Three sectors were selected in the last exercise, the Financial Services Sector, the Information Technology sector. These three sectors have a track record of index beating performances. For instance, the information technology sector companies like Google and Facebook have seen year-on-year growth in their stock. Since its IPO, Facebook stock has appreciated more than 1,100%. On the other hand, the healthcare and financial services have been relatively stable over the past decade. The healthcare industry for example, is known to be immune to macro-economic shocks. This shows that profits and stock price movements can be forecasted to be stable.
The three companies selected for this exercise are Amazon in the information technology sector, JPMorgan Chase & Co in the financial services sector, and Abbott Laboratories in the health sector. The stocks will receive a total investment of $5,000,000. The remaining half, $5,000,000 will be invested in bonds. It is expected that the investments will generate returns that are superior to the S&P index. The time period given is 12 months. Three methods are used to calculate the value of the stocks. The dividend discount model, the Gordon model, and the P/E method.
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Using the dividend discount method, all the future dividends of a given stock are summed and discounted. The dividend discount method ignores prevailing or future market conditions when calculating the value of a stock. According to the dividend discount method, a stock is undervalued if the discount value is higher than the price of the stock (Kulišauskas & Galinienė, 2015). The formula for calculating the intrinsic value of the stock price using the dividend discount method is; value of stock= annual current dividend * (annualized dividend growth rate/100+1)/ (cost of stock/100-annualised dividend growth rate/100). The dividend is calculated at a required rate of return of 20%. The dividend is projected in the course of the next one year.
Using the dividend discount method, the intrinsic value of the stocks were found to be $87.42, $62.58, and $1,352.21 for JP Morgan, Abbott Labs, and Amazon respectively. Important to note, Amazon does not have a dividend history. The Gordon discount model is an alternative model to the dividend discount model. Unlike the dividend discount rate, the Gordon model uses a constant rate to calculate the intrinsic value of a stock (Prusak, 2017). The Gordon model is usually used in companies with a stable rate of return. The formula used to calculate the value of a stock using the Gordon model is; Value of stock =Expected dividend per share/investors rate of return-expected growth rate. The Gordon model shows that the intrinsic value of the stocks are 118.84, $80.76, and $1,633.65 for JP Morgan, Abbott Labs, and Amazon respectively.
With the P/E method, the value of a stock is done using the P/E ratio. The P/E ratio whether the stock price of a share is undervalued or overvalued. In addition, the P/E valuation shows the performance of the company in comparison to other industry players. In calculating the P/E ratio, the prevailing market price of the share is divided by the earnings per share. From the analysis in the attached excel sheet it can be seen that the stocks had an EPS of 11.38, 55.62, and 81.13 for JP Morgan, Abbott Labs, and Amazon respectively.
The consensus earnings forecasts shows that all the three stocks will have positive returns. JP Morgan stock is forecasted to have a yearly EPS of 9.94 and quarterly EPS forecast of 2.43, 2.56, 2.5, 2.37, and 2.78 for the 1 st quarter, 2 nd quarter, 3 rd quarter, and 4 th quarter respectively. Abbott Labs is forecasted to have a yearly EPS of 3.2 and quarterly EPS of 0.61, 0.81, 0.85, 0.93, and 0.69 for the 1 st quarter, 2 nd quarter, 3 rd quarter, and 4 th quarter respectively. On the other hand, Amazon is expected to have a yearly EPS of 26.47 and quarterly EPS forecast of 4.57, 6.08, 7.08, 8.59, and 8.27 for the 1 st quarter, 2 nd quarter, 3 rd quarter, and 4 th quarter respectively.
Our calculations show that the EPS of the three stocks is 9, 1.3, and 20 for JP Morgan, Abbott Labs, and Amazon respectively. For JP Morgan the EPS is forecasted to go up marginally. This increase in EPS is likely to push the stock price up. Apart from pushing the stock price up, it is also expected that the value of the firm will also increase from the perspective of investors. The EPS of Abbott Labs is also forecasted to increase from 1.33 to 3.2. The increase is expected to also increase the share price which will I turn create a positive perception to investors. For Amazon, the EPS also rises considerably. The EPS is expected to jump from 20 to 26.4. Like in the other 2 years, the share price is expected to rise with rise in EPS.
In most instances, investors compare the EPS of a company to the actual EPS. Consensus EPS value represents the assumed value of the future EPS from the perception of different analysts. Although the relationship between EPS and share price is rarely inverse, an inverse relationship may occur in instances where the actual EPS moves below the consensus EPS (Islam, Khan, Choudhury & Adnan, 2014). Companies often resort to buybacks when the EPS falls below the one set by consensus.
The consensus interest focus for bond interest rates in the U.S is 2.5%. The quarterly forecast for 2019 is 2.5% for all the quarters. In general, the bond market interest rates are used as tools to predict the future economic activity of other markets such as real estate and equities. There also exist a high correlation between interest rates and bond yields. To a bond holder, rising interest rates erode the value of existing bonds. On the other hand, dropping interest boost the value of the bonds. In particular, the value of short terms bonds is impacted by investor perception of federal policies. Therefore the higher the interest rates, the lower the bond prices. This is because the market is likely to receive an influx of new bonds with lower prices. These interest rates also affect the yield curve.
The yield curve, a plot of the yield of a bond against maturity, is used to show future expectations of investors. The yield curve gives a graphical view of the performance of both long term and short term bonds. For instance, the upward slope of most yield curves show that investors expect higher returns for long terms investments compared to short term investments. There exists a negative relationship between the price of a bond and its yield curve. In this case, the higher bond prices are likely to result into a flatter yield curve. This is because lower bond prices mean higher entry prices for investors.
References
Islam, M., Khan, T., Choudhury, T., & Adnan, A. (2014). How Earning Per Share (EPS) Affects on Share Price and Firm Value. European Journal of Business and Management , 6 (17), 97-108. Retrieved from https://www.iiste.org/Journals/index.php/EJBM/article/viewFile/13572/13841
Kulišauskas, D., & Galinienė, B. (2015). STOCK EVALUATION METHODS AND THEIR APPLICABILITY IN LITHUANIA ENSURING SUSTAINABLE CAPITAL MARKET DEVELOPMENT. Journal of Security and Sustainability Issues , 5 (1), 74-84. doi: 10.9770/jssi.2015.5.1(6)
Prusak, B. (2017). The accuracy of alternative stock valuation methods – the case of the Warsaw Stock Exchange. Economic Research Journal , 30 (1), 413-438. doi: 10.1080/1331677X.2017.1305793
