Stock Price Behavior and Market Effeciency

1
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 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
2
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?
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 firms accounting statements and
  other financial and economic information to
  assess the economic value of a companys 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 companys 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
• FedEx (FDX), Ford (F), Facebook (FB), First
  Solar (FSLR)

P/E 26.1
P/E 8.6
P/E 112.3
P/E 11.6
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 1990s, it was commonplace. Now, P/E
ratios are all over the map!
8
Price to Earnings Ratio
(continued)

• Historically,
• A companys 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
• eBays 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 19.40 Late-2009
EPS 0.92 5-year average P/E ratio 20.96
P/E EPS growth rate 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 19.40 Late-2009
CFPS 1.74 5-year average P/CF ratio 10.85
P/CF Cash Flow Per Share growth rate
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 19.40 Late-2009
SPS 6.76 5-year average P/S ratio 3.14
P/S Sales Per Share growth rate
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 aint 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 1990s, 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
• 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)
• Did you work on 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 1
  1
• 10,000 2.1589 21,589 (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?
• 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 Dividend1PVM1 Dividend2PVM2
Dividend3PVM3 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)

• Lets do the same example over again
• Using the Present Value Multipliers from the
  Present Value Table on the class web site
• http//wonderprofessor.com/123s14/Chap06/Chap06_Pr
  esentValueTable.pdf
• Three annual dividends of 100 per share
• Required rate of return 15
• Value (1000.870) (1000.756)
  (1000.658)
• 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
• Value of stock ---------------
• Example
• Annual dividend 3.00 per share
• Required rate of return 6
• 3.00 / 6 50.00 per share

Annual dividends
Required rate of return
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
• Value of stock ---------------
• Dividend Yield ---------------

Annual dividends
Required rate of return
Annual dividends
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 55.29 per share (21 Feb
  2014)
• Currently paying 2.52 per year in annual
  dividends
• The question is, What is our required rate of
  return?
• Lets first use 8
• Value 2.52 / 8 31.50
• The stock is overpriced if our required rate of
  return is 8
• What about 5?
• Value 2.52 / 5 50.40
• The stock is still too expensive if our required
  return is 5

With a market price of 55.29, the stock is
yielding 4.6. 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
• Value of stock -------------------
• Example 6.3 Page 184, 6th edition
• Annual dividend 10 per share (Next
  years10.50)
• 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

Annual dividends (1Constant growth rate)
Required rate of return Constant growth rate
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 91.52 (21 Feb 2014)
• Currently paying 2.64 annual dividends
• Assume dividends growing around 8 per year
• Our required rate of return is 13
• (2.64 1.08) / (13 - 8) 2.8512 / 5 ?
  57.02
• Not a great buy if we require 13, huh?
• What if our required rate of return were only
  10?
• (2.64 1.08) / (10 - 8) 2.8512 / 2 ?
  142.56
• 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 77.97 (21 Feb 2014)
• Currently paying 2.41 annual dividends
• Assume dividends growing around 8 per year
• Our required rate of return is 13
• (2.41 1.08) / (13 - 8) 2.6028 / 5 ?
  52.06
• Proctor Gamble doesnt quite measure up to our
  13 rate
• What if our required rate of return were only
  10?
• (2.41 1.08) / (10 - 8) 2.6028 / 2 ?
  130.14
• The model says PG 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 37.18 (21 Feb 2014)
• Currently paying 1.22 annual dividends
• Assume dividends growing around 8 per year
• Our required rate of return is 13
• (1.22 1.08) / (13 - 8) 1.3176 / 5 ?
  26.35
• So much for caramel colored, fizzy sugar water!
• What if our required rate of return were only
  10?
• (1.22 1.08) / (10 - 8) 1.3176 / 2 ?
  65.88
• Maybe we ought to spend more time researching KO
  

In the United States, the average person drinks
over 400 Cokes a year. In China, the average is
38 per year. In India, it is 12. Guess which
country drinks the most
29
Dividend Discount Models
(continued)

• Constant Perpetual Growth Model (Real-life
  Example)
• GE (blue chip)
• Current market price is 24.94 (21 Feb 2014)
• Currently paying 0.88 annual dividends
• Assume dividends also growing around 8 per year
• What if our required rate of return is 13
• (0.88 1.08) / (13 - 8) 0.9504 / 5 ?
  19.01
• Uh, GE does not look so good if we want 13
• How about 10?
• (0.88 1.08) / (10 - 8) 0.9504 / 2 ?
  47.52
• 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, 0.68, 0.76, and now to 0.88 per
year.
30
Dividend Discount Models
(continued)

