Chapter 10 FOR BBA 8th semester finance

BBA 8TH SEMESETER CHAPTER 10

1. Chapter 10Chapter 10
Charles P. Jones, Investments: Analysis and Management,Charles P. Jones, Investments: Analysis and Management,
Ninth Edition, John Wiley & SonsNinth Edition, John Wiley & Sons
Prepared byPrepared by
G.D. Koppenhaver, Iowa State UniversityG.D. Koppenhaver, Iowa State University
Common Stock Common Stock
ValuationValuation
Lecture 29 to 33Lecture 29 to 33
10-10-11

2. 10-10-22
Fundamental AnalysisFundamental Analysis

Common stock Common stock represents a residual ownership represents a residual ownership
position in the corporation.position in the corporation.

Two ApproachesTwo Approaches

Present value approach/Discounted CF TechniquesPresent value approach/Discounted CF Techniques
–Discounted cash flow techniques attempt to estimate the value of a Discounted cash flow techniques attempt to estimate the value of a
stock today (its intrinsic value) using a present value analysisstock today (its intrinsic value) using a present value analysis
–Capitalization of expected incomeCapitalization of expected income
–Intrinsic value based on the discounted value of the expected Intrinsic value based on the discounted value of the expected
stream of cash flowsstream of cash flows

Multiple of earnings approachMultiple of earnings approach
–The earnings multiplier approach attempts to estimate intrinsic The earnings multiplier approach attempts to estimate intrinsic
value based on estimated earnings and a multiplier, the P/Evalue based on estimated earnings and a multiplier, the P/E

3. Multiple of earnings approachMultiple of earnings approach

Estimate EPS for next period, typically the Estimate EPS for next period, typically the
next 12 months.next 12 months.

Determine an appropriate P/E ratio. Part of Determine an appropriate P/E ratio. Part of
this process may involve comparing the this process may involve comparing the
company being valued with its peers in company being valued with its peers in
order to derive the appropriate P/E ratio.order to derive the appropriate P/E ratio.

Multiply the estimated EPS by the P/E Multiply the estimated EPS by the P/E
ratio that has been determined.ratio that has been determined.
10-10-33

4. 10-10-44

Intrinsic value of a security isIntrinsic value of a security is

Estimated value of securityEstimated value of security
–The DCF model estimates the value of a security by The DCF model estimates the value of a security by
discounting its expected future cash flows back to the discounting its expected future cash flows back to the
present and adding them together.present and adding them together.




n
t
t
k) (
Cash Flows
urity secValue of
11
Present Value ApproachPresent Value Approach

5. Present Value ApproachPresent Value Approach

The estimated value of a security is equal to the The estimated value of a security is equal to the
discounted (present) value of the future stream discounted (present) value of the future stream
of cash flows that an investor expects to receive of cash flows that an investor expects to receive
from the securityfrom the security

Estimated intrinsic value compared to the Estimated intrinsic value compared to the
current market pricecurrent market price
–What if market price is different than estimated What if market price is different than estimated
intrinsic value?intrinsic value?
10-10-55

6. 10-10-66
Required InputsRequired Inputs

Discount rateDiscount rate
–Required rate of return: minimum expected Required rate of return: minimum expected
rate to induce purchaserate to induce purchase
–The opportunity cost of dollars used for The opportunity cost of dollars used for
investmentinvestment

Expected cash flowsExpected cash flows
–Stream of dividends or other cash payouts Stream of dividends or other cash payouts
over the life of the investmentover the life of the investment

7. 10-10-77
Required InputsRequired Inputs

Expected cash flows Expected cash flows
–Dividends paid out of earningsDividends paid out of earnings
Earnings important in valuing stocksEarnings important in valuing stocks
–Retained earnings enhance future earnings Retained earnings enhance future earnings
and ultimately dividendsand ultimately dividends
Retained earnings imply growth and future Retained earnings imply growth and future
dividendsdividends
Produces similar results as current dividends in Produces similar results as current dividends in
valuation of common sharesvaluation of common shares

8. TWO DCF APPROACHESTWO DCF APPROACHES

1. Value the equity of the firm, using the 1. Value the equity of the firm, using the
required rate of return to shareholders (the required rate of return to shareholders (the
cost of equity capital).cost of equity capital).

