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How to Value a Stock
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residual value, and the short-term assets to get today s value of the corporation as a whole the corporate or enterprise value. We describe this procedure in greater depth later in this section. Corporate Value Cash Flow Operations Residual Value Short-term Assets
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The ValuePro 2002 Software shows this calculation at the top of the General Pro Forma Page. Again, this simple spreadsheet program does the work automatically. Step 4: Calculate Intrinsic Stock Value. We subtract the value of the company s short-term liabilities and senior liabilities debt and preferred stock from the enterprise value to get value to common equity, as shown in the following. Value to Common Equity Corporate Value (Debt Preferred)
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We then divide value to common equity by the number of shares outstanding to get the per share intrinsic value of common stock. Where do we get all this information for a valuation The inputs necessary to accomplish Step 1 forecast expected cash flow are the focus of 5. The inputs and information needed to accomplish Step 2 estimate the WACC are the subjects of 6. But before we jump ahead, let s now spend a little time discussing the theory of competitive advantage that underlies the calculation of cash flow from operations described in Step 3 above.
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Excess Return Period and Competitive Advantage
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Because of a competitive advantage enjoyed by the firm, the company is able to earn returns on new investments that are greater than its cost of capital during the excess return period. Examples of companies that experienced a significant period of big-time competitive advantage are IBM in the 1950s and 1960s, Apple Computer in the 1980s, and Microsoft, Intel, and Cisco in the 1990s. Success invariably attracts competitors with their own lower-cost versions of the product or service, and whose aggressive practices cut into market share and revenue growth rates. The pricing and market-
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STREETSMART GUIDE TO VALUING A STOCK
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ing activities of competitors also drive down net operating profit margins. A lower NOPM reduces return on new investment to levels that approach the corporation s WACC. When a company loses its competitive advantage and the return from its new investments just equals its WACC, the corporation is investing in business strategies in which the aggregate net present value is 0. Worse yet, companies can generate negative returns and destroy shareholder value witness IBM in the 1980s, Apple in the 1990s, and the telecom companies in the 2000s. Increasing size attracts additional competition. As industries develop and market sectors grow, companies serving those sectors can have relatively small revenue $10 to $100 million and not make the radar screens of competitors or attract their interest. However, when a company hits the $100 million revenue threshold, potential competitors start to notice and begin to enter the sector space, cutting into growth and profit margins. So small-cap firms that initially may have very little competition in a specialty market sector can make some hay and generate abnormal profits from operations. The length of time over which a company can earn abnormal profits depends on the particular products being produced, the industry in which the company operates, and the barriers for competitors to enter the business. Markets that have a high barrier to entry, such as products with patent protection, strong brand names, or unique marketing channels, might have an excess return period that is quite long 10 to 15 years or longer. More typically, the excess return period for most companies will be 5 to 7 years or shorter. All else equal, a shorter excess return period results in a lower stock value. What happens after the excess return period Does the company dry up, shrivel, or go bankrupt No! For valuation purposes, the company loses its competitive advantage over its competitors. The loss of competitive advantage means that the company s stock value may still grow, but only at the market s required rate of return for the stock not at an abnormally high growth rate level. For example, if the common stock price of RST Company (which does not pay dividends) is $10, and its required rate of return is 12 percent, its stockholders expect it to grow to ($10 * 1.12) $11.20 after year one; ($11.20 * 1.12) $12.54 after year two; ($12.54 * 1.12) $14.03 after year three; ad infinitum. Once the excess return period ceases and the company has no more profitable new investments, the company should pay all of
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