CHAPTER 6 Common Stock Valuation Chapter Sections: Security Analysis: Be Careful Out There The Dividend Discount Model The Two-Stage Dividend Growth Model The Residual Income Model The.
Download ReportTranscript CHAPTER 6 Common Stock Valuation Chapter Sections: Security Analysis: Be Careful Out There The Dividend Discount Model The Two-Stage Dividend Growth Model The Residual Income Model The.
CHAPTER 6 1 Common Stock Valuation Chapter Sections: Security Analysis: Be Careful Out There The Dividend Discount Model The Two-Stage Dividend Growth Model The Residual Income Model The Free Cash Flow Model Price Ratio Analysis An Analysis of the McGraw-Hill Company “Value matters. You ignore value at your peril.” Greg Ireland, mutual fund manager with over 35 years experience Common Stock Valuation Stock Valuation The process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance At any given time, the price of a share of common stock depends on investors’ expectations about the future behavior of the security A fundamental assertion of finance holds that the value of a stock is based on the present value of its future cash flows (a.k.a. earnings) The worth of a company is primarily based on the earnings the company will produce in the future. But if we knew what was going to happen in the future, it would not be called the future, would it? 2 3 Common Stock Valuation (continued) Stock Valuation “The most fundamental influence on stock prices is the level and duration of the future growth of earnings and dividends. [However,] future earnings growth is not easily estimated, even by market professionals.” – Burton Malkiel, A Random Walk Down Wall Street So, if someone were to ask you, “What is the most important factor in determining the future value of a company?” In a few words, you could say, “FUTURE EARNINGS!” (or FUTURE DIVIDENDS) But do any of us know what is going to happen in the future? “NO!” So is valuing stock going to be easy? “NO!” 4 Security Analysis Security Analysis The process of gathering and organizing information and then using it to determine the value of a share of common stock Intrinsic Value The underlying or inherent value of a stock, as determined through security analysis The question is, “What security analysis methods or measures does one use to determine the intrinsic value of a company?” Future dividends? Potential capital appreciation? Price/earnings ratio? Financial ratios? Past price performance? Amount of risk? Value is in the eye of the beholder. 5 Fundamental Analysis Fundamental Analysis Examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock Examples of some of the Fundamentals: The competitive position of the company Growth prospects for company and its market Profit margins and company earnings What assets are available The company’s capital structure How much debt, how much equity Simply put, the value of a stock is influenced by the performance of the company that issued the stock. 6 Financial Ratio Analysis Financial Ratio Analysis One method of security analysis involves looking at certain financial ratio measures Financial ratios give us a quick and easy method for comparing one company to other companies within their industry or the stock market as a whole The problem with financial ratios is that there is no single financial ratio that can adequately sum up or summarize the overall general state of affairs, situation, predicament, etc., that a company finds itself in The first financial ratios we will investigate will be price ratios. We will look at others later on. 7 Price to Earnings Ratio Price to Earnings Ratio (Review) a.k.a. Price-earnings Ratio, P/E Ratio, P/E, PE Current Price divided by Earnings per Share Examples: Hormel (HRL), HP (HPQ), Hyatt (H) Current Market Price P/E Ratio = –––––––––––––––––––––––––––––––––––– Earnings per Share (EPS) The most popular stock market statistic! Historically, P/E ratios were in the 5 to 12 range for mature companies and 14 to 20 range for growing companies. Greater than 20 was unusual. In the 1990’s, it was commonplace. Now, P/E ratios are all over the map! 8 Price to Earnings Ratio (continued) Historically, A company’s P/E Ratio was supposed to match its growth rate. If a company was growing at 20% per year, then a P/E of 20 was justified. During the Internet bubble, many companies had P/E ratios in the hundreds eBay’s P/E was 10,000 for a time during the mania! At that P/E, it would take eBay 10,000 years to earn its price “Growth” stocks typically have high-P/E Ratios “Value” stocks typically have low-P/E Ratios But remember our discussion of “growth” vs “value” A “value” stock might not necessarily be a good value! The P/E Ratio tells you how long it will take in years (assuming no changes in earnings) for the company to earn back its price. A P/E of 3 will take three years. A P/E of 20 will take twenty years. 