2. Value the entire firm, using the weighted 2. Value the entire firm, using the weighted
average cost of capital.average cost of capital.
10-10-88

9. 10-10-99

Current value of a share of stock is the Current value of a share of stock is the
discounted value of all future dividendsdiscounted value of all future dividends













1
2
2
1
1
1
111
t
t
cs
t
cscscs
cs
)k(
D

)k(
D
...
)k(
D

)k(
D
P
Dividend Discount ModelDividend Discount Model

10. 10-10-1010
Dividend Discount ModelDividend Discount Model

Problems:Problems:
–Need infinite stream of dividendsNeed infinite stream of dividends
–Dividend stream is uncertainDividend stream is uncertain
Must estimate future dividendsMust estimate future dividends
–Dividends may be expected to grow over timeDividends may be expected to grow over time
Must model expected growth rate of dividends and Must model expected growth rate of dividends and
need not be constantneed not be constant

11. Dividend Growth Pattern Dividend Growth Pattern
AssumptionsAssumptions
The dividend valuation model requires the The dividend valuation model requires the
forecast of forecast of allall future dividends. The following future dividends. The following
dividend growth rate assumptions simplify dividend growth rate assumptions simplify
the valuation process.the valuation process.
Constant GrowthConstant Growth
No GrowthNo Growth
Growth PhasesGrowth Phases
10-10-1111

12. 10-10-1212

Assume no growth in dividendsAssume no growth in dividends
–Fixed dollar amount of dividends reduces the security Fixed dollar amount of dividends reduces the security
to a perpetuityto a perpetuity
–The The zero growth model zero growth model assumes that dividends will assumes that dividends will
grow forever at the rate grow forever at the rate gg = 0= 0
–Similar to preferred stock because dividend remains Similar to preferred stock because dividend remains
unchangedunchanged
csk
D
P
0
0
Dividend Discount ModelDividend Discount Model

13. Zero Growth Model ExampleZero Growth Model Example

Stock ZG has an expected Stock ZG has an expected growth rate growth rate of of
0%. 0%. Each share of stock just received an Each share of stock just received an
annual annual $3.24 dividend $3.24 dividend per share. The per share. The
appropriate appropriate discount rate is 15%discount rate is 15%. What is . What is
the value of the the value of the common stockcommon stock??
DD
11 = = $3.24$3.24 ( 1 + ( 1 + 00 ) = ) = $3.24$3.24
VV
ZGZG = = DD
11 / ( / ( kk
cscs) = ) = $3.24$3.24 / ( / (0.150.15 ) ) == $21.60 $21.60
10-10-1313

14. 10-10-1414

Assume a Assume a constant growth in dividendsconstant growth in dividends
–Dividends expected to grow at a constant Dividends expected to grow at a constant
rate, g, over timerate, g, over time
–DD
11 is the expected dividend at end of the first is the expected dividend at end of the first
periodperiod
–D
1 =D
0  (1+g)
gk
D
P


1
0
Dividend Discount ModelDividend Discount Model

15. 10-10-1515
Dividend Discount ModelDividend Discount Model

Implications of constant growthImplications of constant growth
–Stock Stock pricesprices grow at the same rate as the grow at the same rate as the
dividendsdividends
–Stock Stock total returnstotal returns grow at the required rate of grow at the required rate of
returnreturn
Growth rate in price plus growth rate in dividends Growth rate in price plus growth rate in dividends
equals k, the required rate of returnequals k, the required rate of return
–A lower required return or a higher expected A lower required return or a higher expected
growth in dividends raises pricesgrowth in dividends raises prices

16. Constant Growth Model ExampleConstant Growth Model Example

Stock CG has an expected Stock CG has an expected dividend growth dividend growth
rate of 8%rate of 8%. Each share of stock just . Each share of stock just
received an annual received an annual $3.24 dividend$3.24 dividend. The . The
appropriate appropriate discount rate is 15%discount rate is 15%. What is . What is
the value of the the value of the common stockcommon stock??
DD
11 = = $3.24$3.24 ( 1 + ( 1 + 0.080.08 ) = ) = $3.50$3.50
VV
CGCG = = DD
11 / ( / ( kk
ee - - gg ) = ) = $3.50$3.50 / ( / (0.150.15 - - 0.080.08 ) )
== $50 $50
10-10-1616

