[MUSIC] Hi, I'm professor Scott Weisbenner. Professor of Finance at the University of Illinois. And this is module four of my investments course. And I hope for this module you like roller coasters here. This roller coaster may be a little painful if you've been an investor, particularly in the NASDAQ, over the last 15 years. At the top of the roller coaster as we're heading down, the Summer of 2000, we maybe didn't realize how far down we were going. It takes another 15 years to get to the Spring and Summer of 2015 for the NASDAQ to get to that same level of 5,000. Here we have a little screen showing the NASDAQ change in price from March of 2009 to December of 2001 in blue. And you see this, kind of fairly dramatic here, 60% decline in the NASDAQ index while treasuries aren't changed very much. So clearly, change in expectation about future cash flows, the growth of cash flows going forward fell big time. That's why I call it technology bubble, crash, or popping. So kind of big change in assumptions about current casuals and casual growth, big effect on valuation. Another real-world example here, looking at the S&P S&P 500 in blue. So from January of 2011 through May of 2015, we see this almost 70% increase in the value of the S&P 500 index. At the same time, the yield on 30-year treasuries have fallen almost 1.6 percentage points. Are those related? Kind of a simple perpetuity value of firm valuation. Say, hey one of the key components of value is a future discount rate. The discount rate falls a lot, 30-year Treasuries, 10-year treasuries are falling a lot in terms of their yields are falling. That means cash flows In the future will be worth more in today's terms, so the value of assets should go up. S&P 500 is a great example of that. So when we're looking at the S&P 500, 2011 to May 2015, the question is, are we at the top of the roller coaster here, or are we going to continue upwards and onwards? So you may kind of get the picture of the theme here for module four. It's going to be all about firm and stock valuation, and sometimes, when you're looking at the value of an individual firm or you're looking at kind of an index, like the S&P 500, or NASDAQ, it may seem like valuation is a lot like a roller coaster. There are valuations, individual stock, and index as a whole, seems to move around quite a bit. At least it seems that way over the last 15 or 20 years, but it’s really kind of been that way kind of throughout the history of stock markets. You have continually changing kind of valuations of firms. So it leads to a natural question. What ultimately goes into a firm's kind of value? How sensitive is a firm's value to assumptions about short term cash flow, long term projections, growth rates of the cash flow, and the riskiness of the cash flow? The discount rate, which we have kind of developed during the first part of the investments course, okay? The first part of the course, early on, we're talking about coming up with asset pricing models, coming up with required returns that a security should yield given its risk. And in the capital asset pricing model, that risk was determined by how sensitive is the performance of that asset to the market as a whole? In Module 4, we're going to focus on the level of prices and value, not the return. So the discount rates or acquired return for a stock that we develop earlier in the course. We develop the tools to calculate that required return that will be a component of the total firm value or the stock price. That will be the discount rate that goes into converting future cash flows from the firm into a value today. We'll also look and see, can we glean any insights about what the value our firm should be given how other comparable, or similar firms are currently value in the stock market? So first returns, now prices, here's Apple. I think we showed this stock screen from Finasa a little earlier in the course. When we're looking at the beta, that's going in to determining what's a required return investors have for Apple stock? What's a potential discount rate that Apple should use to discount its' future cash flows to get them in terms of a dollar value today that went in to gain the required return, the beta? What we're interested in module four of the course is focusing on well, let's come up with an estimate, not just of what the required returns are going forward, or kind of evaluating the performance of firms and securities in the past. And seeing, have they exceeded their benchmark, what their benchmark is going forward? Where focus on you know what should be the right level. What should be the value of the company? The market cap. What should be the price per share of the stock? And when we're looking in terms of value, we see all kind of multiple type of value Valuation Ratios reported. And also, a wide variety and the magnitude of these Valuation Ratios across firms. So for example, here looking at Microsoft, top line here on this valuation chart here, provided by Morningstar, is a price-to-earnings ratio. The stock price divided by the earnings per share, or the total market cap divided by total earnings. And you can see here, this was taken May of 2015, Microsoft's Price/Earnings ratio, price divided by earnings over the last year, of about 20, similar to the S&P 500, okay? Another valuation or ratio here, Price to Book. Market to book. So we talked