Stock and about stock how to identify measure

Stock and about stock how to identify measure

1. CHAPTER 10
Stocks and Their Valuation

2. Facts about Common Stock
•Represents ownership
•Ownership implies control
•Stockholders elect directors
•Directors elect management
•Management’s goal: Maximize the stock
price
10-2

3. Intrinsic Value and Stock Price
•Outside investors, corporate insiders, and
analysts use a variety of approaches to
estimate a stock’s intrinsic value (P
0).
•In equilibrium we assume that a stock’s
price equals its intrinsic value.
–Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell.
–Stocks with a price below (above) its intrinsic
value are undervalued(overvalued).
10-3

4. Determinants of Intrinsic Value and
Stock Prices
“True” Investor
Cash Flows
“True” Risk
“Perceived” Investor
Cash Flows
“Perceived”
Risk
Managerial Actions, the Economic Environment,
Taxes, and the Political Climate
Stock’s
Intrinsic Value
Stock’s
Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
10-4

5. Different Approaches for Estimating the Intrinsic
Value of a Common Stock
•Discounted dividend model
•Corporate valuation model
•P/E multiple approach
•EVA approach
10-5

6. Discounted Dividend Model
•Value of a stock is the present value of the
future dividends expected to be generated
by the stock.
•See equation 10-1









)r(1
D
...
)r(1
D

)r(1
D

)r(1
D
Pˆ
s
3
s
3
2
s
2
1
s
1
0
10-6

7. Constant Growth Stockgr
D

gr
g)(1D
Pˆ
s
1
s
0
0





•A stock whose dividends are expected to grow
forever at a constant rate, g.
D
1= D
0(1 + g)
1
D
2= D
0(1 + g)
2
D
t= D
0(1 + g)
t
•If g is constant, the discounted dividend formula
converges to:
10-7

8. Future Dividends and Their Present
Valuest
t
t
) r 1 (
D
PVD

 t0
PVDP
$
0.25
Years (t)0t
0t
)g1(DD 
10-8

9. Dividends vs. Growth
•Dividends are paid out of earnings.
•Hence, growth in dividends requires growth in
earnings.
•Earnings growth in the long run occurs primarily
because firms retain earnings and reinvest them in the
business.
•Hence, the higher percentage of earnings retained, the
higher the growth rate.
Next year’s earnings = prior earnings + ROE(RE)
Next year’s dividends = payout ratio*next year’s earnings
Growth rate = (1-payout ratio)*ROE

10. What happens if g > r
s?
•If g > r
s, the constant growth formula leads
to a negative stock price, which does not
make sense.
•The constant growth model can only be
used if:
–r
s> g.
–g is expected to be constant forever.
10-10

11. Use the SML to Calculate the Required
Rate of Return (r
s)
•If r
RF= 7%, r
M= 12%, and b = 1.2, what is
the required rate of return on the firm’s
stock?
10-11

12. Find the Expected Dividend Stream for the Next
3 Years and Their PVs
1.8761
1.7599
1.6509
r
s= 13%
g = 6%
0 1
2.247
2
2.382
3
2.12
D
0= $2 and g is a constant 6%.
10-12

13. Using the constant growth model:
What is the stock’s intrinsic value?

g r
D
P
ˆ
s
1
0


10-13

14. •D
1will have been paid out already. So, expected P
1
is the present value (as of Year 1) of D
2, D
3, D
4, etc.
•Could also find expected P
1as:
What is the stock’s expected value, one year
from now?
gr
D
P
ˆ
s
2
1

 g)(1P P
ˆ
01

10-14

15. Find Expected Dividend Yield, Capital Gains
Yield, and Total Return During First Year
•Dividend yield
= D
1/P
0
•Capital gains yield
= (P
1–P
0)/P
0
•Total return (r
s)
= Dividend yield + Capital gains yield
10-15

16. The dividend stream would be a perpetuity.
What would the expected price today be,
if g = 0?
r
PMT
P
ˆ
0

2.00 2.002.00
0 1 2 3
r
s= 13%
10-16

17. Supernormal Growth: What if g = 30% for 3 years
before achieving long-run growth of 6%?
•Can no longer use just the constant growth
model to find stock value.
•However, the growth does become
constant after 3 years.
10-17

