7 stock valuation

Common Stock Valuation

• Stockholders expect to be compensated for their

investment in a firm’s shares through periodic

dividends and capital gains.

• Investors purchase shares when they feel they are

undervalued and sell them when they believe they are

overvalued.


• Investors base their investment decisions on their

perceptions of an asset’s risk.

• In competitive markets, the interaction of many buyers

and sellers result’s in an equilibrium price – the market

value – for each security.

• This price is reflective of all information available to

market participants in making buy or sell investment

decisions.

Market Efficiency


• The process of market adjustment to new information

can be viewed in terms of rates of return.

• Whenever investors find that the expected return is

not equal to the required return, price adjustment will

occur.

• If expected return is greater than required return,

investors will buy and bid up price until new

equilibrium price is reached.

• The opposite would occur if required return is greater

than expected return.

Market Adjustment to New Information


• The efficient market hypothesis, which is the basic

theory describing the behavior of a “perfect” market

specifically states:– Securities are typically in equilibrium, meaning they are

fairly priced and their expected returns equal their required returns.

– At any point in time, security prices full reflect all public information available about a firm and its securities and these prices react quickly to new information.

– Because stocks are fairly priced, investors need not waste time trying to find and capitalize on mis-priced securities.

The Efficient Market Hypothesis

Stock Valuation ModelsThe Basic Stock Valuation Equation

The zero dividend growth model assumes that

the stock will pay the same dividend each year,

year after year.

Stock Valuation ModelsThe Zero Growth Model

Stock Valuation ModelsThe Zero Growth Model

What would an investor pay for a stock if she expected to receive a dividend of $2.50 each year

indefinitely and her RRR is 15%

16.67

• The constant dividend growth model assumes that the

stock will pay dividends that grow at a constant rate

each year -- year after year.

Stock Valuation ModelsThe Constant Growth Model

Constant Growth - Example:

The next Dividend for Rolta India will be Rs.4 per share. Investors require a 16% return on companies such as Rolta India. Rolta’s Dividend increases by 6% every year. Based on the Dividend Growth Model, What is the value of Rolta India stock today?, what is its value in four years?

P0 = D1/r-g = 4 / (0.16 - .06) = Rs.40

D4 = D1 (1+g)3 = Rs.4.764

P4 = D4 (1+g) / (r-g) = Rs.50.50

GROWTH?

Stock Valuation ModelsThe Constant Growth Model

What would an investor be willing to pay for a stock if he just received a dividend of $2.50, his RRR is 15% and he expects dividends to grow at 5% per year?

26.25

• The non-constant dividend or variable growth model assumes that the stock will pay dividends that grow at one rate during one period, and at another rate in another year or thereafter.

Stock Valuation ModelsVariable Growth Model

Step 1: Compute the expected dividends during the first growth period.

g 10.0%

D0 2.50$

D1 2.75$

D2 3.03$

What would an investor be willing to pay for a stock if she just received adividend of $2.50, her required return is 15%, and she expected dividnedsto grow at a rate of 10% per year for the first two years, and then at a rate of5% thereafter.



Step 2: Compute the Estimated Value of the stock at the end of year 2using the Constant Growth Model

D2 3.03$

k 15.00%g 5.00%

V2? 31.76$



Step 3: Compute the Present Value of all expected cash flows to find the price of the stock today.

Cash PV atFlow 15%

1 D1 2.75$ 2.39$

2 D2 3.03$ 2.29$

3 V2? 31.76$ 24.02$

V0 ? 28.69$

Variable Growth Model

Stock Valuation Models

A common stock just paid a dividend of A common stock just paid a dividend of Rs.2. The dividend is expected to grow at Rs.2. The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in 8% for 3 years, then it will grow at 4% in perpetuity. What is the stock worth if the perpetuity. What is the stock worth if the required rate of return is 12%?required rate of return is 12%?

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Other Approaches to Stock Valuation

• Book value per share is the amount per share that

would be received if all the firm’s assets were sold for

their exact book value and if the proceeds remaining

after paying all liabilities were divided among common

stockholders.

• This method lacks sophistication and its reliance on

historical balance sheet data ignores the firm’s

earnings potential and lacks any true relationship to

the firm’s value in the marketplace.

Book Value


• Liquidation value per share is the actual amount per

share of common stock to be received if al of the firm’s

assets were sold for their market values, liabilities

were paid, and any remaining funds were divided

among common stockholders.

• This measure is more realistic than book value

because it is based on current market values of the

firm’s assets.

• However, it still fails to consider the earning power of

those assets.

Liquidation Value


• Some stocks pay no dividends. Using P/E ratios are one way to evaluate a stock under these circumstances.

• The model may be written as:

– P = (m)(EPS)

– where m = the estimated P/E multiple.

For example, if the estimated P/E is 15, and a stock’s earnings are $5.00/share, the estimated

value of the stock would be P = 15*5 = $75/share.

Valuation Using P/E Ratios

Determining the appropriate P/E ratio.◦ Possible Solution: use the industry average P/E ratio

Determining the appropriate definition of earnings.◦ Possible Solution: adjust EPS for extraordinary items

Determining estimated future earnings◦ forecasting future earnings is extremely difficult

Other Approaches to Stock ValuationWeaknesses of Using P/E Ratios

Free Cash Flow Model


• The free cash flow model is based on the same premise as the dividend valuation models except that we value the firm’s free cash flows rather than dividends.



• The free cash flow valuation model estimates the value of the entire company and uses the cost of capital as the discount rate.

• As a result, the value of the firm’s debt and preferred stock must be subtracted from the value of the company to estimate the value of equity.



Dewhurst Inc. wishes to value its stock using the free cash flow model. To apply the model, the firm’s CFO developed the data given in Table.



Step 1: Calculate the present value of the free cash flow occurring from the end of 2009 to infinity, measured at the beginning of 2009.



Total FCF2008 = $600,000 + $10,300,000 = $10,900,000

Step 2: Add the PF of the FCF found in step 1 to the FCF for 2008.

Step 3: Find the sum of the present values of the FCFs for 2004 through 2008 to determine VC. This

is shown in Table 7.4 on the following slide.



VS = $8,628,620 - $3,100,000 = $4,728,620

Step 4: Calculate the value of the common stock using equation 7.8.

7 stock valuation

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