9 Price-to-Cash Flow Ratio Price-to-Cash Flow Ratio Current price divided by current cash flow per share Cash flow often differs from earnings per share For several reasons – one major reason is… Depreciation is not an actual cash expenditure But there are many reasons cash flow & earnings differ “Good quality” versus “poor quality” earnings Current Price Price-Cash Flow Ratio = –––––––––––––––––––––––––––– Cash Flow per Share During the Internet mania, many companies were reporting record earnings. At the same time, their cash flow was negative. Huh? How could that be? Example: Lucent Technologies 10 Price-to-Sales Ratio Price-to-Sales Ratio Current price divided by annual sales per share Historically, a higher Price-to-Sales Ratio suggested a higher sales growth And a lower Price-to-Sales Ratio suggested a lower sales growth Current Price Price-to-Sales Ratio = ––––––––––––––––––––––––––––– Annual Sales per Share During the Internet mania, many analysts used Price-to-Sales instead of Price-to-Earnings since most all of the new companies never generated any earnings! 11 Price-to-Book Ratio Price-to-Book Ratio Current price divided by book value Historically, if the Price-to-Book Ratio was greater than 1.0, then shareholders believed that the firm was creating value above and beyond the physical assets of the corporation Current Price Price-to-Book Ratio = ––––––––––––––––––––––––––––– Book Value per Share The Book Value of a stock is the value of the assets the company possesses. Historically, it was fairly close to the price of the stock. Today, it is rarely close to the price of the stock. 12 Applications of Price Ratio Analysis To predict future stock price using price ratios, Multiply a historical price ratio by the expected future value price-ratio denominator (“What? Huh?”) Price-to-Earnings Per Share Example Page 204, 6th Edition: Intel Corp (INTC) – Price-to-Earnings (P/E) Analysis Late-2009 stock price Late-2009 EPS 5-year average P/E ratio EPS growth rate $19.40 $0.92 20.96 P/E 8.5% Expected stock price = historical P/E ratio projected EPS* $20.92 = 20.96 $0.92 (1 + 0.085) *projected EPS = current EPS * (100% + expected EPS growth rate) 13 Applications of Price Ratio Analysis (continued) Applications of Price Ratio Analysis (continued) Price-to-Cash Flow Per Share Example Page 204, 6th Edition: Intel Corp (INTC) – Price-to-Cash Flow (P/CF) Analysis Late-2009 stock price Late-2009 CFPS 5-year average P/CF ratio Cash Flow Per Share growth rate $19.40 $1.74 10.85 P/CF 7.5% Expected stock price = historical P/CF ratio projected CFPS* $20.29 = 10.85 $1.74 (1 + 0.075) *projected CFPS = current CFPS * (100% + expected CFPS growth rate) This is fairly close to the Price-to-Earnings estimate 14 Applications of Price Ratio Analysis (continued) Applications of Price Ratio Analysis (continued) Price-to-Sales per Share Example Page 204, 6th Edition: Intel Corp (INTC) – Price-to-Sales (P/S) Analysis Late-2009 stock price Late-2009 SPS 5-year average P/S ratio Sales Per Share growth rate $19.40 $6.76 3.14 P/S 7.0% Expected stock price = historical P/S ratio projected SPS* $22.71 = 3.14 $6.76 (1 + 0.07) *projected SPS = current SPS * (100% + expected SPS growth rate) A bit more optimistic, yes? 15 Reality Check! Can we reasonably assume that the formulas on the previous slides will give us realistic figures? For many companies, yes For many companies, no But there are countless other factors at work It is like trying to predict the weather – only worse! The major assumption of these models is that the price multiples will remain constant. However, we are using averages without taking into account the variances and standard deviations of the averages. (Remember them?) Is it reasonable to expect predictions from these models to be accurate if the variances of the averages are large? 