finance lecture 16 with answers

7/28/2019 Finance Lecture 16 With Answers

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Lecture 16: Outline

Topic 6: Stock Valuation (Chapter 9)

Value and Growth stocks

Relative valuation b com arables


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Valuation metrics: Dividend Yields

Dividend Yield: Dividend as a fraction of stock price

market as a whole Can be based on

Most recently paid dividend, or

Next periods expected dividend

Note: Dividend is annualized (i.e., times 4 if quarterly dividend)

,estimate is that next periods (annualized) dividend will be $0.20.

What is the dividend yield?

0.5%or005.040

20.0

YieldDiv0

1

=== P

Div


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Dividend Yields and the risk free rate

Should a stocks dividend yield be higher or lower than

the risk free rate?

Recall, if we assume dividends are in the form of a growingperpetuity, then

Div1 Div 1grE

0P

E

0

So answer depends on the stocks required return and dividend

growth rate, and how the difference between the two compare to

the risk free rate


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Dividend Yields: Example 1

Example: GM has a required rate of return, rE, of 11%,

and dividends are ex ected to remain constan = 0

in perpetuity. The risk free rate is 7%. Should GM havea higher or lower dividend yield than the risk free rate?

10 =

DivP fE rr

Div=>== %7%11 1

When the er etual dividend is constant the dividend

E 0

yield equals the stocks required rate of return

Which is usually greater than the risk free rate

Because dividends are risky (positive Beta)

Exception is if the stock has a zero or negative beta


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Dividend Yields: Example 2

Example: GOOG has a required rate of return, rE, of

11% and dividends are ex ected to row at a 6% rate in

perpetuity. The risk free rate is 7%. Should GOOG havea higher or lower dividend yield than the risk free rate?

rrDiv =


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Dividend Yields and risk free rates


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Dividend Yields: Summary

Although people look at Dividend Yield as a rough

Fairly priced stocks can have different dividend yields if

t ey ave e t er erent growt rates or erent r s

All else equal

Higher growth rate lower dividend yield

As growth expectations change

Which in turn change as a result of changing risk free rates or changing

risk premium


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Dividends and Earnings

People often think of dividends as being paid out of

Board of directors decides how much to pay out

Number of factors to consider: discussed in advanced finance courses

In reality, a company can pay dividends even if they

Or, they may have a large profit and not pay a dividend

Thus, investors also like to look at a companys

earnin s or earnin s er share EPS and com are it to

the stock price


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Valuation metrics: Earnings Yields

Earnings Yield: Earnings per share as a fraction ofstock rice

Rough valuation metric for stocks and the market Can be based on

Most recent earnings, or

Next periods expected earnings e w use nex per o s expec e earn ngs

Note: Earning is annualized (i.e., times 4 if quarterly earnings)

Example: JPM stock price is $40, and analysts consensusestimate is that next periods (annualized) earnings per share will

be $4. What is the earnin s ield?

10%or10.040

4

YieldEarnings 0

1===

P

E


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Earnings Yields and PE ratio

Assume a company pays a fraction of their earnings

.

growing perpetuity, then

grgr

P

EE

=

=11

0

P

E =

0

1

Similar conclusions as before: Two fairly priced stocks

can have different earnings yields if they have

Different required rates of return (different risk) Different growth rates

n ese can c ange over me or e same company

(dont worry about different s for this course)


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Price Earnings (PE) ratio

Investors usually talk about PE ratios, which are just the

inverse of the earnin s ield

1=

P=

earn ngs grE

multiple of that companys earnings

Willing to pay a higher multiple if

Higher growth rate


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Some PE ratio comments/questions (1)

Q: Suppose a company is going through a very bad

,

recover strongly. Would you expect that company to

happen to the PE ratio in the future?

Since investors care about all future earnings, the stock

rice will be hi h and the PE ratio will be hi h since E

is currently low.

ven ua y w en r ses, e ra o w a .


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Q: Suppose a company is expected to post decent

earn ngs next per o , ut earn ngs are expecte to

collapse after that. Would you expect that company to

to the PE ratio in the future?

Since investors care about all future earnings, the stock

price will be low and the PE ratio will be low since E is

s a r y g .

, .


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: All else e ual would ou ex ect PE ratios to be

lower (earnings yield higher) when interest rates arehigher?

Yes, investors would want to pay less per dollar ofearning (they would require higher yields) since they

can get attractive yields in government bonds when

n eres ra es are g .


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Value and Growth stocks

Stocks with low PE ratios are said to be valuecompan es

Stocks with high PE ratios are said to be growthcompan es

More on these when we talk about market efficiency


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Relative valuation by comparables

Recall: PE ratios can be different for several reasons Different growth

Different risk

But looking at PE ratios for firms that are comparable,

can be useful forrelative valuation


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Valuation by comparables: Example 1

Today is t = 0. You believe companies A and B haveexpected dividends of $1, and $4 at t = 1, and that A

and B have the same dividend growth rate of 3% inperpetuity, and have the same beta of 1. The risk free,

market risk premium is. Stock A is trading for $18 and

stock B is trading for $80.

Can you determine the fair prices of these stocks?

,

Is one stock mispriced relativeto the other? How wouldyou exploit this mispricing?


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Valuation by comparables: Solution

You know that for stocks A and BADiv BDiv

AAE gr =

0 BBE gr =

0

BA,

We are also given that gA = gBEE

AA

It follows that

4

1

1

0

0==

BB DivP

So stock A should be worth 1/4 of stock B

, Could still be that both are too expensive, just that A is less expensive than B


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Valuation by comparables: Solution (2)*

One way to exploit the mispricing is to set up a position where youare long the relatively underpriced security, and short the relativelyoverpr ce secur y

The ratio of the positions is equal to the ratio of the dividends,

dividend

Thus ou would o short one unit of stock B and lon 4 units of A

This would yield a positive cash inflow at t = 0, and expected 0

zero cas ows n e u ure, w c ave a zero e a Note, the position is not necessarily an arbitrage, because the future

, ,though they have the same beta


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Other comparables

Startu firms often have no dividends or earnin s for

long periods of time

Can look at sales

Similarly, if firms have no sales, can look at web pagevisits, for example

Of course, you need to make sure companies are indeed


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Valuation by comparables: Example 2

Today is t = 0. Given info on 3 stocks: Stock A

xpecte v en at t = s

Dividend growth rate = 4%Market Beta = 1.3

Expected dividend at t = 1 is $3Dividend growth rate = 4%

Market Beta = 2.6 Stock C

Expected dividend at t = 1 is $9Dividend growth rate = 4%

.

If the prices of Stocks A, B, C, are $10, $6, and $28, respectively,what position would you take in the above stocks based on the

concept of relative valuation? (Note: you dont necessarily need to

take a position in all three stocks.)


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Valuation by comparables: Solution

If two stocks have the same rE and same g, then their Price toDividend ratios must be the same.

Stocks A and C, have the same Beta and thus the same rE. They. ,

same price to dividend ratio. Since the ratio of their dividends is

3 to 1, stock C should be 3 times more expensive than stock A.ut t s on y . t mes more expensve, t us stoc s reat vey

cheap relative to stock A. So you want to go long C, and short 3units of A.

(Note: Because stock B has a different beta, it has a different rEand thus we cannot make any comparative statements about

stock B.)

finance lecture 16 with answers

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