year. If the required return on this stock is 10 percent, what is the current share price? 7. Deriving the Required Rate of Return The next expected annual dividend for Sun, Inc., will be $1.20 per share, and analysts expect the dividend to grow at an annual rate of 7 percent indefinitely. If Sun stock currently sells for $22 per share, what is the required rate of return? 8. Deriving the Required Rate of Return A share of common stock currently sells for $110. Current dividends are $8 per share annually and are expected to grow at 6 percent per year indefinitely. What is the rateof return required by investors in the stock? 9. Deriving the Required Rate of Return A stock has a beta of 2.2, the risk-free rate is 6 percent, and the expected return on the market is 12 percent. Using the CAPM, what would you expect the required rate of return on this stock to be? What is the market risk premium? 10. Deriving a Stock’s Beta You are considering investing in a stock that has an expected return of 13 percent. If the risk-free rate is 5 percent and the market risk premium is 7 percent, what must the beta of this stock be? 11. Measuring Stock Returns Suppose you bought astock at the beginning of the year for $76.50. During the year, the stock paid a dividend of $0.70 per share and had an ending share price of $99.25. What is the total percentage return from investing in that stock over the year? 14. Value at Risk Assume that Quitar Co. has a beta of 1.31. a. If you assume that the stock market has a maximum expected loss of -3.2 percent on a daily basis (based on a 95 percent confidence level), what is the maximum daily loss for the Quitar Co. stock? b. If you have $19,000 invested in Quitar Co. stock, what is your maximum daily dollar loss?