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STREETSMART GUIDE TO VALUING A STOCK
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TABLE 3-1
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ABC Stock Price
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Changing Earnings 10% Capitalization Rate
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Earnings Scenario No Growth 50% Growth 90% Shrinkage No Earnings
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Earnings $200 million $300 million $20 million 0
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Market Equity $2 billion $3 billion $200 million 0
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Increase of 50% Decrease of 90% Decrease of 100%
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How about interest rates Do changing interest rates affect ABC s stock value YES! If interest rates change, the market equity that the profits of ABC Utility Company support also will change. If the required yield rises, e.g., to 12 percent, the market equity drops to: [$200 million/(.12)] $1.667 billion. That s the amount that $200 million in profits and dividends, capitalized at 12 percent, can support. If the required yield falls, e.g., to 8 percent, the ABC s market equity rises to [$200 million/(.08)] $2.5 billion. The inverse relationship between the change in a stock s price and a change in interest rates is shown in Table 3-2. In this simple example we see that the market equity level of a stock is crucially dependent upon two variables: the amount of future profits that the firm is expected to generate greater profits increase a stock s market value and lower profits decrease value, and the interest rate or required yield level that is expected from the investment with lower yields and interest rates increasing market value, and higher yields and interest rates reducing market value.
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TABLE 3-2
ABC Stock Price
Changing Interest Rate Constant Earnings
Interest Rate Scenario 10% 12% 8%
Earnings $200 million $200 million $200 million
Market Equity $2 billion $1.667 billion $2.5 billion
Change in Market Equity Decreases 16.7% Increases 25%
Stock Valuation: Some Preliminaries
For the moment, let s forget the complexity of changing yields, and growth and contraction in profits and dividends. In our simple, static, no-growth stock valuation example, the operations of ABC Utility Company support a market equity value of $2 billion. The bells and whistles of stock splits, aggressive accounting practices, or fancy capital structure that complicate valuing a stock don t confuse us now, as they do in real life, and as they will when we value real companies in the examples that follow.
We Caused the High-Tech Bubble
In July of 2000, someone bought JDS Uniphase at $140.50 per share! Look at the price history of JDSU shown in Exhibit 3-2. The company had less than a billion dollars in sales and lost money by the hundreds of millions of dollars. Based on its 1.52 billion shares outstanding, JDSU had market equity of over $200 billion more than 200 times revenue, and it had a price/earnings ratio of infinity. JDSU may have been a good company with bright prospects, but its underlying operations and business should never have justified $200 billion in market equity. How could we bid the price of a company with operating characteristics like JDSU to such a stupid level JDSU closed 2002 at $2.47 per share. How about an investment in Internet Capital Group Someone paid $200.94 per share for ICGE. At that time, ICGE had negative book value
EXHIBIT 3-2
JDSU Five-Year Stock Price Chart
STREETSMART GUIDE TO VALUING A STOCK
and $131 million in sales. Could these performance numbers ever justify its total market equity of over $50 billion in January 2000 Why buy stock in a risky company that is trading at a very high price The shares trade now at $0.36 per share that s 36 cents per share, and ICGE has market equity of about $100 million down 99.9 percent from its high. We d prefer buying shares in ABC Utility Company. How about Lucent This was a real company, one that had substantial revenues, thousands of employees, and billions in assets. One of the authors of this book owned a small amount (under 100 shares) of Lucent that he received in its 1996 spinoff from AT&T. He watched as LU hitched its fortune to the fiber optic cable craze, and its price increased to $64 per share for a total equity value of over $200 billion on Lucent s 3.4 billion shares. In September of 1999, he answered a posting regarding Lucent on the message board of the Web site, www.valuepro.net/, owned and administered by the authors of this book. The posting questioned the $64 price of Lucent and referenced a DCF valuation of Lucent, which was done by the postor and showed an intrinsic value of less than $10/share. The postor used an earlier version of the ValuePro 2002 software for his Lucent valuation. The author checked the assumptions underlying the lower valuation, found no holes or oversights in the valuation, emailed his thanks to the postor, and sold the shares at $64. A month later he was second-guessing himself as Lucent continued its rise to $75. Ultimately, the market realized that LU had no clothes. From that $75 peak, the stock price declined steadily (see Exhibit 3-3) to $1.26 per share on December 31, 2002. The reality underlying the high-tech bubble is that all investors individuals and institutions, domestic and foreign, women and men, workers and retirees bid stock prices of companies up to unrealistic levels. The operating profits of the underlying businesses of the companies could never support the overvaluation by the market. We all participated in this stupid activity. We all are at fault. We all are guilty. True, the stock analysts of Wall Street urged us to pay up to buy shares of these great companies. Henrico, the Internet analyst said, No price is too high for a great company. The real risk is not buying, standing on the sideline, seeing your aggressive, risk-taking neighbor or coworker make bundles in the market, while conservative, cautious YOU owns bonds and money market funds and misses the upward
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