INSTRUCTOR MANUAL
Instructor’s Manual for Principles of Finance
03/21/22 1
, Instructor’s Manual for Principles of Finance
Chapter 11
Stocks and Stock Valuati on
Chapter Summary
Bond valuation, as described in the chapter Bonds and Bond Valuation, has one basic method.
It is an application of Time Value of Money concepts. This is because bonds are simple, regular
instruments. A bond’s cash flows are easily identifiable and do not change, at least for fixed-
rate bonds. Determine the present value of the stream of coupon interest payments and then
add the present value of the bond’s face amount at maturity, and you’re done.
Stock valuation is different. There is not one valuation method, but many. Valuation approaches
can be fundamental—for example, discounting a stock’s cash flow—or relative—for example,
comparing the subject company to industry bellwethers or leaders using a common financial
metric. There are many cash flows that can be discounted, and many common metrics are
usable, so valuing stock is anything but uniform.
If stock valuation is so subjective, then why invest in it? The best answer is that stocks provide
some of the best returns to investors over the long term. There are trade-offs for stocks’ high
rates of return.
+ Stocks are liquid investments and can be bought or sold in secondary markets easily.
+ Information about companies, markets, and important trends are widely available to
investors.
- General risks are greater than with bonds or other fixed-income investments.
- When to buy and when to sell are difficult decisions.
- Dividends (if they are paid) are uncertain and subject to change.
Lecture Outline
11.1 Multiple Approaches to Stock Valuation
A commonly used valuation method is relative valuation. Here a target company is compared
with other companies in the same industry in terms of a particular financial ratio. The approach
assumes the target follows a similar relationship between the common metric and the metric’s
value. The text example includes the often-used metric of the price earnings (PE) ratio.
Step 1: Identify the PE ratio for the target company’s industry.
Step 2: Calculate the target company’s earning per share (EPS).
Step 3: Multiply the target company’s EPS by the industry’s PE ratio, and a company value is the
result.
Price per Share
By using this formula: P/ E Ratio=
Earnings per Share
and solving for price per share, the analyst has conducted a relative valuation of the target
company’s share. Further refinement of this method is possible. If the target company is
considered among the best companies in the industry, the PE might be adjusted higher.
Likewise, a target company that underperforms industry peers might warrant a lower PE
multiple.
03/21/22 2
Instructor’s Manual for Principles of Finance
03/21/22 1
, Instructor’s Manual for Principles of Finance
Chapter 11
Stocks and Stock Valuati on
Chapter Summary
Bond valuation, as described in the chapter Bonds and Bond Valuation, has one basic method.
It is an application of Time Value of Money concepts. This is because bonds are simple, regular
instruments. A bond’s cash flows are easily identifiable and do not change, at least for fixed-
rate bonds. Determine the present value of the stream of coupon interest payments and then
add the present value of the bond’s face amount at maturity, and you’re done.
Stock valuation is different. There is not one valuation method, but many. Valuation approaches
can be fundamental—for example, discounting a stock’s cash flow—or relative—for example,
comparing the subject company to industry bellwethers or leaders using a common financial
metric. There are many cash flows that can be discounted, and many common metrics are
usable, so valuing stock is anything but uniform.
If stock valuation is so subjective, then why invest in it? The best answer is that stocks provide
some of the best returns to investors over the long term. There are trade-offs for stocks’ high
rates of return.
+ Stocks are liquid investments and can be bought or sold in secondary markets easily.
+ Information about companies, markets, and important trends are widely available to
investors.
- General risks are greater than with bonds or other fixed-income investments.
- When to buy and when to sell are difficult decisions.
- Dividends (if they are paid) are uncertain and subject to change.
Lecture Outline
11.1 Multiple Approaches to Stock Valuation
A commonly used valuation method is relative valuation. Here a target company is compared
with other companies in the same industry in terms of a particular financial ratio. The approach
assumes the target follows a similar relationship between the common metric and the metric’s
value. The text example includes the often-used metric of the price earnings (PE) ratio.
Step 1: Identify the PE ratio for the target company’s industry.
Step 2: Calculate the target company’s earning per share (EPS).
Step 3: Multiply the target company’s EPS by the industry’s PE ratio, and a company value is the
result.
Price per Share
By using this formula: P/ E Ratio=
Earnings per Share
and solving for price per share, the analyst has conducted a relative valuation of the target
company’s share. Further refinement of this method is possible. If the target company is
considered among the best companies in the industry, the PE might be adjusted higher.
Likewise, a target company that underperforms industry peers might warrant a lower PE
multiple.
03/21/22 2