16 Reality Check! (continued) For the record, the price of Intel one year later in late-2010 was around $20.50 Not bad, eh? Well, one out of four ain’t good! The predictions from the 3rd, 4th, and 5th editions for the next year prices of Intel were far from the actual prices 3rd edition predictions: $19.61, $27.54, and $31.63 The actual price one year later was $33.50 4th edition predictions: $50.84, $43.49, and $40.92 The actual price one year later was $17.50 5th edition predictions: $25.47, $25.36, and $29.63 The actual price one year later was $20.00 Notice that the 3rd edition predictions were too low and the 4th and 5th edition predictions were too high. Gives you lots of confidence in the price models, huh? Take heart, the predictions for Disney from the book were much closer to the actual prices. 17 Dividend Discount Models Shares of stock are valued on the basis of the present value of the future dividend streams the stock is projected to produce a.k.a. DDMs, Dividend Valuation Models (DVMs), Discounted Cash Flows Models Recall: The value of a stock is based on the present value of its future cash flows Therefore, dividend discount models should be extremely popular, right? During the 1990’s, investors who adhered to these types of models were considered old fashioned and outdated. But those investors weathered the 2000-2002 downturn very well. Dividends have become important again. 18 Dividend Discount Models (continued) Dividend Discount Model (Purest incarnation) Value of stock = present value of all expected future dividend payments D1 D2 D3 DT P0 2 3 1 k 1 k 1 k 1 k T Example 6.1: Page 183, 6th edition Three annual dividends of $100 per share Required rate of return = 15% ($100/1.15)+($100/1.152)+($100/1.153) = $228.32 But how many companies pay three annual dividends and then go out of business?! Plus, we keep using this term “present value.” What does it mean anyway? 19 What is “Present Value?” Present Value The value today of a lump sum (or series of payments) to be received at some future date It is the opposite of future value! (a.k.a. the inverse) Remember the optional future value calculations? Future value of $10,000 in 10 years at 8% $10,000 * 2.1589 = $21,589 (1 + 8%) 10 years Present value of $21,589 in 10 years at 8% $21,589 * 0.4632 = $10,000 $10,000 * 2.1589 = $21,589 1 1 (1 + 8%) 10 years Present value and future value are just two sides of the same coin. In finance, present value tells us what the future value is worth now. 20 Present Value & DDM (continued) Did the formula for the DDM scare you? D1 D2 D3 DT P0 2 3 1 k 1 k 1 k 1 k T This formula has the present value calc built into it We mortals simply use the Present Value tables Just as we used the Future Value tables in Chapter 1 The formula becomes: Value = Dividend1*PVM1 + Dividend2*PVM2 + Dividend3*PVM3 + etc PVM1 is the present value multiplier for the rate of growth for one year, PVM2 is the multiplier for two years, etc. 21 Present Value & DDM (continued) Let’s do the same example over again Using the Present Value Multipliers from the Present Value Table on the class web site http://wonderprofessor.com/123s12/Chap06/Chap06_PresentValueTable.pdf Three annual dividends of $100 per share Required rate of return = 15% Value = ($100*0.870) + ($100*0.756) + ($100*0.658) = $87.00 + $75.60 + $65.80 = $228.40 $228.32 (from page 183) What is the present value of the future stream of dividends? At 15%, $100 in 1 year is worth $87, in 2 years $75.60, 3 years $65.80. The sum of the present values of the future dividend cash flows equals our perceived value of the stock. 22 Dividend Discount Models (continued) Zero Growth Model (Not covered in our book) Assume dividends will continue at a fixed rate indefinitely into the future Annual dividends Value of stock = ─────────────── Required rate of return Example: Annual dividend = $3.00 per share Required rate of return = 6% $3.00 / 6% = $50.00 per share Does the Zero Growth Model look familiar? It is simply another way to view Dividend Yield. 