Analysis of Common Stocks

Investments and Portfolio Management (MB 72)

OutlineProcess of Valuation of a Financial AssetProcess of Valuation of Common StocksDetermining parameters of models

How to determine the growth rate?Length of growth periodHow to determine the required rate of return

Models for Stock ValuationDividend Discount ModelsPrice-Earnings ModelsFree Cash Flow to Equity Valuation Models

Valuation of Financial AssetsProcess of determining the fair market value of a financial asset on the basis of present value of the expected cash flowsThree step process:

Estimate the expected cash flowsDetermine the appropriate interest rate or interest rates to discount the cash flowsCompute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2

Estimating Cash Flows

Holding aside the risk of bankruptcy, the cash flows of a common stock are:

• Payment of dividend so long as we hold the stock

• Sale price of common stock when we sell the stock

Is it difficult to estimate the cash flows of a common stock?

Value of a Common Stock

Fair Market Value of a common stock depends on

PV of cash flows from a stockPV of an infinite dividend stream ORPV of a finite dividend stream plus PV of the sale price of the stock

Discounted Cash Flow Valuation

Value of any asset—a function of 3 variables

How it generates its cash flows?When these cash flows are expected to occur?Uncertainty of these cash flows

t=n CFt

Value = ---------- t=1 (1+r)t

Dividend Discount Model (DDM)Value of a share of common stock is the present value of all future dividends

n DPSt

Value per share of stock= ---------- t=1 (1+r)t

What if the stock is not held for an infinite period?

One year holding periodMultiple year holding periods

Dividend Discount Model

Two types of cash flowsDividends during the holding periodExpected price at the end of holding period—this itself is dependent on future dividends

How to determine the value of a share of common stock?

Infinite Holding Period

What will be the value of a share of common stock?

Present value of an infinite stream of anticipated dividends

Simplified assumptions to simply valuation model

Zero Growth ModelConstant Growth ModelTwo-stage growth modelThree-stage growth model

Zero Growth Model

Dividend every year will be the sameInvestor anticipates to receive the same amount dividend per year forever

DPSV = -------------

rcs

Constant Growth Model

Assume that firm grows at a stable growth rate of g per year forever

DPS1

V = --------- r - g

Two-Stage DDMIn general version of the model, two stages of growth

An initial period of extraordinary growthAfter initial period, a period of stable growth

n DPSt Pn

P0 = ---------- + --------- t=1 (1+r)t (1 + r)n

DPSn+1

Where Pn = -----------------

(r – gn)

Three-stage growth model

Four Basic Inputs

Length of high growth periodDividends per share each periodRequired rate of return by stockholders each periodTerminal price at the end of high growth period

High Growth Rate and Stable Growth Rate

Stable Growth Rate?Growth rate expected to last foreverFirm’s other measures of performance including can be expected to grow at the same rate

What growth rate is reasonable as a “stable” growth rate?

A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy

Length of High Growth Period?How much is the current growth rate?Source of high growth?

High Growth Period

The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth periodThe larger the current size of the firm, the shorter the high-growth period.

Guide to Length of High-Growth Period

Current Growth Length of HighRate Growth Period

1% higher than stable No high growth1 – 10% higher than stable 5 years> 10% higher than stable 10 years

How do we Estimate Growth Rate?

g = b[ROA+D/E(ROA-I (1-t))]Where b refers to the retention ratioROA is the return on assetsD/E is the debt to equity ratio in book value termsi = interest expense/book value of debt

FCFE Valuation Model

The cash flow that the firm can afford as dividends and contrasted with actual dividends—may not payout as dividendsThe residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and create new assets for future growth.

FCFE = Net Income + Depreciation – Capital Spending - Working Capital – Principal Repayments + New Debt Issues

If there is a target debt ratio, FCFE = Net Income - (1 - )(Capital

Expenditure – Depreciation) - ( 1- ) Working Capital

FCFE Model

n FCFEt Pn

P0 = ---------- + ---------

t=1 (1+r)t (1 + r)n

FCFEn+1

Where Pn = -----------------

(r – gn)