about this would be an indicator of growth or value, in the investments world, you usually talk about book to market, the reciprocal of that is price to book. So you can see here, Microsoft's price to book ratio is 4.2, the S&P 500, 2.8. So Microsoft's more on the category of growth stock, but by this measure here, the market value exceeding the book value by quite a bit for Microsoft, more than the market as a whole. Facebook also market a value ratios or valuation ratios provided for Facebook as well. Here, you can see the difference in various types of price earnings ratios. So, for example, currently again measured on May of 2015, the price to earnings ratio for Facebook, when we measured earnings over the past year, is 80. Compared to the overall market when it's 19. So why is Facebook's price to earnings ratio so much higher than the market? Almost a factor of four, what's going into that? Well, the key is for people to kind of buy Facebook stock at the current price it's trading at. There is an embedded assumption that Facebook is going to be growing much faster than the overall market. If that's not the case, the stock price for Facebook will drop dramatically. That's reflected by that price of Facebook divided by last year's earnings of 80. How about if we look at what's called a Forward Price Earnings ratio? Well, this is the the price of Facebook not divided by earnings over the last year, but earnings expected by analysts over the next year. So here you can see the forward price earnings ratio is 32.5 as opposed to 80. So that means that analysts expect tremendous growth in Facebook's earnings to knock that price ratio. From 80, when earnings are measured over last year, to a price range ratio of 32. When earnings are measured over the next year in the future, there has to be a lot of growth in earnings to make that happen. That's what analysts are expecting. If you look at the S&P 500, there are kind of the price earnings ratio in the future is 18.6 using earnings expected next year, compared to the 19.4 using earning over the last year. So embedded in the S&P 500 valuation is only a small growth in earnings. Embedded in the Facebook valuation is a tremendous growth and earnings. So we'll also talk about this module, on average, is there persistence in growth rates? So firms like Facebook, on average, are they able to deliver this high growth and earnings over long periods of time, which is currently embedded in the value of Facebook? This high growth, do firms achieve this on average would be something that we talk about in the course. So big differences in evaluation, ratios. Why do firms have different valuation ratios, in terms of price earnings, or price to book, what’s embedded in the price earnings? What’s that telling us about growth prospects expected by the market for the firm? What's it telling us about how the market perceives a riskiness and cash flow? There's a lot we can learn by looking at price/earnings or ratio of firms and comparing the price/earnings ratio across firms. Also, when we're doing a market multiple valuation analysis, can we use evaluation ratio of one firm to estimate the value of another? So Corporate Finance and Investments, and that's really what this last module is linking. It's linking what we learned in investments to value firms. Now, certainly when you do look at the topic of firm valuation. This is typically covered in more depth in a corporate finance class than it would be an investments class. So the investments course, like this one, provides guidance in terms of coming up with hurdle rates, or required returns for firms based on, for example, estimates from a CAPM model of the beta. Using that in assumptions about the equity market premium and treasury yields. Going forward, you can come up with a hurdle rate or discount rate to convert future cash flows of the firm in question to a value today, and thus a stock price today. An investment is giving us this kind of discount rate component to go into the cash flow valuation. So even though firm valuation is typically covered more in a corporate finance class, I thought it would be useful to take our investments knowledge, take a stab at some firm valuation techniques in this investments class as well. So what do we plan to accomplish in Module 4? We're on the last quarter of the investments course, so let's make it count here. So we've just kind of wrapping up our objectives, an overview of the course, then basics on perpetuities, okay? So when you think of a stock, buying stock in a firm or a firm. Think that's an asset with a very long life. So that would suggest, let's use a perpetuity to value, kind of, the stocks. If we put an assumption about short-term cash flows, long-term growth in the cash flow. The discount rate to use to convert future cash flows into a value today. You're willing to make all those assumptions. Plug them into a perpetuity formula. That will give you the value of the underlying asset or stock. So once we develop the perpetuity formula, we'll do a simple application of that to recent changes in the S&P 500 index from 2011 through May of 2015. And we highlighted that a little bit earlier on in this introduction to module four. How much of the rise in value the overall US stock market over the past few years, 2012 to 2015, can be explained by simply the reduction in US treasuries, the