23 Dividend Discount Models (continued) Zero Growth Model (Not covered in our book) Assume dividends will continue at a fixed rate indefinitely into the future Annual dividends Value of stock = ─────────────── Required rate of return Annual dividends Dividend Yield = ─────────────── Market price of stock Investors who emphasize the Zero Growth Model are valuing the stock almost exclusively for its dividend yield. 24 Dividend Discount Models (continued) Zero Growth Model (Real-life Example) Consolidated Edison – ED (Utility income stock) Current market price is $59.13 per share (10 Feb 2012) Currently paying $2.42 per year in annual dividends The question is, “What is our required rate of return?” Let’s first use 8% Value = $2.42 / 8% = $30.25 The stock is overpriced if our required rate of return is 8% What about 5%? Value = $2.42 / 5% = $48.40 The stock is still too expensive if our required return is 5% With a market price of $59.13, the stock is yielding 4.1%. The Zero Growth Model works well for stable, income-producing stocks. 25 Dividend Discount Models (continued) Constant Perpetual Growth Model Assume dividends will continue to grow at a specified rate perpetually into the future Annual dividends * (1+Constant growth rate) Value of stock = Required ─────────────────── rate of return – Constant growth rate Example 6.3: Page 184, 6th edition Annual dividend = $10 per share (Next year’s=$10.50) Annual dividend growth rate = 5% per year Required rate of return = 15% ($10 * 1.05) / (15% - 5%) = $10.50 / 10% = $105 The stock should be worth $105 per share Good for companies with consistent dividend growth. 26 Dividend Discount Models (continued) Constant Perpetual Growth Model (Real-life Example) Johnson & Johnson (blue chip) Current market price is $64.60 (10 Feb 2012) Currently paying $2.28 annual dividends Assume dividends growing around 8% per year Our required rate of return is 13% ($2.28 * 1.08) / (13% - 8%) = $2.4624 / 5% $49.25 Not a great buy if we require 13%, huh? What if our required rate of return were only 10%? ($2.28 * 1.08) / (10% - 8%) = $2.4624 / 2% $123.12 What a deal! Note: The model is very sensitive to our choice of our required rate of return Do you think Johnson & Johnson is a good value? 27 Dividend Discount Models (continued) Constant Perpetual Growth Model (Real-life Example) Proctor & Gamble (blue chip) Current market price is $63.88 (10 Feb 2012) Currently paying $2.10 annual dividends Assume dividends growing around 8% per year Our required rate of return is 13% ($2.10 * 1.08) / (13% - 8%) = $2.268 / 5% $45.36 Proctor & Gamble doesn’t quite measure up to our 13% rate What if our required rate of return were only 10%? ($2.10 * 1.08) / (10% - 8%) = $2.268 / 2% $113.40 The model says P&G is undervalued if we require only 10% Are people all of a sudden going to stop using soap, toothpaste, diapers, toilet paper, shampoo, and shaving cream? 28 Dividend Discount Models (continued) Constant Perpetual Growth Model (Real-life Example) Coca-Cola (blue chip) Current market price is $67.94 (10 Feb 2012) Currently paying $1.88 annual dividends Assume dividends growing around 8% per year Our required rate of return is 13% ($1.88 * 1.08) / (13% - 8%) = $2.0304 / 5% $40.61 So much for caramel colored, fizzy sugar water! What if our required rate of return were only 10%? ($1.88 * 1.08) / (10% - 8%) = $2.0304 / 2% $101.52 Maybe we ought to spend more time researching KO … In the United States, the average person drinks 360 Cokes a year. In China, the average is only 6 per year. In India, it is 2. 29 Dividend Discount Models (continued) Constant Perpetual Growth Model (Real-life Example) GE (blue chip) Current market price is $18.88 (10 Feb 2012) Currently paying $0.68 annual dividends Assume dividends also growing around 8% per year What if our required rate of return is 13% ($0.68 * 1.08) / (13% - 8%) = $0.743 / 5% $14.69 Uh, GE does not look so good if we want 13% How about 10%? ($0.68 * 1.08) / (10% - 8%) = $0.743 / 2% $36.72 If we are happy with 10%, GE appears to be a great deal But this is after GE dropped its dividend down to $0.40 (from $1.24) in 2009 after decades of growing the dividend. In 2010, they started raising the dividend again, first to $0.48, then $0.56, $0.60, and now to $0.68 per year. 30 Dividend Discount Models (continued) Constant Perpetual Growth Model (Real-life Example) Altria (blue chip) Current market price is $29.21 (10 Feb 2012) Currently paying $1.64 annual dividends Assume dividends also growing around 8% per year Same required rate of return of 13% ($1.64 * 1.08) / (13% - 8%) = $1.7712 / 5% $35.42 What a buy! Better than a 13% rate of return! If you ignore the potential tobacco related lawsuit damage And that tobacco kills 400,000 Americans each year… Using this model, investors are currently requiring approximately a 14.06% required rate of return ($1.64 * 1.08) / (14.06% - 8%) $29.23 Hey! Would you buy Altria? 