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STREETSMART GUIDE TO VALUING A STOCK
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Equity Risk Premium
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The equity risk premium is an estimate of the excess return an investor expects to earn on a risky stock relative to a risk-free asset. We use the yield on the 10-year U.S. Treasury Bond as a measure of the return on a risk-free asset. The equity risk premium is not an item that you stumble upon while surfing the Web. Aswath Damodaran, on his Web page (www.stern.nyu.edu/ adamodar/ ), calculates implied equity risk premiums on a yearly basis from 1960 until 2001. His most recent calculations for the year 2001 show an implied equity risk premium for the S&P 500 of 1.73 percent, using a dividend discount valuation model, and 3.62 percent, using the free cash flow to equity model of valuation. Based on the economy of early 2003, we believe that 3 percent represents a reasonable equity risk premium.
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As we have discussed, a company s beta is the risk measure used in the CAPM, the model most frequently used by market professionals in assessing the risk of a stock. Both Yahoo Finance and MSN Investor list their estimate of a stock s beta. For example, on the date that Yahoo had a beta estimate of 1.93 for Cisco listed in the Profiles link, MSN Investor had a beta estimate of 1.90. Why the difference, and which beta should you use A company s beta is calculated by a statistical test (known as regression analysis) relating the price movement of the stock and the price movement of the stock market in general. Various market participants use different time periods and measurement techniques in performing these calculations, and different beta estimates may result. When a difference arises, the most conservative approach, which results in a higher WACC and lower stock value, is to use the higher beta. Another approach is to use the average of the betas for the analysis. For the valuations in this book, we use the higher value of beta.
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Book values of debt and preferred stock are listed in the balance sheet section of the corporation s annual reports. The best (and to our knowledge, only) way to get an accurate reading of total market value of debt and preferred stock is the old-fashioned way price each separate issue and aggregate the values.
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For some companies, like Cisco, which has no debt or preferred stock outstanding, this exercise is easy. For corporations like Consolidated Edison, which has 38 issues of various types of debt outstanding, this procedure can be tedious. What is a rational way of handling this potentially time-consuming problem Here s how we do it. If we re just making a quick and dirty valuation to see how a company is trading by comparing it to its rough intrinsic value, we use the book value of debt and preferred stock as reported in the company s annual or quarterly report. If we are being employed under a consulting contract on a grossly overpaid hourly basis to perform a valuation, we perform an in-depth analysis of every feature and option embedded in the debt or preferred stock so that we can value the company to the penny (and maximize our billing time). It s fortunate that the market value of debt and preferred stock generally does not vary too much from its book value. With the exception of valuing a highly leveraged company for which debt and preferred stock make up a large percentage of the market capitalization, the use of book values does not significantly bias the analysis of the common stock s intrinsic value.
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Custom Valuations The Next Step
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In 5, we discuss how to estimate the future cash flows of a company, using Cisco as an example. In 6 we see how to estimate the company s WACC, using Cisco and Consolidated Edison as examples. In this chapter, we have discussed where to get the various inputs needed to perform a valuation for Cisco, and have given you suggestions for getting the info while minimizing your online computer time. The exercise that follows pulls together the inputs that we gathered in this chapter. In 8 we get a bit fancier and vary our assumptions regarding revenue growth rates, net operating profit margins, and WACC s. First, we finish our Cisco valuation example.
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