Hi, I'm Professor Scott Weisbenner, a Professor of Finance at the University of Illinois, and this is Module 4 of my investments course. I hope for this module you like roller coasters here. This roller coaster may be a little painful if you've been 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 just a little screen showing the NASDAQ change in price from March of 2009 to December of 2001 in blue, and you see this fairly dramatic here, 60 percent 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 what I call the technology bubble. Crash or popping. A big change in assumptions about current cash flows and cash flow growth, big effect on valuation. Another real-world example here, looking at the S&P 500 in blue. From January of 2011 through May of 2015, we see this almost 70 percent 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. All those related simple perpetuity value of firm valuation and say, hey, one of the key components of value is the future discount rate. The discount rate falls a lot. Thirty-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. The value of assets should go up. S&P 500 is a great example of that. 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 upward, upward, and onward? See me get the picture, the theme here for Module 4, it's going to be all about firm and stock valuation. Sometimes when you're looking at the value of an individual firm or you're looking at an index like the S&P 500 or NASDAQ, it may seem like valuation is a lot like a roller coaster. The valuations, individual stock, the index, as a whole seem to move around quite a bit. You know, at least it seems that way over the last 15 or 20 years. But it's really been that way, throughout the history of stock markets you have continually changing valuations of firms. Listen, natural question, what ultimately goes into a firm's value? How sensitive is a firm value? Two assumptions about short-term cash flow. Long-term projections and growth rates at the cash flow and the riskiness of the cash flow, the discount rate which we've developed during the first part of the investments course. Okay? First part of the curve. Of course, early on, we're talking about coming up with asset pricing models, coming up with required returns that security should yield given its risk. In the CAPM, 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 rate or required return for a stock that we developed 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 of our firm should be given how other comparable or similar firms are currently valued in the stock market. First returns, now prices. Here's Apple, I think we showed this stock screen from finace.yahoo earlier in the course. When we're looking at the Beta, that's going in to determining what's the required return investors have for Apple stock. What's the 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 into getting the required return, the Beta. What we're interested in Module 4 of the course is focusing on, let's come up with an estimate not just of what the required returns are going forward or evaluating the performance of firms and securities in the past and seeing how they exceeded their benchmark what their benchmark is. Going forward where folks on 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? When we're looking in terms of value, we see, multiple type of value evaluation ratios reported and also a wide variety and the magnitude of these valuation ratios across firms. For example, we're looking at Microsoft, top line here on this, valuation chart here provided by Moningstar is a price-to-earnings ratio. The stock price divided by the earnings per share or the total market cap divided by total earnings. You can see here, this was taken in 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. Another valuation or ratio here, price-to-book, market to book. We talked about this would be even indicated at growth or value. In the investments world usually talk about book-to-market. The reciprocal of that is price-to-book. You can see here Microsoft's price-to-book ratio is 4.2, the S&P 500,2.8. Microsoft has more in 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, you know market value ratios or valuation ratios provided for Facebook as well. Here you can see the difference in various types of price earnings ratio. For example currently and again measured in May of 2015, the price to earnings ratio for Facebook, when we measure 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, key is for people to buy Facebook stock at the current price it's trading at. There's 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? This is the price of Facebook not divided by earnings over the last year, but earnings expected by analysts over the next year. Here you can see the forward price earnings ratio is 32.5 as opposed to 80. That means that analysts expect tremendous growth in Facebook's earnings to knock that price earnings ratio from 80 when earnings are measured over last year to a price-earnings 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, the price earnings ratio in the future is 18.6 using earnings expected next year compared to the 19.4 using earnings 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 in earnings. We'll also talk about this module on average, is there persistence in growth rates? Firms like Facebook on average, are they able to deliver this high growth in earnings over long periods of time, which is currently embedded in the value of Facebook. This high-growth, do firms achieve this on average. It will be something that we talk about in the course. Big differences is in valuation 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 at cash-flow? There's a lot we can learn by looking at price earnings ratio of firms and comparing the price earnings ratio across firms. Also, when we're doing a market multiple valuation analysis, can we use a valuation ratio of one firm to estimate the value of another? Corporate finance and investments and that's really what this last module is linking. It's linking what we learned in investments to value of 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. 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 and 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 and questioned to a value today and as a stock price today. An investment is giving us this discount rate component to go into the cash-flow valuation. Even though firm valuation is typically covered more in a Corporate Finance class, I thought it'd be useful to take our Investments. Now let's take a stab at some firm valuation techniques in this Investments class as well. 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. We've just wrapping up our objectives and overview of the course, then, basics on perpetuities. When you think of a stock buying stock in a firm or a firm, think that's an asset with a very long life. That would be suggests, let's use a perpetuity to value the stocks. That's 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. 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. We highlighted that a little bit earlier on in this introduction to Module 4. How much of the rise in value, the overall US stock market or the past few years, 2011-2015, can be explained by just 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. Building on 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 forecasts on discount rates and growth rates. Keeping that in mind, then let's go through some actual concrete examples applying our investments and valuation techniques. First of which will be 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. We'll take that issue head-on using the logic that we have developed in. Investments course as to the determination of what's appropriate discount rate to convert future liabilities into a present value cost 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 like Yahoo for example. To value yourself. In the case, I have Google. We'll do a market multiple analysis, valuing Google at the time of their IPO, where we'll use Yahoo! as our comparison firm. Google isn't publicly traded yet, doesn't have any market data. Let's use the market value ratios of Yahoo!. Yahoo! and Google at the time of the IPO in 2004, pretty similar firms. If 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. That will be a fun example to look at. Then finally, as always, we wrap up with a module for review. 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 evaluating this takeover target, Interco, this is one of my favorite case studies I teach it in investments class, I teach it in corporate finance class. Even if I was teaching Spanish literature, I'd find some way to get this Interco case study is 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 to 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. What's nice about this Interco case study is there is ultimately a lawsuit involving Interco that enable there to be disclosure of all the valuations that were done by the investment bank, Wasserstein Perella, that Interco hired to do evaluation for them. Interco is a 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 evaluations that were given to Interco at the time of their takeover bid. Interco is a company conglomerate with very diverse brands like Ethan Allen furniture, Converse, London Fog coats. It's a fun company to look at. Practical knowledge experiences that you should take away from Module 4. How to conduct and apply perpetuity valuations and appreciate the sensitivity of the value of an asset or security today to small changes in 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 2011-2015. We're going to learn the market multiple approach and the discounted cash flow or income approach to valuing a stock. But when we do these valuations, we also want to be cognizant of some of the risks, or I should say, some of the limits in our long-term forecasting ability for discount rates and growth rates. We know the formula to do the discounted cash flow valuation. Anyone can punch in the numbers and get an answer. The question is, how reasonable are the assumptions that go into that final answer. That's really where most of the skill is, is deciding what assumptions are reasonable or not, not punching the numbers and in getting the final calculation. 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.