31 Dividend Discount Models (continued) Constant Perpetual Growth Model (continued) The Constant Perpetual Growth Model is very sensitive to the assumed growth rate of dividends The recent dividend growth rates of Coke, Altria, P&G, and J&J are all currently higher than 8% Coke is 9.9%, Altria is 12.5%, P&G is 13.2%, and J&J is 14.2%! But the model does not work if the required rate of return is equal to or less than the dividend growth rate (You get division by zero or negative prices) Therefore, we should actually raise our expected rates of returns for all of these companies! All are actually much better buys than what the model is telling us for our 10% or 13% rates of return Note: These are blue chip companies with long histories of rising dividends 32 Dividend Discount Models (continued) Constant Growth Model Assume dividends will continue to grow at a specified rate for a specified number of years D0(1 g) P0 kg Constant Perpetual Growth Model T 1 g 1 1 k ¡Aye, Paquito! Do we have to know how to do this?! (No.) Added term to account for growth for a number of years This model takes the Constant Perpetual Growth Model one step further, adding a term to account for constant growth for a number of years Just as the Constant Perpetual Growth Model evolved from the Zero Growth Model, adding an additional term to account for the constant growth of dividends 33 Dividend Discount Models (continued) Two-Stage Dividend Growth Model a.k.a. Variable Growth Model Assume dividends will continue to grow at a specified rate into the future (presumably the fastgrowth stage) and then grow at a second (presumably slower growth rate once the company matures) T T D0(1 g1) 1 g1 1 g1 D0(1 g2) P0 1 k g1 1 k 1 k k g2 Many decades ago, Benjamin Graham warned against using overly sophisticated mathematical models to value stocks. This model may look very impressive, especially to those who love math, but it has some serious problems. It is very difficult to accurately predict future dividend growth during the initial fast growth stage of a stock. Usually companies do not pay significant dividends while they are growing quickly. 34 Dividend Discount Models (continued) Observations of the Dividend Discount Models How do you use them for a company that isn’t paying any dividends? The simple answer is, “You can’t!” Constant perpetual growth is usually an unrealistic assumption (except for a very small number of companies) Dividend growth rates are very difficult to estimate With large cap, well-established companies, historical growth rates may be useful But with fast growing companies in new industries, it is almost impossible The problems of DDMs notwithstanding, repeat after me: “The value of a stock is based on the present value of its future cash flows.” 35 Dividends and Earnings Model Uses present value of expected dividends and the present value of the expected future price to value a share of stock Does not really use any earnings… Also called the Discounted Cash Flow Model (better name) Value of stock = present value of future dividends + present value of the price of stock when we plan to sell We use the present value multipliers from the table Not covered specifically in our text But it is really just the pure form of the DDM with the present value of the expected price of the stock as our final cash inflow As with the other DDMs, this model is very sensitive to our estimates and our choice of required rate of return and, hence, can be very far off the mark. 36 Dividends and Earnings Model (continued) Example 1: Assume it is January 1, 2012. Pretzels Unlimited is currently selling for $22 per share and