Stocks and their valuation (chapter 9)

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Stocks and their valuation(chapter 9)


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Facts about common stock

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock

price


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Intrinsic Value and Stock Price Outside investors, corporate insiders, and analysts use a variety

of approaches to estimate a stock’s intrinsic value (P0). 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 its intrinsic value are undervalued Buy or Sell?

- Stocks with a price above its intrinsic value are overvaluedBuy or Sell?


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Different Approaches for Estimating the Intrinsic Value of a Common Stock

Discounted dividend model Corporate valuation model P/E multiple approach EVA approach (NOT for the exam)


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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. r s is the required rate of return (think the one from CAPM)

)r(1

D ...

)r(1

D

)r(1

D

)r(1

D P

s3

s

32

s

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 formula converges to:

g -r

D

g -r

g)(1D P

s

1

s

00

^


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What happens if g > rs?

If g > rs, the constant growth formula leads to a negative stock price, which does not make sense.

The constant growth model can only be used if:- rs > g

- g is expected to be constant forever


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If rRF = 7%, rM = 12%, and β = 1.2, what is the required rate of return on the firm’s

stock?

Use the SML to calculate the required rate of return (rs):

rs = rRF + (rM – rRF)β

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

= 13%


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If D0 = $2 and g is a constant 6%, What is the stock’s market value?

Using the constant growth model:

$30.29

0.07

$2.12

0.06 - 0.13

$2.12

g - r

D P

s

10


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Find the Expected Dividend Stream for the Next 3 Years and Their PVs

1.8761

1.7599

D0 = 2.00

1.6509

rs = 13%

g = 6%0 1

2.247

2

2.382

3

2.12

D0 = $2 and g is a constant 6%.

Total PV= 5.287 without D0


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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 / $30.29 = 7.0%

Capital gains yield= (P1 – P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0%

Total return (rs)= 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.

$15.38 0.13

$2.00

r

PMT P

^

0


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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 growth model to find stock value.

However, the growth does become constant after 3 years.


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Valuing common stock with nonconstant growth

rs = 13%

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

$P =0.06

$66.543

4.658

0.13 -=

2.6/(1+0.13) = 2.301

2.647

3.045

66.54/(1+0.13)^3 = 46.114

54.107 = P0

^

0 1 2 3 4

D0 = 2.00 2.6 3.380 4.394

...

4.658


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Calculations:

D1 = D0*(1+g1)= 2x(1+0.3)= 2.6D2 = D1*(1+g1)= 2.6x(1+0.3)= 3.38D3 = D2*(1+g1)= 3.38x(1+0.3)= 4.394

D4 = D3*(1+g2)= 4.394x(1+0.06) = 4.658

Present Value of D1= 2.6/(1+0.13) = 2.301Present Value of D2= 3.38/(1+0.13)^2 = 2.647Present Value of D3= 4.394/(1+0.13)^3 = 3.045


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Exam type questionThe last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on equity (rs) is 12 percent. What is the current price of Klein’s common stock? a. $21.00b. $33.33c. $42.25d. $50.16 *


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Corporate value 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.

1. Find the market value (MV) of the firm.- Find PV of firm’s future FCFs

2. Subtract MV of firm’s debt and preferred stock to get MV of common stock.- MV of = MV of – MV of debt and

common stock firm preferred3. Divide MV of common stock by the number of shares outstanding

to get intrinsic stock price (value).- P0 = MV of common stock / # of shares

NOWC esexpenditur

Capital onamortizatiand Depr. T)EBIT(1 FCF


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Issues regarding the corporate value model

Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast.

Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate.

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


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Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find

the firm’s intrinsic value.

g = 6%

r = 10%

21.20

0 1 2 3 4

-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20530 = = TV30.10 0.06-


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Calculations:Present Value of CF1= -5/(1+0.1) = -4.545Present Value of CF2= 10/(1+0.1)^2 = 8.264Present Value of CF3= 20/(1+0.1)^3 = 15.026

CF 4= CF3*(1+g)=20*(1+0.06)= 21.2

Present Value of Terminal Value in 3 years (at time 3)= = 530/(1+0.1)^3 = 388.197


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

intrinsic value per share?

MV of equity = MV of firm – MV of debt

= $416.94m - $40m

= $376.94 million Value per share = MV of equity / # of shares

= $376.94m / 10m

= $37.69


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Exam type questionAn analyst is trying to estimate the intrinsic value of the stock of Harkleroad Technologies. The analyst estimates that Harkleroad’s free cash flow during the next year will be $25 million. The analyst also estimates that the company’s free cash flow will increase at a constant rate of 7 percent a year and that the company’s cost of capital is 10 percent. Harkleroad has $200 million of long-term debt, and 30 million outstanding shares of common stock. What is the estimated per-share price of Harkleroad Technologies’ common stock?a. $ 1.67b. $ 5.24c. $18.37d. $21.11 *


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Exam type question

Which of the following statements is most correct?a. If a company has two classes of common stock, Class A and

Class B, the stocks may pay different dividends, but the two classes must have the same voting rights.

b. An IPO occurs whenever a company buys back its stock on the open market.c. The preemptive right is a provision in the corporate charter that gives

common stockholders the right to purchase (on a pro rata basis) new issues of common stock. *

d. Statements a and b are correct.


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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.


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If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s

expected return?

10% 0.10$50$5

r̂

r$5

$50

rD

V

p

p

pp


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Learning objectives Read from the text the following topics: control of the firm; types of common

stock; The market for common stock Know how to apply the dividend growth model, constant and non-constant

growth Know how to calculate total return, dividend yield and capital gains Know how to use corporate value model to value common stock Preferred stock Recommended end-of-chapter problems: ST-1, Questions 9-3, 9-4;

Problems 9-1 to 9-5, 9-11,9-1 to 9-17

Stocks and their valuation (chapter 9)

Documents

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