17. 10-10-1717
2
1
1
1
1
1
1
10
0
k-g
)g(D
k)(k)(
)g(D
P
cn
n
t
nt
t







Dividend Discount ModelDividend Discount Model

The The growth phases model growth phases model assumes that assumes that
dividends for each share will grow at two or dividends for each share will grow at two or
more more differentdifferent growth rates. growth rates.

Multiple growth rates: two or more Multiple growth rates: two or more
expected growth rates in dividendsexpected growth rates in dividends
–Ultimately, growth rate must equal that of the Ultimately, growth rate must equal that of the
economy as a wholeeconomy as a whole
–Assume growth at a rapid rate for n periods Assume growth at a rapid rate for n periods
followed by steady growthfollowed by steady growth

18. D
0
(1 + g
1
)
t
D
n+1
Growth Phases ModelGrowth Phases Model
Note that the second phase of the Note that the second phase of the growth growth
phases model phases model assumes that dividends will grow assumes that dividends will grow
at a constant rate at a constant rate gg
22. We can rewrite the . We can rewrite the
formula as:formula as:
(1 + k
e
)
t (k
e
– g
2)
V =
t=1
n
+
1
(1 + k
e
)
n

19. 10-10-1919
Dividend Discount ModelDividend Discount Model

Multiple growth ratesMultiple growth rates
–First present value covers the period of super-First present value covers the period of super-
normal (or sub-normal) growthnormal (or sub-normal) growth
–Second present value covers the period of Second present value covers the period of
stable growthstable growth
Expected price uses constant-growth model as of Expected price uses constant-growth model as of
the end of super- (sub-) normal periodthe end of super- (sub-) normal period
Value at n must be discounted to time period zero Value at n must be discounted to time period zero

20. Growth Phases Model ExampleGrowth Phases Model Example
Stock GP has an expected Stock GP has an expected growth rate of growth rate of
16% 16% for the first for the first 3 years 3 years and and 8%8% thereafter. thereafter.
Each share of stock just received an annual Each share of stock just received an annual
$3.24 dividend $3.24 dividend per share. The appropriate per share. The appropriate
discount rate is 15%discount rate is 15%. What is the value of . What is the value of
the common stock under this scenario?the common stock under this scenario?

21. Growth Phases Model Growth Phases Model
ExampleExample
Stock GP has two phases of growth. The first, 16%, starts at Stock GP has two phases of growth. The first, 16%, starts at
time t=0 for 3 years and is followed by 8% thereafter starting time t=0 for 3 years and is followed by 8% thereafter starting
at time t=3. We should view the time line as two separate at time t=3. We should view the time line as two separate
time lines in the valuation.time lines in the valuation.

0 1 2 3 4 5 6
D
1 D
2 D
3 D
4 D
5 D
6
Growth of 16% for 3 yearsGrowth of 8% to infinity!

22. Growth Phases Model Growth Phases Model
ExampleExample
Note that we can value Phase #2 using the Note that we can value Phase #2 using the Constant Constant
Growth ModelGrowth Model

0 1 2 3
D
1 D
2 D
3
D
4 D
5 D
6
0 1 2 3 4 5 6
Growth Phase
#1 plus the infinitely
long Phase #2

23. Growth Phases Model Growth Phases Model
ExampleExample
Note that we can now replace Note that we can now replace allall dividends from dividends from year 4 to year 4 to
infinityinfinity with the with the valuevalue at time at time t=3t=3, , VV
33! Simpler!!! Simpler!!

V
3 =
D
4 D
5 D
6
0 1 2 3 4 5 6
D
4
k-g
We can use this model because
dividends grow at a constant 8%
rate beginning at the end of Year 3.

