Stocks and Their Valuation (Ref: Brigham, E.F., and J.F. Houston. 2001. Fundamentals of Financial Management, 9th Ed, Harcourt College Publishers, Ch. 9). Features of common stock Determining common stock values Efficient markets Preferred stock. Facts about Common Stock. - PowerPoint PPT Presentation
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Definitions of TermsDt = Dividend the stockholder expects to
receive at the end of Year t. D0 is the most recent dividend, which has already been paid; D1 is the first dividend expected, and will be paid
at the end of this year; D2 is the dividend expected at the end of two years, and so forth. D1 represents the first cash flow a new purchaser of the stock will receive. Note that D0, the dividend that has been paid, is known with certainty. But all future dividends are expected values, so the estimate of Dt may differ among investors.
P0 = Expected price of the stock at the end of Year t (pronounced “P hat t”). P0 is the intrinsic, or theoretical, value of the
stock today as seen by the particular investor doing the analysis; P1 is the price
expected at the end of one year; and so on. Note that P0 is the intrinsic value of the stock today based on a particular
investor’s estimate of the stock’s expected dividend stream and the riskiness of that stream. Hence, whereas the market price P0 is fixed and is identical for all investors, P0 could differ among investors depending on how optimistic they are about the company. The caret, or “hat” is used to indicate that Pt is an estimated value.
P0, the individual investor’s estimate of the intrinsic value today, could be above or below P0, the current stock price, but an investor would buy the stock only if his/her estimate of P0 were equal or greater than P0. Since they are many investors in the market, there can be many values for P0. However, we can think of an “average” or “marginal” investors whose actions actually determine the market price. For these marginal investors, P0 must = P0; otherwise a disequilibrium would exist, and buying and selling in the market would change P0, until P0 = P0 for the marginal investor.
Market Price, P0 = the price at which the stock sell in the market
Intrinsic Value, P0 = the value of an asset that, in the mind of a particular investor, is justified by the facts; P0 may be different from the asset’s current market price.
Growth Rate, g = The expected rate of growth in dividends per share.
g = expected growth rate in dividends as predicted by a marginal investor. If dividends are expected to grow at a constant rate, g is also equal to the expected rate of growth in earnings and in the stock’s price. Different investors may use different g’s to evaluate a firm’s stock, but the market price, P0, is set on the basis of the g estimated by marginal investors.
Required Rate of Return, ks = The minimum rate of return on a common stock that a stockholder considers acceptable.
ks = minimum acceptable, or required, rate of return on the stock, considering both its riskiness and the returns available on other investments. Again, this term generally relates to marginal investors. The determinants of ks include the real rate of return, expected inflation, and risk.
Expected Rate of Return, ks = The rate of return on a common stock that a stockholder expects to receive in the future.
ks = Expected rate of return that an investor who buys the stock expects to receive in the future. Ks (pronounced “k hat s”) could be above or below ks, but one would buy the stock only if ks were equal or greater than ks.
Actual, Realized Rate of Return, ks = The rate of return on a common stock actually received by stockholders in some past period. Ks may be greater, or less than, and/or ks.
ks = actual, or realized, after-the fact rate of return (pronounce “k bar s”). You may expect to obtain a return of ks= 15% if you buy Exxon today, but if the market goes down, you may end up next year with an actual realized return that is much lower, perhaps even negative.
Dividend Yield = The expected dividend divided by the current price of a share of stock.
D1/P0 = Expected dividend yield on the stock during the coming year. If the stock is expected to pay a dividend of D1 = $1 during the next 12 months, and its current price is P0 = $10, then the expected dividend yield is $1/$10 = 0.10 = 10%
Capital Gains Yield = The capital gain during a given year divided by the beginning price.
(P1-P0)/P0 = Expected capital gains yield on the stock during the coming year. If the stock sells for $10 today, and if it is expected to rise to $10.50 at the end of one year, the expected capital gain is P1- P0 = $0.50. Expected capital gain yield = $0.50/$10 = 5%
Expected Total Return = The sum of the dividend yield and the expected capital gains yield.
Expected total return = ks = Expected dividend yield (D1/P0) + expected capital gains yield (P1-P0)/P0. In our example, the expected total return is 10% + 5% = 15%
2. Compute the stock’s price at a future point in time, using constant growth model Pt = Dt+1/(r-g). (You must pick a point after the dividend growth rate has become constant)
3. Compute the PV of the expected future sale price and add that to the PV of all the expected cash dividends between now and then.
(Source: Emery, D.R., J.D. Finnerty and J.D. Stowe.1998. Principles of Financial Management. Prentice Hall, pp 172-173)
Netscape is operating in a new industry that has recently caught on with the public. Sales are growing at 80% per year. This high sales growth is expected to translate into a 25% growth rate in cash dividends for each of the next 4 years. After that, the dividend growth rate is expected to be 5% forever. Annual dividend paid yesterday is $0.75. The stock’s required return is 22%. What is Netscape’s stock’s price?
(Source: Emery et al, Principles of Financial Management. 1998.
Novell’s dividend was $1 last year and is to be $1 for each of the next 3 years. After its projects have been developed, earnings are expected to grow at a high rate for 2 years as sales resulting from new projects are realized. The higher earnings are expected to result in 40% increase in dividends for 2 years. After these 2 extraordinary increases in dividends, the dividend growth rate is expected to be 3% per year forever. Novell’s required rate of return is 12%. What is the worth of its share today?
(i) First compute the expected future dividends: Time 0 1 2 3 4 5 6 7 …..
(ii) D5 is where the growth rate in dividends is expected to become constant forever and is the earliest point that satisfies the constant-growth assumption. With D5 =$1.96, g=3%, and r = 12%,
Free Cash Flow Method/Total Company or Corporate Valuation Model
The free cash flow method suggests that the value of the entire firm equals the present value of the firm’s free cash flows (calculated on an after-tax basis).
Recall that the free cash flow in any given year can be calculated as:
NOPAT – Net capital investment(NOPAT= Net operating profit after taxes)
Free cash flow method is often preferred to the dividend growth model -- particularly for the large number of companies that don’t pay a dividend, or for whom it is hard to forecast dividends.
Similar to the dividend growth model, the free cash flow method generally assumes that at some point in time, the growth rate in free cash flow will become constant.
Terminal value represents the value of the firm at the point in which growth becomes constant.
Expected returns are obtained by estimating dividends and expected capital gains (which can be found using any of the three common stock valuation approaches).^Ks = (D1/P0) + g
Required returns are obtained from the CAPM: ks = kRF + (kM – kRF)βfirm
All publicly available information is reflected in stock prices, so doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information.
3. Strong-form EMH:All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.