十
三
Asset
Valuation: Equity Investments
1.A: An Introduction to Security Valuation
a: Explain the top-down approach and its underlying logic to the security valuation process.
Step 1 General economic influences: fiscal policy: tax cuts encourage spending and tax
increases discourage spending. monetary policy: a restrictive policy reduces the availability of
funds and causes interest rates to rise putting upward pressures on costs. In addition to fiscal
and monetary actions you must also consider the economic consequences of political
changes around the globe. From a global portfolio perspective you have to consider the
economic events in other countries.
Step 2 Industry influences: The next step in the valuation process is to identify those
industries that will prosper or suffer during the time frame of your economic forecast. You
should consider the cyclical nature of the industry under study. Some industries are cyclical,
some are contra cyclical and some are non-cyclical. Finally, your analysis should also
account for foreign economic shifts. In general, an industry’s prospects within the global
business environment determine how well or poorly individual firms in the industry do.
Step 3 Company Analysis: After determining the industry’s outlook you should compare the
individual firm’s performance within the entire industry using financial ratios and cash flow
values. Your goal is to identify the best company in a promising industry. This involves not
only examining the firm’s past performance, but also its future prospects.
b: Calculate the value of a preferred stock, assuming a perpetual dividend.
Valuation of preferred stock is easy since the dividend is fixed and the preferred’s life is
infinite (it’s a perpetuity) appears in the upper right hand corner. Again, the only problem is
determining k
P
. Because of default risk factors, the preferred’s discount rate (k
P
) should be
above the firm’s bond rate (k
B
). But since dividends paid by one corporation to another
corporation are 80% tax exempt, preferred yields are below the firm’s highest-grade bond
yields.
preferred value=
D
+
D
+...+
D
=
D
(1 +k
p
)
1
(1 + k
p
)
2
(1 + k
p
)°°
k
p
Example: value the preferred of a company that pays a $5 annual dividend. The firm’s bonds
are currently yielding 8.5% and preferred shares are selling to yield fifty basis points below
the firm’s bond yield.
Step 1: determine the discount rate. 8.5% - .5% = 8%
Step 2: value the preferred. D/k
P
= $5/.08 = $62.50
c: Calculate the value of a common stock, using the dividend discount model (DDM) for both a
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