• Constant Perpetual Growth Model (Real-life
  Example)
• Altria (blue chip)
• Current market price is 35.37 (21 Feb 2014)
• Currently paying 1.92 annual dividends
• Assume dividends also growing around 8 per year
• Same required rate of return of 13
• (1.92 1.08) / (13 - 8) 2.0736 / 5 ?
  41.47
• 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 13.86 required rate of
  return
• (1.92 1.08) / (13.86 - 8) ? 35.37 (35.39
  actually)

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,
  PG, and JJ are all currently higher than 8
• Coke is 8.8, JJ is 9.1, PG is 9.5, and
  Altria is 10.2!
• 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. But they are not
alone. Check out ExxonMobil, McDonalds, United
Technologies, Honeywell, 3M, Johnson Controls,
and Yum Brands.
32
Dividend Discount Models
(continued)

• Constant Growth Model
• Assume dividends will continue to grow at a
  specified rate for a specified 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

Aye, Paquito! Do we have to know how to do
this?! (No.)
Added term to account for growth for a number of
years
Constant Perpetual Growth Model
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
  fast-growth stage) and then grow at a second
  (presumably slower growth rate once the company
  matures)

?
?
?
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 isnt
  paying any dividends?
• The simple answer is, You cant!
• 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
Discounted Cash Flow Model

• Uses present value of expected dividends and the
  present value of the expected future price to
  value a share of stock
• Also called the Dividends Earnings Model (?)
• 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
Discounted Cash Flow Model
(continued)

• Example 1
• Assume it is January 1, 2014. Pretzels Unlimited
  is currently selling for 22 per share and will
  pay 2.00 per share in dividends in 2014. PU
  expects to increase their dividends to 2.20 in
  2015, 2.30 in 2016, and 2.30 in 2017. We will
  be selling the stock at the end of 2017 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 (2.000.893)(2.200.797)(2.300.712
  )(2.300.636)
• (27.000.636)
• 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
Discounted Cash Flow Model
(continued)

• Example 1
• Pretzels Unlimited in Table Format

Years Cash Flows PVM12 Discounted Cash Flows
2014 2.00 0.893 1.786
2015 2.20 0.797 1.7534
2016 2.30 0.712 1.6376
2017 2.30 0.636 1.4628
2017 27.00 0.636 17.172
Total Present Value Total Present Value Total Present Value 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
Discounted Cash Flow Model
(continued)

• Example 1 (Simplified)
• Pretzels Unlimited in a More Simplified Table
  Format

Years Cash Flows PVM12 Discounted Cash Flows
2014 2.00 0.893 1.786
2015 2.20 0.797 1.7534
2016 2.30 0.712 1.6376
2017 2.30 27 29.30 0.636 18.6348
Total Present Value Total Present Value 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
Discounted Cash Flow 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
Discounted Cash Flow 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
2014 2.00 2.00 dividend enter cash inflows as possible numbers
2015 2.20 2.20 dividend
2016 2.30 2.30 dividend
2017 29.30 2.30 dividend 27.00 proceeds from sale of stock
14.51 Internal Rate of Return IRR(B2B5,0.12)
Lets take a look at the example spreadsheet on
the class web page
41
Discounted Cash Flow 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 Discounted Cash Flow Model can still be used!
• Value of stock present value of future
  dividends
• present value of price of stock when you
  plan to sell
• Value 0.00 (from dividends)
  (50.000.543) 27.13

Unlike the other DDMs, the Discounted Cash Flow
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 Discounted Cash Flow 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
• Well 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 years 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 industrys
  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 companys materials
• Expensive (598 per year print edition, 538
  online www.valueline.com), but can be obtained
  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 companys 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)

• Lets put The Value Line to the test
• In late 2009, the price of McGraw-Hill was 28.73
• Their price prediction for early 2013 was in the
  range from around 48 to 68
• On February 15th, 2013, McGraw-Hills price
  closed at 44.95
• Not too bad, eh? Actually, pretty darned good!
• 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 lets 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-Hills 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, youve
  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?
55
CHAPTER 6 REVIEW
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)