Chapter 18_Hand-out 13(1)

Chapter 18_Hand-out 13(1) - CHAPTER 18 EQUITY VALUATION...

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CHAPTER 18 EQUITY VALUATION MODELS This chapter describes the ways stock market analysts try to uncover mispriced securities. The models presented are those used by fundamental analysts , those analysts who use information concerning the current and prospective profitability of a company to assess its fair market value. Fundamental analysts are different from technical analysts, who essentially use trend analysis to uncover trading opportunities. 18.1 VALUATION BY COMPARABLES The purpose of the fundamental analysis is to identify stocks that are mispriced relative to some measure of “true” value that can be derived from observable financial data. There are many convenient sources of such information. (Many web sites such as finance.yahoo.com and EDGAR web site, www.sec.gov/edgar.shtml of the Securities and Exchange Commission in the U.S. provide analysis and data derived from the EDGAR reports. Another source available to users of this text is Standard & Poor’s Market Insight Service which includes COMPUSTAT. Table 18.1 in the textbook shows COMPUSTAT’s selection of financial highlights for Microsoft Corporation on October 25, 2007. ) Of course, true values can only be estimated. In practice, stock analysts use models to estimate the fundamental value of a corporation’s stock from observable market data and from the financial statements of the firms and its competitors. These valuation models differ in the specific data they use and in the level of their theoretical sophistication. 1. Limitations of Book Value The market price of a share of Microsoft stock on October 25, 2007 was 9.4 times its book value. Book value is the net worth of a company as reported on its balance sheet. For the average firm in the PC software industry it was 6.3. By comparison with this standard Microsoft seems a bit overvalued. What is the difference between book and market value per share? Whereas book values are based on original cost, market values measure current values of assets and liabilities. The market value of shareholder’s equity investment equals the difference between the current values of all assets and liabilities. We have emphasized that current values generally will not match historical ones. Equally or even more important, many assets, for example, the value of a good brand name or specialized expertise developed over many 1
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years, may not be even included on the financial statements. Market prices therefore reflect the value of the firm as a going concern. In other words, the market price reflects the present value of its expected future cash flows. It would be unusual if the market price of a stock were exactly equal to its book value. Can book value represent a “ floor ” for the stock’s price, below which level the market price can never fall? Although Microsoft’s book value per share in 2007 was less than its market price, other evidence disproves this notion. While it is not common, there are always some firms selling at a market price below book
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Chapter 18_Hand-out 13(1) - CHAPTER 18 EQUITY VALUATION...

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