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Principles of InvestingFIN 330

Chapter 7Valuation of the Firm

Dr. David P Echevarria

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Student Learning Objectives

A. Basic Valuation MethodsB. Evaluating Risk/Return relationshipsC. Sustainable GrowthD. EPS Forecasting Techniques

Dr. David P Echevarria

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Basic Valuation Concepts

A. Dividend Valuation Models: Gordon Growth (see Eq. 7-5)

B. Earnings Valuation (P/E ratio) – a measure of attractiveness to investors

C. Capital Asset Pricing Model (CAPM)1. Expected returns a function of risk free

rates, beta, and a risk premium (see Eq. 7-2)2. Beta (b) = a measure of risk relative to the

broad market3. Value = Cash Flow / E(r)

Dr. David P Echevarria

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Sustainable Growth Measures

A. Earnings growth is [partly] a function of profits reinvested in the firm (retention ratio)

B. Sustainable Growth rate = ROE * RRC. ROE = Return on Equity = Net

Income / Stockholder EquityD. Growth companies typically pay

small dividends and reinvest most of their earnings

Dr. David P Echevarria

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Forecasting Earnings

A. Least Squares (regression analysis): EPS over time

B. Income Statement method (see Table 7-9 for example of methodology)1. Forecast Revenues and Expenses2. Rev – Exp = Profits3. Profits / # shares outstanding = EPS4. EPS / Ke = Price per share

Dr. David P Echevarria

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Elements of Company Analysis

A. Description of business and properties

B. Historical Financial Performance data

C. Details about senior managementD. Competitive Position

1. Sales Revenue (growth)2. Profitability (trend)3. Product line (turnover, age)

Dr. David P Echevarria

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Elements of Company Analysis

E. Output rate of new products1. Product innovation strategies2. R&D budgets

F. Operating efficiency3. Output / Input ratio4. Position on cost curve

G Pricing Strategy5. Low price6. High quality - price

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Elements of Company Analysis

A. Patents and technologyB. Nature of Management

1. Organizational performancea. Effective application of company resourcesb. Efficient accomplishment of company goals

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Homework

A. Discussion Questions: 2, 3, 5, 11, 19B. Problems: 2, 5, 8, 15

Dr. David P Echevarria