24. Growth Phases Model Growth Phases Model
ExampleExample
Now we only need to find the first four dividends to Now we only need to find the first four dividends to
calculate the necessary cash flows.calculate the necessary cash flows.
0 1 2 3
D
1 D
2 D
3
V
3
0 1 2 3
New Time
Line
D
4
k-g Where V
3
=

25. Growth Phases Model Growth Phases Model
ExampleExample
Determine the annual dividends.Determine the annual dividends.
DD
00 = $3.24 = $3.24 (this has been paid already)(this has been paid already)
DD
11 = = DD
00(1 + (1 + gg
11))
11
= = $3.24$3.24(1(1.16.16))
11
= =$3.76$3.76
DD
22 = = DD
00(1 + (1 + gg
11))
22
= = $3.24$3.24(1(1.16.16))
22
= =$4.36$4.36
DD
33 = = DD
00(1 + (1 + gg
11))
33
= = $3.24$3.24(1(1.16.16))
33
= =$5.06$5.06
DD
44 = = DD
33(1 + (1 + gg
22))
11
= = $5.06$5.06(1(1.08.08))
11
= =$5.46$5.46

26. Growth Phases Model Growth Phases Model
ExampleExample
Now we need to find the present value of Now we need to find the present value of
the cash flows.the cash flows.
0 1 2 3
3.76 4.36 5.06
78
0 1 2 3
Actual
Values
5.46
0.15–0.08 Where $78

=

27. Growth Phases Model Growth Phases Model
ExampleExample
We determine the PV of cash flows.We determine the PV of cash flows.
PV(PV(DD
11) = ) = DD
11(PVIF(PVIF
15%15%, , 11) = ) = $3.76 $3.76 (0.870) = (0.870) = $$3.273.27
PV(PV(DD
22) = ) = DD
22(PVIF(PVIF
15%15%, , 22) = ) = $4.36 $4.36 (0.756) = (0.756) = $$3.303.30
PV(PV(DD
33) = ) = DD
33(PVIF(PVIF
15%15%, , 33) = ) = $5.06 $5.06 (0.658) = (0.658) = $$3.333.33
PP
33 = = $5.46 $5.46 / (/ (0.150.15 - - 0.080.08) = $78 [CG Model]) = $78 [CG Model]
PV(PV(PP
33) = ) = PP
33(PVIF(PVIF
15%15%, , 33) = ) = $78 $78 (0.658) = (0.658) = $$51.3251.32

28. D
0(1 +0.16)
t
D
4
Growth Phases Growth Phases
Model ExampleModel Example
Finally, we calculate the Finally, we calculate the intrinsic value intrinsic value by by
summing all of cash flow present values.summing all of cash flow present values.
(1 +0.15)
t
(0.15–0.08)
V = 
t=1
3
+
1
(1+0.15)
n
V = $3.27 + $3.30 + $3.33 + $51.32
V = $61.22V = $61.22

29. 0 k=16%1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D
0 = 4.00 5.20 6.76 8.788 9.315
4.48
5.02
5.63
59.68 P
3
= 9.315
74.81 = P
0
.10
Example: Valuing equity with growth ofExample: Valuing equity with growth of
30% for 3 years, then a long-run constant 30% for 3 years, then a long-run constant
growth of 6%growth of 6%

30. 10-10-3030
What About Capital Gains?What About Capital Gains?

Is the dividend discount model only Is the dividend discount model only
capable of handling dividends?capable of handling dividends?
–Capital gains are also importantCapital gains are also important

Price received in future reflects Price received in future reflects
expectations of dividends from that point expectations of dividends from that point
forward forward
–Discounting dividends or a combination of Discounting dividends or a combination of
dividends and price produces same resultsdividends and price produces same results

31. 10-10-3131
P/E Ratio or P/E Ratio or
Earnings Multiplier ApproachEarnings Multiplier Approach

Alternative approach often used by Alternative approach often used by
security analystssecurity analysts

P/E ratio is the strength with which P/E ratio is the strength with which
investors value earnings as expressed in investors value earnings as expressed in
stock pricestock price
–Divide the current market price of the stock by Divide the current market price of the stock by
the latest 12-month earnings(EPS)the latest 12-month earnings(EPS)
–Price paid for each $1 of earningsPrice paid for each $1 of earnings

