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Chapter 14 FUNDAMENTALS OF COMMON STOCK VALUATION. What is intrinsic value (IV)? What is the dividend discount model (DDM)? What is the earnings model (EM)? How does an investor conduct fundamental analysis on a company stock?. FUNDAMENTALS OF COMMON STOCK VALUATION- Cont.

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Chapter 14FUNDAMENTALS OF COMMON STOCK VALUATION

  • What is intrinsic value (IV)?

  • What is the dividend discount model (DDM)?

  • What is the earnings model (EM)?

  • How does an investor conduct fundamental analysis on a company stock?

Contemporary Investments: Chapter 14


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FUNDAMENTALS OF COMMON STOCK VALUATION-Cont.

  • How can an investor value a stock with nonconstant growth?

  • How is the market-to-book ratio (MV/BV) used for investment purposes?

  • What are the pros and cons of using the price/earnings multiple, or P/E ratio?

Contemporary Investments: Chapter 14


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Intrinsic Value

  • Definition of an intrinsic value

    • What affects intrinsic value

    • How to invest based on intrinsic value

      • Undervalued

      • Overvalued

Contemporary Investments: Chapter 14


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Four intrinsic valuation models

  • Dividend Discount Model (DDM)

  • Earnings Model (EM)

  • P/E Ratio

  • MV/BV Ratio

Contemporary Investments: Chapter 14


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Dividend Discount Model (DDM)

  • Develop the intrinsic value, Vs0

  • Two implications

  • The general Dividend Discount Model

    • An example: Lone Star Steakhouse (STAR)

Contemporary Investments: Chapter 14


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Figure 14.1 – General Rule for Fundamental Analysis

Contemporary Investments: Chapter 14


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Figure 14.2 – Summary of the STAR Example

Contemporary Investments: Chapter 14


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Trading rule for fundamental analysis

  • Undervalued

  • Overvalued

Contemporary Investments: Chapter 14


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Earnings Model (EM)

  • Lone Star Steakhouse: An Earnings Model example

  • The no-growth example

  • The constant-growth example

Contemporary Investments: Chapter 14


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Implications for growth companies

  • Discussion of the five implications

  • Contrast growth company with a growth stock

Contemporary Investments: Chapter 14


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Fundamental Analysis in Practice

  • Estimate Growth, g

    • historical dividend trend growth rate

    • historical EPS trend growth rate

    • growth rate g = ROE x b

  • Estimate the required rate of return, ERs

  • Estimate DIV1

Contemporary Investments: Chapter 14


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Figure 14.3 – Value Line Report for Lone Star Steakhouse (STAR)

Contemporary Investments: Chapter 14


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Caveats for DDM

  • DDM is very sensitive to changes in g

  • The market risk premium, (ERM-RF) is difficult to determine

  • ROE1 is a book value and is an average of many project returns

Contemporary Investments: Chapter 14


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Nonconstant-Growth Model

  • Value the nonconstant-growth phase via an example

  • Value of the constant-growth phase

  • Intrinsic value of a two-phase nonconstant growth stock

  • General formula for nonconstant-growth model

  • Three-phase nonconstant-growth model

  • Estimating the nonconstant and constant growth rates

Contemporary Investments: Chapter 14


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Market-to-Book Ratio (MV/BV)

  • Define Market-to-Book Ratio (MV/BV)

  • Why it may discover undervalued stocks

  • Beware of MV/BV

Contemporary Investments: Chapter 14


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Price/Earnings (P/E) Ratio

  • Define Price/Earnings (P/E) Ratio

  • Interpret P/E ratios

  • Determining value from P/E

  • What about low P/Es?

  • Implications for investors

Contemporary Investments: Chapter 14


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Two alternative ways to use P/E

  • Holt’s alternative use of P/E

  • Firms that pay no dividends or when g > ERs

  • Implications for investors using fundamental analysis

  • A growth company may not necessarily be a good investment

  • Use P/E and MV/BV with caution

Contemporary Investments: Chapter 14