chapter 18 investing in stocks lawrence j. gitman jeff madura introduction to finance

Chapter

18

Investing in Stocks

Lawrence J. GitmanJeff Madura

Introduction to Finance

18-2Copyright © 2001 Addison-Wesley

Explain how stocks can be valued using valuation models that are alternatives to the dividend discount model.

Explain the valuation of the stock market.

Describe the valuation and performance of initial public offering (IPO) stocks.

Identify benchmarks commonly used for assessing investment performance.

Describe the forms of stock market efficiency.

Describe the valuation, performance, measurement, and efficiency of foreign stocks.

Learning Goals


Alternative Stock Valuation Models

The Basic Stock Valuation Equation Recall from Chapter 7, the basic stock valuation method (also

referred to as the dividend discount model) can be expressed as:

Unfortunately, this model is not directly applicable to valuing firms that have low or zero dividends—so alternative methods must be used.


P/E Multiples This approach is popular because many investors believe

earnings are a good proxy for a firm’s cash flows.

A firm’s stock can be valued using the P/E method by multiplying the industry average P/E ratio by the firm’s expected earnings.




P/E Multiples Critical to this approach is the determination

of a firm’s forecasted earnings.

Unfortunately, it is not uncommon for these forecasts to be off by as much as 20 to 40 percent.

Earnings can be forecast using outside sources (Value Line), or can be forecast directly using pro forma income statements.

This is demonstrated on the following slide.



P/E Multiples

Table 18.1



P/E Multiples



P/E Multiples Limitations of applying P/E multiples include

the following:

• Uncertainty surrounding the proper earnings forecast.

• Uncertainty surrounding the proper P/E multiple (see Table 18.2 on the following slide).

• P/E multiple is not applicable to firms with negative earnings.



P/E Multiples

Table 18.2



Book Value Multiples A book value multiple is the market value of the firm’s

common stock in relation to (as a multiple of) the book value of the firm’s common stock as shown in the financial statements.

The market/book (M/B) ratio is the market value per share dividend by the book value per share and can be used for valuation purposes as shown below:


Book Value Multiples The M/B ratio is subject to error if an improper M/B

is applied.

A second problem with this approach is that the book value of a firm does not reflect relevant information such as the firm’s potential for growth.

Investors may adjust the industry M/B ratio for firms differences.

However, these adjustments are also subject to error.




Revenue Multiples A common revenue multiple used for valuing a firm’s

stock is the price/revenue (P/R) ratio, which is the ratio of the share price to a stock’s revenue per share.

Unfortunately, the P/R ratio generally suffers from the same shortcomings as the M/B ratio.



Revenue Multiples

Table 18.3



Valuation During the Recent Market Run-Up Explanations based on the dividend discount model

Explanations based on the speculative-bubble theory


Valuation and Performance of IPO Stocks

Valuation

Performance


Stock Performance Benchmarks for Investors

Market Indexes Dow Jones Industrial Average

Standard & Poor’s 500

New York Stock Exchange Index

Nasdaq Composite

Sector Indexes

Stock Price Quotations


Stock Quotations

Figure 18.2 (Panel 1)


Stock Quotations



ADR Quotations

Figure 18.3


Stock Market Data Bank



Stock Market Efficiency

Table 18.4

Forms of Efficiency



Evidence of Inefficiency January effect

Monday and weekend effects

Size effect

Price/earnings effect



Limitations on Capitalizing on Price Discrepancies Trading commissions

Tax effects

Relationships are not applicable to all firms


Foreign Stocks

Valuing Foreign Stocks Dividend discount model

Price/earnings (P/E) method

Foreign Stock Performance Benchmarks

Foreign Stock Market Efficiency

Chapter

18

End of Chapter

Lawrence J. GitmanJeff Madura

Introduction to Finance

chapter 18 investing in stocks lawrence j. gitman jeff madura introduction to finance

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