32. 10-10-3232

To estimate share valueTo estimate share value

P/E ratio can be derived fromP/E ratio can be derived from
–Indicates the factors that affect the estimated Indicates the factors that affect the estimated
P/E ratioP/E ratio
11 /E P Eo P/E rati justified
earnings estimated P
o
o


k - g
/ED
/E or P
k - g
D
P
oo
11
1
1

P/E Ratio ApproachP/E Ratio Approach

33. 10-10-3333
P/E Ratio ApproachP/E Ratio Approach

The higher the payout ratio, the higher the The higher the payout ratio, the higher the
justified P/Ejustified P/E
–Payout ratio is the proportion of earnings that Payout ratio is the proportion of earnings that
are paid out as dividends (Payout are paid out as dividends (Payout
Ratio=DPS/EPS)Ratio=DPS/EPS)

The higher the expected growth rate, g, the The higher the expected growth rate, g, the
higher the justified P/E1higher the justified P/E1

The higher the required rate of return, k, the The higher the required rate of return, k, the
lower the justified P/Elower the justified P/E

34. 10-10-3434
Understanding the P/E RatioUnderstanding the P/E Ratio

Can firms increase payout ratio to increase Can firms increase payout ratio to increase
market price?market price?
–Will future growth prospects be affected?Will future growth prospects be affected?

Does rapid growth affect the riskiness of Does rapid growth affect the riskiness of
earnings?earnings?
–Will the required return be affected?Will the required return be affected?
–Are some growth factors more desirable than Are some growth factors more desirable than
others?others?

P/E ratios reflect expected growth and riskP/E ratios reflect expected growth and risk

35. Chapter 10Chapter 10
Charles P. Jones, Investments: Analysis and Management,Charles P. Jones, Investments: Analysis and Management,
Ninth Edition, John Wiley & SonsNinth Edition, John Wiley & Sons
Prepared byPrepared by
G.D. Koppenhaver, Iowa State UniversityG.D. Koppenhaver, Iowa State University
Common Stock Common Stock
ValuationValuation
Lecture 33Lecture 33
10-10-3535

36. 10-10-3636
P/E Ratios and Interest RatesP/E Ratios and Interest Rates

A P/E ratio reflects investor optimism and A P/E ratio reflects investor optimism and
pessimismpessimism
–Related to the required rate of returnRelated to the required rate of return

As interest rates increase, required rates As interest rates increase, required rates
of return on all securities generally of return on all securities generally
increaseincrease

P/E ratios and interest rates are indirectly P/E ratios and interest rates are indirectly
relatedrelated

37. 10-10-3737
Which Approach Is Best?Which Approach Is Best?

Best estimate is probably the present value Best estimate is probably the present value
of the (estimated) dividends of the (estimated) dividends
–Can future dividends be estimated with Can future dividends be estimated with
accuracy?accuracy?
–Investors like to focus on capital gains not Investors like to focus on capital gains not
dividendsdividends

P/E multiplier remains popular for its ease P/E multiplier remains popular for its ease
in use and the objections to the dividend in use and the objections to the dividend
discount modeldiscount model

38. 10-10-3838
Which Approach Is Best?Which Approach Is Best?

Complementary approaches?Complementary approaches?
–P/E ratio can be derived from the constant-P/E ratio can be derived from the constant-
growth version of the dividend discount modelgrowth version of the dividend discount model
–Dividends are paid out of earningsDividends are paid out of earnings
–Using both increases the likelihood of Using both increases the likelihood of
obtaining reasonable resultsobtaining reasonable results

Dealing with uncertain future is always Dealing with uncertain future is always
subject to errorsubject to error

39. 10-10-3939
Other MultiplesOther Multiples

Price-to-book value ratioPrice-to-book value ratio
–Ratio of share price to stockholder equity as Ratio of share price to stockholder equity as
measured on the balance sheetmeasured on the balance sheet
–Price paid for each $1 of equityPrice paid for each $1 of equity

Price-to-sales ratioPrice-to-sales ratio
–Ratio of a company’s total market value (price Ratio of a company’s total market value (price
times number of shares) divided by salestimes number of shares) divided by sales
–Market valuation of a firm’s revenuesMarket valuation of a firm’s revenues