18. Valuing Common Stock with
Nonconstant Growth
r
s = 13%
g = 30% g = 30% g = 30% g = 6%
2.301
2.647
3.045
46.114
54.107 =
0 1 2 3 4
2.600 3.380 4.3944.658 Pˆ
0 $66.54
06.0 0.13
4.658
Pˆ
3



D
0= $2.00.
10-18

19. Find Expected Dividend and Capital Gains
Yields During the First and Fourth Years
•Dividend yield (first year)
= ?
•Capital gains yield (first year)
= ?
•During nonconstant growth, dividend yield
and capital gains yield are not constant, and
capital gains yield ≠ g.
•After t = 3, the stock has constant growth and
dividend yield = 7%, while capital gains yield =
6%.
10-19

20. NonconstantGrowth: What if g = 0% for
3 years before long-run growth of 6%?
r
s = 13%
g = 0% g = 0% g = 0% g = 6%
1.77
1.57
1.39
20.99
25.72 =
0 1 2 3 4
2.00 2.00 2.00 2.12 Pˆ
0 $30.29
06.0 0.13
2.12
Pˆ
3



D
0= $2.00.
10-20

21. Find Expected Dividend and Capital Gains
Yields During the First and Fourth Years
•Dividend yield (first year)
= ?
•Capital gains yield (first year)
= ?
•After t = 3, the stock has constant growth
and dividend yield = 7%, while capital
gains yield = 6%.
10-21

22. •Yes. Even though the dividends are declining, the stock
is still producing cash flows and therefore has positive
value.
If the stock was expected to have negative growth (g = -6%),
would anyone buy the stock, and what is its value?
g r
)g (1D

g r
D
P
ˆ
s
0
s
1
0





10-22

23. Find Expected Annual Dividend and Capital
Gains Yields
•Capital gains yield
= g = -6.00%
•Dividend yield
= 13.00% –(-6.00%) = 19.00%
•Since the stock is experiencing constant
growth, dividend yield and capital gains yield
are constant. Dividend yield is sufficiently
large (19%) to offset negative capital gains.
10-23

24. Corporate Valuation Model
•Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s free
cash flows.
•Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment.












 NOWC
esexpenditur
Capital

onamortizati
and Depr.
T)EBIT(1 FCF
10-24

25. Applying the Corporate Valuation
Model
•Find the market value (MV) of the firm, by
finding the PV of the firm’s future FCFs.
•Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
•Divide MV of common stock by the
number of shares outstanding to get
intrinsic stock price (value).
10-25

26. Issues Regarding the Corporate
Valuation Model
•Often preferred to the discounted dividend
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
•Similar to discounted dividend model,
assumes at some point free cash flow will
grow at a constant rate.
•Horizon value (HV
N) represents value of firm
at the point that growth becomes constant.
10-26

27. 3
HV
06.0 0.10
21.20
530 

 Use the Corporate Valuation Model to Find
the Firm’s Intrinsic Value
Given: Long-Run g
FCF= 6% and WACC = 10%
r= 10%
g = 6%
-4.545
8.264
15.026
398.197
416.942
0 1 2 3 4
-5 21.2010 20
10-27

28. What is the firm’s intrinsic value per
share?
The firm has $40 million total in debt and
preferred stock and has 10 million shares of
common stock.million 94.376$
40$94.416$
preferred and debtof MVfirmof MV equityof MV


 $37.69
/1094.376$
sharesof quity/#eof MV share per Value



10-28

29. 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
this by expected earnings to back out an
estimate of the stock price.
10-29

30. EVA Approach
EVA = Equity capital(ROE –Cost of equity)
MV
Equity= BV
Equity+ PV of all future EVAs
Value per share = MV
Equity/# of shares
10-30

31. Preferred Stock
•Hybrid security.
•Like bonds, preferred stockholders receive
a fixed dividend that must be paid before
dividends are paid to common
stockholders.
•However, companies can omit preferred
dividend payments without fear of
pushing the firm into bankruptcy.
10-31

32. If preferred stock with an annual dividend of $5
sells for $50, what is the preferred stock’s
expected return?p
p
p
V
rˆ
V
D
r
D
p


10-32

33. References
•Brighmam, E.F., danHouston, J.F. (2013).
Essential of Financial Management, 3rd
Edition. Thomson.

34. Thank You