Análisis De Los Resultados De La Observación

The last method we'll look at is sort of a catch-all method that can be used if you are unable to value the company using any of the other models, or if you simply don't want to spend the time crunching the numbers. The method doesn't attempt to find an intrinsic value for

the stock like the previous two valuation methods do; it simply compares the stock's price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for this is based off of the Law of One Price, which states that two similar assets should sell for similar prices. The intuitive nature of this method is one of the reasons it is so popular.

This method can be used in almost all circumstances because of the vast number of

multiples that can be applied, such as the price-to-earnings (P/E), price-to-book (P/B), price- to-sales (P/S), price-to-cash flow (P/CF) and many others. Of these ratios, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investment's value. (For more on this subject, see 6 Basic

Financial Ratios And What They Reveal.)

When can you use the P/E multiple for a comparison? You can generally use it if the company is publicly traded because you need the price of the stock, and you need to know the earnings of the company. Secondly, the company should be generating positive

earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong; earnings should not be too volatile and the accounting practices used by management should not drastically distort the reported earnings. (Companies can manipulate their numbers, so you need to learn how to determine the accuracy of EPS. Read How To Evaluate The Quality Of EPS.)

These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, simply look at using a different ratio such as the price-to-sales multiple.

No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select the valuation method that best suits the situation. In addition, investors are not limited to just using one method. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one.

PREFERRED STOCK VALUATION

have the qualities of both a stock and a bond, which makes valuation a little different than a common share. The owner of the preferred share is part owner of the company, just like a common shareholder. The stake in the company is in proportion to the held stocks. Also, there is a fixed payment which is similar to a bond issued by the company. The fixed payment is in the form of a dividend and will be the basis of the valuation method for a

preferred share. These payments could come quarterly, monthly or yearly, depending on the policy stated by the company.

Valuation

Preferred stocks have a fixed dividend, which means we can calculate the value by discounting each of these payments to the present day. This fixed dividend is not guaranteed in common shares. If you take these payments and calculate the sum of the present values into perpetuity, you will find the value of the stock.

For example, if ABC Company pays a 25 cent dividend every month and the required rate of return is 6% per year, then the expected value of the stock, using the dividend discount approach, would be $0.25/0.005 = $50. The discount rate was divided by 12 to get 0.005, but you could also use the yearly dividend of (0.25*12) $3 and divide it by the yearly discount rate of 0.06 to get $50. The point is that each issued dividend payment in the future needs to be discounted back to the present and each value is then added together.

Where:

V = the value

D1 = the dividend next period

r = the required rate of return

Considerations

Although the preferred shares give a dividend, which is usually guaranteed, the payment can be cut if there are not enough earnings to accommodate a distribution. This risk of a cut payment needs to be accounted for. This risk increases as the payout ratio (dividend payment compared to earnings) gets higher. Also, if the dividend has a chance of growing,

the value of the shares will be higher than the result of the constant dividend calculation, given above.

Preferred shares usually lack the voting rights of common shares. This might be a valuable feature to individuals who own large amounts of shares, but for the average investor this voting right does not have much value. However, it still needs to be accounted for when evaluating the marketability of preferred shares.

Preferred shares have an implied value similar to a bond. This means the value will also move inversely with interest rates. When the interest rate goes up, the value of the

preferred shares will go down, holding everything else constant. This is to account for other investment opportunities and is reflected in the discount rate used.

Callable

If the preferred shares are callable, the company gains a benefit and the purchaser should pay less, compared to if there was no call provision. The call provision allows the company to basically take the shares off of the market at a predetermined price. A company might add to this if the current market interest rates are high (requiring a higher dividend payment) and the company expects the interest rates to go down. This is a benefit to the issuing company, because they can essentially issue new shares at a lower dividend payment. (Due to their lowered price, callable shares pose risk: read Bond Call Features: Don't Get

Caught Off Guard.)

If the dividend has a history of predictable growth, or the company states a constant growth will occur, you need to account for this. The calculation is known as the Gordon Growth Model.

The added g is the growth of the payments.

By subtracting the growth number, the cash flows are discounted by a lower number resulting in a higher value.

Preferred shares are a type of equity investment, which provide a steady stream of income and potential appreciation. Both of these features need to be taken into account when attempting to determine value. Calculations using the dividend discount model are difficult because of the assumptions involved, such as the required rate of return and the growth or length of higher returns.

The dividend payment is usually easy to find; the difficult part comes when this payment is changing or potentially could change in the future. Also, finding a proper discount rate is very difficult and if this figure is off, it could drastically change the calculated value of the shares. When it comes to classroom homework, these numbers will be simply given, but in the real world we are left to estimate the discount rate or pay a company to do the

calculation. CHAPTER 6

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield and is used in capital budgeting to assess the profitability of an investment or project.

NPV is calculated using the following formula:

If the NPV of a prospective project is positive, the project should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV. (Sometimes losing investments aren't what they seem. Learn more in How To Profit From Investment "Losers".)

Internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is

considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.

You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. (For related reading, see The Top New Investment: Doing Nothing.)

Differences between NPV and IRR and Their Uses

Both NPV and IRR are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.

To do this, the firm estimates the future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value (NPV) of the investment.

Let's illustrate with an example: suppose JKL Media wants to buy a small publishing company. JKL determines that the future cash flows generated by the publisher, when discounted at a 12% annual rate, yield a present value of $23.5 million. If the publishing company's owner is willing to sell for $20 million, then the NPV of the project would be $3.5 million ($23.5 - $20 = $3.5). The $3.5 million dollar NPV represents the intrinsic value that will be added to JKL Media if it undertakes this acquisition.

So, JKL Media's project has a positive NPV, but from a business perspective, the firm should also know what rate of return will be generated by this investment. To do this, the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now-unknown discount rate. The rate that is produced by the solution is the project's internal rate of return (IRR).

For this example, the project's IRR could, depending on the timing and proportions of cash flow distributions, be equal to 17.15%. Thus, JKL Media, given its projected cash flows, has a project with a 17.15% return. If there were a project that JKL could undertake with a higher IRR, it would probably pursue the higher-yielding project instead. Thus, you can see that the usefulness of the IRR measurement lies in its ability to represent any investment opportunity's return and to compare it with other possible investments. (Learn about

industry-specific investment options in Fine Art Funds: A Beautiful Investment, The Perfect

NET PRESENT VALUE

The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives. The NPV rule states that all projects which have a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted.

In the two examples below, assuming a discount rate of 10%, project A and project B have respective NPVs of $126,000 and $1,200,000. These results signal that both capital

budgeting projects would increase the value of the firm, but if the company only has $1 million to invest at the moment, project B is superior.