reduction in the discount rate Component of the perpetuity formula? Then, a primer on valuation where we talk about market multiple approaches and income approaches to valuing a firm, okay? Building on that, on kind of the income approach to valuation, which requires assumptions about the discount rate and growth rate. I think it's useful to take a step back and provide some lessons to give you a little caution when making long term forecast on discount rates and growth rates. Keeping that in mind, then let's go through some actual concrete kind of examples, applying our investments in valuation techniques, first of which will be a discounted cash flow valuation example applied to pension plan liabilities. What´s a big issue for state governments, like the state of Illinois for example? Or California, or for firms like General Motors? For example is how to value these defined benefit promises? How to value this stream of liabilities, to come up with a value in today's terms, okay? We'll take that kind of issue head on using kind of a logic that we have developed in investments course, as to the determination of what's an appropriate discount rate to convert future liabilities into present value costs today to get a sense of how big is this liability for state governments and for firms that offer defined benefit plan packages in the past? Then moving on, using the market multiple technique, this is when you use things like a price/earnings ratio or a market to book ratio. Some ratio that has market data divided by accounting data. You use a ratio like that of a firm ylike Yahoo, for example, to value yourself. In the case, I have Google. So we'll do a market multiple analysis, valuing Google at the time of their IPO. Where we'll use Yahoo as our comparison firm. So Google isn't publicly traded yet, doesn't have any market data. Let's use the market value ratios of Yahoo and Google at the time of the IPO in 2004, pretty similar, similar terms. So we're willing to make the assumption that Google should be valued the same way Yahoo is, take Yahoo's market multiples, multiply them by Google's accounting data, and it gives you estimates of Google's market data. And what price Google should have set at the time of their IPO. So that will be kind of a fun example to look at. Then finally, as always, we kind of wrap up with the module four review. So for those who are taking the course for high engagement to get University of Illinois credit. I'm going to provide even more practice on market multiple valuation techniques, discounted-cash flow techniques when we do the case study valuating this takeover target Interco. This is one of my favorite case studies, I teach it in investments class, I teach in corporate finance class. Even if I teach in Spanish literature, I'd find some way to get this Interco case study as part of the lesson plan. It's really a great case, because it allows you to kind of dig deep and explore the sensitivity of the valuations of various assumptions, critique the reasonableness of the various assumptions that go into the valuation. And identify corporate actions that may make the stock and firm appear to be more valuable in the eyes of investors. And what's nice about this Interco case study, is there was ultimately a lawsuit involving Interco that enabled there to be disclosure of all the valuations that were done by the investment bank, Wasserstein and Perella, that Interco hired to do a valuation for them. Interco was subject to a takeover. It hired Wasserstein Perella to do various valuations, to get a sense of what a reasonable price is. The great thing for us is we actually see what those valuations were. And then we can reverse engineer and to see what assumptions were consistent with the valuations that were given to Interco at the time of takeover bid. And Interco is a company, a conglomerate with very diverse brands like Ethan Allen furniture, Converse, London Fog coats. So it's kind of a fun company to look at. Okay, practical knowledge, experiences you should take away from module four. How to conduct and apply perpetuity valuations and appreciate the sensitivity of the value of an asset or security day. Today, to small changes and discount rates, or growth rates, and then we'll have a direct application of the simple perpetuity formula to get an understanding of S&P 500 movements, and value over 2011 to 2015. They're going to learn the market multiple and the discounted cash flow or income approach to valuing a stock. But when we do these evaluations, we also want to be cognisant of some of the kind of risk, or I should say some of the limits in our long term forecasting ability for discount rates and growth rates. So we know the formula to do the discounted cash flow evaluation, anyone can punch in the numbers and get an answer. The question is, how reasonable are the assumptions that go into that final answer? And that's really where most of the skill is, is deciding what assumptions are reasonable or not. Not kind of punching the numbers in and getting the final calculation. And then finally, specific examples of how to conduct a market multiple valuation in terms of valuing Google at the time of its IPO, and a discounted cash flow valuation, where I'll give you a choice of valuing either Apple, Facebook or Google. And then I'll do a valuation of Microsoft that I'll share with you.