will pay $2.00 per share in dividends in 2012. PU expects to increase their dividends to $2.20 in 2013, $2.30 in 2014, and $2.30 in 2015. We will be selling the stock at the end of 2015 and we expect the price to be $27 per share at that time. Our required rate of return is 12%. Value of stock = present value of future dividends + present value of price of stock when you plan to sell Value = ($2.00*0.893)+(2.20*0.797)+(2.30*0.712)+(2.30*0.636) + ($27.00*0.636) = = [ $1.786 + $1.7534 + $1.6376 + $1.4628 ] + $17.172 = = $6.6398 + $17.172 = $23.8118 $23.81 If our required rate of return is 12%, this is a pretty good stock to buy. 37 Dividends and Earnings Model (continued) Example 1: Pretzels Unlimited in Table Format 12% Years Cash Flows PVM 2012 $2.00 0.893 $1.786 2013 $2.20 0.797 $1.7534 2014 $2.30 0.712 $1.6376 2015 $2.30 0.636 $1.4628 2015 $27.00 0.636 $17.172 Total Present Value: Discounted Cash Flows $23.8118 $23.81 Here is the problem in spreadsheet format. I think it is much easier to comprehend and calculate in this format, yes? 38 Dividends and Earnings Model (continued) Example 1 (Simplified): Pretzels Unlimited in a More Simplified Table Format 12% PVM Discounted Cash Flows Years Cash Flows 2012 $2.00 0.893 $1.786 2013 $2.20 0.797 $1.7534 2014 $2.30 0.712 $1.6376 2015 $2.30 + $27 = $29.30 0.636 $18.6348 Total Present Value: $23.8118 $23.81 Adding the dividend and the stock price in the last year saves us a couple of manual calculations but more importantly, it also allows us to use a special spreadsheet function to calculate … 39 Dividends and Earnings Model (continued) Internal Rate of Return (a.k.a. IRR) The Internal Rate of Return is a measure of what rate of return we expect to get from a series of cash flows, including positive and negative flows Someday, when you take an upper-level or graduate finance or investment class, you will learn how to manually compute Internal Rate of Return Hopefully, you will not have a sadistic professor who will require you to calculate it manually more than once! We are simply going to enter the numbers into a spreadsheet formula and press , okay? In other words, we required a 12% rate of return from Pretzels Unlimited, but what do our numbers tell us will be our expected rate of return? 40 Dividends and Earnings Model (continued) Internal Rate of Return (a.k.a. IRR), continued The spreadsheet formula is: =IRR(values,approximate-rate-of-return) where values is the block of cells containing the cash flows, both positive and negative, and approximate-rate-of-return is our guess as to what the Internal Rate of Return will be Year Cash Flows Comments $ (22.00) Our initial outlay is $22.00 – enter any outflows as negative numbers 2012 $ 2.00 $2.00 dividend – enter cash inflows as possible numbers 2013 $ 2.20 $2.20 dividend 2014 $ 2.30 $2.30 dividend 2015 $ 29.30 $2.30 dividend + $27.00 proceeds from sale of stock 14.51% Internal Rate of Return =IRR(B2:B5,0.12) Let’s take a look at the example spreadsheet on the class web page … 41 Dividends and Earnings Model (continued) Example 2: Genes ’R’ Us (symbol GRUS) is currently selling for $21 per share. It pays no dividend. We believe that GRUS will sell for around $50 per share in five years. Our required rate of return is 13%. How can we determine if this is a good investment? With no dividends, which model can we use? The Dividends & Earnings Model can still be useful! Value of stock = present value of future dividends + present value of price of stock when you plan to sell Value = $0.00 (from dividends) + ($50.00*0.543) = $27.13 Unlike the other DDM’s, the Dividends and Earnings model can still be used if there are no dividends. Very cool! 42 Residual Income Model Another method that is a cousin of the DDMs is the Residual Income Model As with the Dividends & Earnings model, it allows us to value a company that is not paying dividends Instead of using dividends, the model uses earnings It is very similar to the Constant Perpetual Growth Model We’ll skip it for now and maybe come back to it later I think you have enough on your plate as it is … Ditto for all the other models described in chapter 6 The Residual Income Model is covered in the 4th, 5th, and 6th editions of the text but not in the 3rd edition. 