Equity Valuation

If an individual were given $100,000 to investment in three different company's stocks, how does one approach with his or her selection? Expect return from stock investment comes along with extend degree with risks depending on the type of stock invested. Investors seek return from stock investments in two forms: cash dividend and difference between the selling price and purchasing price, known as the capital gains or loses. This paper is to demonstrate how and why three company's stocks were chosen to include in the $100,000 investment portfolio, and at what market prices would these stock be sold.

Industry Selection

The first step in choosing the stocks is to decide investing in either income stock or growth stock. As Ross, Westerfield, and Jeffe (2004) mentioned, a firm that pays all the earning to stockholders as dividend is referred as a cash cow. Not retaining part or all the earning and plowing back to the firm is not always the most optimal choice; firm that decides to pay out all its earning is missing the its growth opportunities to invest in other profitable projects. Investors who are seeking cash dividend prefer income stocks, as oppose to growth stocks are related to investors' capital gains and lose. Stocks from matured industries, such as utilities and banking are refer to as income stock because stockholders generally receive a streams of dividends. This form of return from stocks is similar to return from bonds, which involves less risk than growth stocks. Investors that choose growth stock are not promised with dividend return; instead the return comes from the capital gain when the selling price of the stock is higher than original purchasing price. Growth stocks are more prone to risks since the return depends on the firms' actual growth and market fluctuation. The common belief in risk reduction is to diversify the investment portfolio. Gibson (2004) advocated the one-third-investment strategy. He believes to reduce equity risk; investors ought to spread investments among common stock, real-estate investment, and bond. Using his suggestions to diversify types of investment as a risk reduction tool, each of the three stocks chosen for the investment portfolio must possess one of the following characteristics:

1. High growth rate with majority of earning plowed back for future growth.

2. Low growth rate, but declares majority of earning to investors.

3. Evenly distributed dividend and plowback ratio.

Using Yahoo! Finance, the following chart is provided to select three industries that meet the selection criteria.

Table 1Industry Analysis

Sectors P/E Div. Yield %

Basic Materials 14.458 2.142

Conglomerates 19.4 2.338

Consumer Goods 28.931 2.36

Financial 13.838 2.694

Healthcare 19.486 1.536

Industrial Goods 17.781 1.503

Services 30.589 1.292

Technology 44.855 1.792

Utilities 17.907 3.459

Table 1 above illustrates that utilities industry yields the most dividend while P/E ratio determines the industry growth; the technologies industry possesses the most growth. Basic material is located in the middle that distributes averaged dividend and has averaged P/E ratio. As the result, industries selected for investment is as follows:

1. Technology - Growth stock with the highest P/E ratio and relatively low dividend yield percentage.

2. Utilities - Income stock with lower P/E ratio but the highest dividend yield percentage.

3. Basic Material - Average P/E and dividend yield percentage.

Stock Selection

After industry selection, the next step is to choose a company within the industry. For growth stocks, top three companies with the highest P/E ratio would be chosen to further analyze these three companies net present value of growth opportunities (PVGO). Top three companies within the utilities industry are also chosen. However, instead of applying PVGO as the selection criteria, the stock with the highest five years dividend yield would be selected. The stock for basic material would be chosen base upon both PVGO calculation and five years average dividend yield.

Selecting Growth Stock

From Yahoo! Finance search, semi-conductor for memory chips has the highest P/E ratio; therefore, the top three companies selected are from the semi-conductor for memory chips industry. Table 2 below presents three highest P/E ratios companies, and those companies are: Rambus Inc, Micron Technology Inc, and NetLogic Microsystems Inc.

Table 2Semiconductor Memory Chip

Company P/E

Rambus Inc. 116.89

Micron Technology Inc. 92.42

NetLogic Microsystems Inc. 49.28

Technology 44.86

SanDisk Corp. 41.78

MIPS Technologies Inc. 39.53

M Systems Flash Disk Pioneers 37.89

Pixelplus Co., Ltd. 27.72

Silicon Image Inc. 25.53

Estimated PVGOs To determine the estimated PVGOs, the following information is required:

1. Stock Price: Average stock price in December 2005. The average is calculated by stocks' daily closing price, and the information is obtained from Yahoo! Finance.

2. EPS: Estimated December 2006 EPS is obtained from Yahoo! Finance's analysis section.

3. Cost of Equity, r: The cost of equity is calculated using the capital asset pricing model. The risk free rate is the current yield on a one-year Treasury bill, beta is provided by Standard & Poor's Stock Report, and expected return is set at 10% for all three stocks.

The formula used to calculate PVGO for all three stocks is:

PVGO = Po - EPS / r

Table 3 below illustrates the PVGO calculations and results:

Table