CHAPTER 9 Stocks and Their Valuation

Features of common stock Determining common stock values Preferred stock

9-1

Facts about common stock

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Managements goal: Maximize the stock price
9-2

Intrinsic Value and Stock Price

Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stocks intrinsic value (P0). In equilibrium we assume that a stocks 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).
9-3

Determinants of Intrinsic Value and Stock Prices (Figure 1-1)

9-4

Different approaches for estimating the intrinsic value of a common stock

Dividend growth model Corporate value model Using the multiples of comparable firms

9-5

Dividend growth model

Value of a stock is the present value of the future dividends expected to be generated by the stock.

D3 D1 D2 D P0 ... 1 2 3 (1 rs ) (1 rs ) (1 rs ) (1 rs )
^

9-6

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:

D 0 (1 g) D1 P0 rs - g rs - g
^

9-7

Future dividends and their present values

$

D t D0 ( 1 g )

0.25

Dt PVD t ( 1 r )t

P0 PVD t
0 Years (t)
9-8

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

9-9

If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firms stock?

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

rs = rRF + (rM rRF)b = 7% + (12% - 7%)1.2 = 13%

9-10

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

0 D0 = 2.00

g = 6%

1 2.12
rs = 13%

2 2.247

3 2.382

1.8761
1.7599 1.6509
9-11

What is the stocks intrinsic value?

Using the constant growth model:

D1 $2.12 P0 rs - g 0.13 - 0.06 $2.12 0.07 $30.29

9-12

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. ^ D2 $2.247 P1 rs - g 0.13 - 0.06 $32.10 Could also find expected P1 as:
^

P1 P0 (1.06) $32.10
9-13

What are the expected dividend yield, capital gains yield, and total return during the first year?

Dividend yield Capital gains yield Total return (rs)

= D1 / P0 = $2.12 / $30.29 = 7.0% = (P1 P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0%

= Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

9-14

What would the expected price today be, if g = 0?

The dividend stream would be a perpetuity.

rs = 13%

...
2.00 2.00 2.00

PMT $2.00 P0 $15.38 r 0.13

^

9-15

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.

9-16

Valuing common stock with nonconstant growth

0 r = 13% 1 s
g = 30% g = 30%

2
g = 30%

3
g = 6%

...

D0 = 2.00
2.301 2.647 3.045 46.114

2.600

3.380

4.394

4.658

$ P 3
= P0
^

4.658 0.13 - 0.06

$66.54
9-17

54.107

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% = 8.19%

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%.
9-18

Nonconstant growth: What if g = 0% for 3 years before longrun growth of 6%?

0 r = 13% 1 s
g = 0% g = 0%

2
g = 0%

3
g = 6%

...

D0 = 2.00
1.77 1.57 1.39 20.99

2.00

2.00

2.00

2.12

$ P 3
= P0
^

2.12 0.13 - 0.06

$30.29
9-19

25.72

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%.
9-20

If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value?

The firm still has earnings and pays dividends, even though they may be declining, they still have value.

D0 ( 1 g ) D1 P0 rs - g rs - g
^

$2.00 (0.94) $1.88 $9.89 0.13 - (-0.06) 0.19

9-21

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 a negative capital gains.
9-22

Summary: Dividend Growth Model D0 = $2.00

Assumption about g? 1. g = 6% constant 2. g = 0% constant 3. g = -6% constant Price $30.29 $15.38 $9.89

4. gs = a. 30% supernormal, 3 yrs gn = b. 6% constant $54.11 5. g = a. 0% for 3 years b. 6% constant $25.72

9-23

Corporate value model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firms free cash flows. Remember, free cash flow is the firms after-tax operating income less the net capital investment

FCF = NOPAT Net capital investment

9-24

Applying the corporate value model

Find the market value (MV) of the firm, by finding the PV of the firms future FCFs. Subtract MV of firms 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).
9-25

Issues regarding the corporate value model

Often preferred to the dividend growth model, especially when considering number of firms that dont 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.
9-26

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

0 r = 10%

4
g = 6%

...

-5
-4.545 8.264 15.026 398.197 416.942

10

20

21.20

21.20

530 =

0.10 - 0.06

= TV3
9-27

If the firm has $40 million in debt and has 10 million shares of stock, what is the firms intrinsic value per share?

MV of equity = MV of firm MV of debt = $416.94 - $40 = $376.94 million Value per share = MV of equity / # of shares = $376.94 / 10 = $37.69

9-28

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.
9-29

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, two conditions hold:

The current market stock price equals its ^ intrinsic value (P0 = P0).
Expected returns must equal required returns.

D1 rs g P0
^

rs rRF (rM - rRF )b

9-30

Market equilibrium

Expected returns are determined by estimating dividends and expected capital gains. Required returns are determined by estimating risk and applying the CAPM.

9-31

How is market equilibrium established?

If price is below intrinsic value

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

Buy orders will be greater than sell orders.

P0 will be bid up until expected return equals required return.
9-32

How are the equilibrium values determined?

Are the equilibrium intrinsic value and expected return estimated by managers or are they determined by something else?

Equilibrium levels are based on the markets estimate of intrinsic value and the markets required rate of return, which are both dependent upon the attitudes of the marginal investor.
9-33

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.
9-34

If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stocks expected return? Vp = D / rp $50 = $5 / rp ^ rp = $5 / $50 = 0.10 = 10%

9-35