43 Sources of Information Okay, Paiano, this is all great, but just where are we supposed to get all this historical information, anyway? And just who decides what next year’s earnings per share, sales per share, cash flow per share, dividends per share, etc., etc., etc. are going to be, let alone the expected price of a stock in 3 to 5 years?! Before the Internet (BI?), this information was not readily available Normally, you would ask your broker for it Or you would use one of the securities industry’s trusted information sources Traditionally, the most respected source was … 44 The Value Line Still one of the most respected and trusted sources of data and analysis Traditionally, it was often the only source many investors used for data and analysis Along with the company’s materials Expensive ($598 per year print edition, $538 online valueline.com), but can be gotten for free at the library I am a big fan of Value Line, especially their Timeliness and Safety indicators. One study (which ignored transaction costs and tax consequences) only used their Timeliness indicator. It showed how you would have beaten the market handsomely over a twenty year period by just buying and selling stocks as they received and lost their #1 Timeliness designation. 45 The Value Line (continued) Can you find… The Value Line indicators? The future price projections? The historical data? The cash assets, receivables, inventory, and other assets? The description and analysis of the business? The historical annual rates? The insider and institutional buying & selling? The amount of debt and number of shares outstanding? The company’s financial strength, stability, price growth, and earnings predictability ratings? Value Line Example: McGraw-Hill, Page 206 (6th edition) 46 The Value Line (continued) 47 The Value Line (continued) 48 The Value Line (continued) Let’s put The Value Line to the test In late 2009, the price of McGraw-Hill was $28.73 Their price prediction for early 2012 was in the range from around $48 to $68 On February 10th, 2012, McGraw-Hill’s price closed at $45.52 (It almost hit $48 on January 10th) Not bad! When they made this prediction at the end of 2009, the stock market had rallied from the depths of the 2008/2009 crisis but many people were still predicting the end of the world By the way, some of them are still predicting the end of the world Now let’s look at The Value Line prediction for McGraw-Hill from the 4th edition 49 The Value Line (continued) 50 The Value Line (continued) 51 The Value Line (continued) How did they do in mid-2005? Their price prediction for late 2009 was in the range from around $66 to around $82 Aye! McGraw-Hill’s price was hovering around $24 in late 2009 What happened? It reached $70 in mid-2007 and started falling as the credit markets started reacting to the home mortgage loan crisis McGraw-Hill owns Standard & Poors (Uh, you’ve heard of them) It then plummeted as the home mortgage loan crisis spread to the entire financial sector in 2008 & 2009 Their mid-2007 prediction from the 5th edition of the text was even uglier! But what about their early-2003 prediction from the 3rd edition? 52 The Value Line (continued) 53 The Value Line (continued) 54 The Value Line (continued) In early 2003, The Value Line predicted that the price of McGraw-Hill would be around $90 to $110 in 2005 & 2006 (Why so much higher? McGraw-Hill split their stock 2 for 1. You have to divide these prices by 2 to compare them to the previous two predictions.) Hurray for The Value Line! They were bang on the money! McGraw-Hill reached the $120 level by the end of 2006 ($60 split adjusted) I get a kick when some investors trash The Value Line. They make mistakes, too, just like everybody else. But I would sure love to see how those investors’ long-term results stack up against the long-term results of The Value Line! Who do you think would have the better results? CHAPTER 6 – REVIEW 55 Common Stock Valuation Chapter Sections: Security Analysis: Be Careful Out There The Dividend Discount Model The Two-Stage Dividend Growth Model The Residual Income Model The Free Cash Flow Model Price Ratio Analysis An Analysis of the McGraw-Hill Company Next week: Chapter 17, Projecting Cash Flow and Earnings (Ratio Analysis)