stockvaluation

8/7/2019 Stockvaluation

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Stocks and Their Valuation

Features of common stock

Determining common stock values Efficient markets Preferred stock


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Facts about common stock Represents ownership

Ownership implies control Stockholders elect directors

Directors elect management

Managements goal: Maximize thestock price


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Social/Ethical Question Should management be equally concerned

about employees, customers, suppliers,

and the public, or just the stockholders? In an enterprise economy, management

should work for stockholders subject toconstraints (environmental, fair hiring,etc.) and competition.


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Types of stock market

transactions

Secondary market

Primary market Initial public offering market

(going public)


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Different approaches for

valuing common stock

Dividend growth model

Corporate value model Using the multiples of comparable

firms


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Dividend growth model Value of a stock is the present value of the

future dividends expected to be generated by

the stock.

g

g

!

)k(1

D...

)k(1

D

)k(1

D

)k(1

DP

s3

s

3

2s

21

s

10

^


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Constant growth stock A stock whose dividends are expected to

grow forever at a constant rate, g.

D1 = D0 (1+g)1

D2 = D0 (1+g)2

Dt= D0 (1+g)t

If g is constant, the dividend growth formulaconverges to:

g-k

D

g-k

g)(1DP

s

1

s

00

^

!

!


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Future dividends and their

present valuest

0t )g1(DD !

t

tt

)k1(

DD

!

t0 D!

$

0.25

Years (t)0


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What happens if g > ks? If g > ks, the constant growth formula

leads to a negative stock price, whichdoes not make sense.

The constant growth model can only beused if:

ks > g

g is expected to be constant forever


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If kRF = 7%, kM = 12%, and = 1.2,what is the required rate of return on

the firms stock?

Use the SML to calculate the requiredrate of return (k

s

):

ks = kRF + (kM kRF)

= 7% + (12% - 7%)1.2= 13%


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If D0 = $2 and g is a constant 6%,find the expected dividend stream for

the next 3 years, and their PVs.

1.8761

1.7599

D0 = 2.00

1.6509

ks = 13%

g = 6%0 1

2.247

2

2.382

3

2.12


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What is the stocks market value? Using the constant growth model:

. 9

.

.

.-..

g-k

s

!

!

!! 1


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What is the expected market price

of the stock, one year from now?

D1 will have been paid out already. So,P1 is the present value (as of year 1) of

D2, D3, D4, etc.

Could also find expected P1 as:32.1

.-.13

2.24

-k

DP

s

2

1

!

!!

$32.( . ) !!


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What is the expected dividend yield,capital gains yield, and total return

during the first year?

Dividend yield= D1 / P0 = $2.12 / $30.2 = 7.0%

Capital gains yield= (P1 P0) / P0= ($32.10 - $30.2 ) / $30.2 = 6.0%

Total return (ks)= Dividend Yield + Capital Gains Yield

= 7.0% + 6.0% = 13.0%


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What would the expected price

today be, if g = 0? The dividend stream would be a

perpetuity.

2.00 2.002.00

0 1 2 3ks = 13% ...

$15.38.13

$2.

k !!!


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Supernormal growth:What if g = 30% for 3 years before

achieving long-run growth of 6%?

Can no longer use just the constant growthmodel to find stock value.

However, the growth does becomeconstant after 3 years.


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Valuing common stock with

nonconstant growth

ks = 13%

g = 30% g = 30% g = 30% g = 6%

$P !0.06

$66.5434.658

0.13 !

2.301

2.647

3.045

46.114

54.107 = P0^

0 1 2 3 4

D0 = 2.00 2.600 3.380 4.394

...

4.658


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Find expected dividend and capital gains

yields during the first and fourth years.

Dividend yield (first year)

= $2.60 / $54.11 = 4.81%

Capital gains yield (first year)= 13.00% - 4.81% = 8.1 %

During nonconstant growth, dividend yieldand capital gains yield are not constant,

and capital gains yield g. After t = 3, the stock has constant growth

and dividend yield = 7%, while capitalgains yield = 6%.


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Nonconstant growth:What if g = 0% for 3 years before long-

run growth of 6%?

ks = 13%

g = 0% g = 0% g = 0% g = 6%

0.06

$ $30.29P32.12

0.13!

!

1.77

1.57

1.39

20.99

25.72 = P0^

0 1 2 3 4

D0 = 2.00 2.00 2.00 2.00

...

2.12


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Find expected dividend and capital gains

yields during the first and fourth years.

Dividend yield (first year)

= $2.00 / $25.72 = 7.78%

Capital gains yield (first year)

= 13.00% - 7.78% = 5.22%

After t = 3, the stock has constant

growth and dividend yield = 7%,while capital gains yield = 6%.


