Corporate Finance Basics

How do I value a stock?

There are numerous ways to value a stock. One that many experts feel is the most accurate is to use the Capital Asset Pricing Model followed by the Dividend Valuation Formula to find fair value of the stock. This is the way in which we will value Cinergy's stock.

Before we can begin using the CAPM there is certain data that must be gathered. The company's BETA, the RISK FREE RATE OF RETURN, the MARKET RISK PREMIUM, the company's DIVIDEND and the expected DIVIDEND GROWTH RATE must be located. This information can be found on web sites such as MARKET GUIDE or WALL STREET RESEARCH NET.

FORMULA FOR CAPM:

R(rs)= rf + Bs [E(rm)-rf]

In words:

Required return on stock S= return on risk free asset + beta [expected return on market - return on risk free asset]

NOTE:

- The Market Risk Premium is equal to the E(rm)-rf

-The risk free return is the same rate of return set on US Treasury Bills; for our example we will use 4.5%

-The Expected Return on the market is given as a percent; for our example we will use 6.6%.

- A corporation's Beta = Covariance/Variance - it is the way in which we measure the sensitivity of a stock's returns to the overall market return (we use the S&P 500 as a proxy for the market).

EXAMPLE:

For this example, we will be doing a valuation of the utility company, CINERGY CORP.It trades on the NYSE under the ticker symbol, CIN.

The market risk premium = 6.6%

The rate on Treasury Bills = 4.5%

According to the Wall Street Research Network:

CIN has a beta of .15

A current dividend rate of $1.80

A five year expected dividend growth rate of 3.27%

Using CAPM we must first calculate a required rate of return for CIN:

R(rs)= .045+.15(.066)

R(rs)= .0549 or 5.49%

Once we have found the company's Required Return, we can use the DIVIDEND VALUATION FORMULA to solve for the stock's value.

FORMULA FOR DIVIDEND VALUATION:

V= D1 / {R(r)-gn}

In words: the value of the stock = next year's dividend / required return on the stock - the expected dividend growth rate.

EXAMPLE:

Since the dividend we are given for CIN is the current dividend, we must discount it so that we have next year's dividend.

1.80(1.0327)= $1.86

Now we may use our Dividend Valuation Formula:

1.86/(.0549-.0327)

1.86/.0222 = $83.78

According to the CAPM, CIN has a value of $83.78 Now we have figured out what a fair value for Cinergy's stock is. The current price (as of 4/1/99) for the stock is $29.81 Would you buy this stock?

NOTE: The CAPM works very well to value certain stocks, such as utility stocks. There are some types of stock, however, that do not work well. For example, if the stock does not have a dividend, this model cannot be used. We must then look at other areas of the corporation. Areas such as cash flow, P/E ratio, Debt/Equity ratio, and Earnings/Share can give us a good indication of the stock's value. In addition, models such as the CAPM assume that the market is efficient. The fact that the market has proven to be inefficient (for example, because some stocks are extremely overpriced), must be taken into account when putting a value on a stock. Essentially, the investor must use her good judgement to decide if a calculated intrinsic value of a stock is accurate.

Alternatives to the CAPM, such as the Arbitrage Pricing Model, attempts to take into account other factors that influence the way the economy is moving. This model includes factors such as GNP or inflation in its valuation.

Aribitrage Pricing Model:

R(rs)=rf+b1(E(f1))+b2 (E(f2))+...bn(E(fn))

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This website was created in May 1999 by Alison Hirsch '01, and is maintained by Professor Satya Gabriel, of the Economics Department at Mount Holyoke College