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If the stock was expected to havenegative growth (g = -6%), would anyone

buy the stock, and what is its value?

The firm still has earnings and paysdividends, even though they may be

declining, they still have value.

$ .80.1

$1.88

(-0.06)-0.13

(0. 4)$2.00

g-k

)g1(D

g-k

DP

s

0

s

1^

0

!!!

!!


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Find expected annual dividend and

capital gains yields.

Capital gains yield= g = -6.00%

Dividend yield= 13.00% - (-6.00%) = 1 .00%

Since the stock is experiencing constant

growth, dividend yield and capital gainsyield are constant. Dividend yield issufficiently large (1 %) to offset a negativecapital gains.


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Corporate value model Also called the free cash flow method.

Suggests the value of the entire firmequals the present value of the firmsfree cash flows.

Remember, free cash flow is the firms

after-tax operating income less the netcapital investment

FCF = NOPAT Net capital investment


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Applying the corporate value model

Find the market value (MV) of the firm. Find PV of firms future FCFs

Subtract MV of firms debt and preferred stock toget MV of common stock. MV of = MV of MV of debt and

common stock firm preferred

Divide MV of common stock by the number ofshares outstanding to get intrinsic stock price(value). P0 = MV of common stock / # of shares


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Issues regarding the

corporate value model Often preferred to the dividend growth

model, especially when considering number

of firms that dont pay dividends or whendividends are hard to forecast.

Similar to dividend growth model, assumes atsome point free cash flow will grow at a

constant rate.

Terminal value (TVn) represents value of firmat the point that growth becomes constant.


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Given the long-run gFCF = 6%, andWACC of 10%, use the corporate value

model to find the firms intrinsic value.

g = 6%

k = 10%

21.20

0 1 2 3 4

-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20

530 = = TV30.10 0.06-


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If the firm has $40 million in debt andhas 10 million shares of stock, what is

the firms intrinsic value per share?

MV of equity = MV of firm MV of debt

= $416. 4m - $40m

= $376. 4 million

Value per share = MV of equity / # of shares

= $376. 4m / 10m

= $37.6


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Firm multiples method Analysts often use the following multiples

to value stocks.

P / E P / CF

P / Sales

EXAMPLE: Based on comparable firms,estimate the appropriate P/E. Multiply thisby expected earnings to back out anestimate of the stock price.


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What is market equilibrium? In equilibrium, stock prices are stable and

there is no general tendency for people to

buy versus to sell. In equilibrium, expected returns must equal

required returns.

F!!! )k(kkkk s1^

s


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Market equilibrium Expected returns are obtained by

estimating dividends and expected

capital gains.

Required returns are obtained byestimating risk and applying the CAPM.


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How is market equilibrium

established? If expected return exceeds required

return

The current price (P0) is too low andoffers a bargain.

Buy orders will be greater than sell

orders. P0 will be bid up until expected return

equals required return


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Factors that affect stock price Required return (ks) could change

Changing inflation could cause kRF tochange

Market risk premium or exposure tomarket risk () could change

Growth rate (g) could change Due to economic (market) conditions

Due to firm conditions


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What is the Efficient Market

Hypothesis (EMH)? Securities are normally in equilibrium

and are fairly priced.

Investors cannot beat the marketexcept through good luck or betterinformation.

Levels of market efficiency Weak-form efficiency

Semistrong-form efficiency

Strong-form efficiency


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Semistrong-form efficiency All publicly available information is

reflected in stock prices, so it doesnt

pay to over analyze annual reportslooking for undervalued stocks.

Largely true, but superior analysts

can still profit by finding and usingnew information


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Strong-form efficiency All information, even inside

information, is embedded in stock

prices.

Not true--insiders can gain bytrading on the basis of insider

information, but thats illegal.


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Is the stock market efficient? Empirical studies have been

conducted to test the three forms ofefficiency. Most of which suggest thestock market was: Highly efficient in the weak form. Reasonably efficient in the semistrong

form. Not efficient in the strong form. Insiders

could and did make abnormal (andsometimes illegal) profits.


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Preferred stock Hybrid security

Like bonds, preferred stockholdersreceive a fixed dividend that must bepaid before dividends are paid tocommon stockholders.

However, companies can omitpreferred dividend payments withoutfear of pushing the firm intobankruptcy.


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If preferred stock with an annualdividend of $5 sells for $50, what is the

preferred stocks expected return?

Vp = D / kp

$50 = $5 / kp

kp = $5 / $50

= 0.10 = 10%

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