STOCK VALUATION:

STOCK = Contract characterized by 2 features:

1. Entitlement to DIVIDENDS (…not always paid)
2. Can be—fairly easily—sold  Capital Gains or Losses.

Like any Financial Asset: STOCK VALUE = PV{ E(CASH FLOW) } and
EXPECTED CASH FLOWS CONSIST OF:
(1)DIVIDENDS,
(2)CAPITAL GAINS.

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 STOCK VALUATION:

Let: Dt = Dividend expected at end of each period (year);

D0 = Recently paid dividend (=known)
D1= Expected dividend at year-end
P0 = Actual share price today (known)
P*t = E(price) end of year t
g = Growth rate in dividends or the sustainable growth
rate of earnings
Ks = Required rate of return

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 STOCK VALUATION:

Define: Intrinsic value of STOCK =

PV { E(future dividends)} = P*0

∞ 𝐷𝑡
and P*0 = σ𝑡=1 = General Stock Valuation Model
1+𝐾𝑠 𝑡

Note: Even if you sell at t = m  P*m = is again the PV of all

E(dividends)!!!

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 STOCK VALUATION:

Continue…

𝐷𝑡
so we have: P*0 = σ∞
𝑡=1 but Dt = ? can be zero for
1+𝐾𝑠 𝑡
many years and it may go up and down.

In practice, the hard part is getting an accurate forecast of future

dividends………

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STOCK VALUATION:

In practice, the hard part is getting an accurate forecast of future

dividends………
We therefore distinguish some basic patterns:

1. Zero Growth 
𝐷0 1 𝐷0
P*0 = σ∞
𝑡=1 = 𝐷0 . σ∞
𝑡=1 =
1+𝐾𝑠 𝑡 1+𝐾𝑠 𝑡 𝐾𝑠

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STOCK VALUATION:

Continue…

2. Gordon Model (After Myron J. Gordon) → Developed the

“Constant Growth Model” = Stock valued as a “Growing
Perpetuity”:
∞ 𝐷0 . 1+𝑔 𝑡 ∞ 1+𝑔 𝑡 𝐷0 . 1+𝑔 𝐷1
P*0 = σ𝑡=1 = 𝐷0 . σ𝑡=1 = =
1+𝐾𝑠 𝑡 1+𝐾𝑠 𝑡 𝐾𝑠−𝑔 𝐾𝑠−𝑔
𝑓𝑜𝑟 𝑔 < 𝐾𝑠

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 STOCK VALUATION:

3. Differential growth  2 or more growth rates; for example

HIGH, MODERATE, and STABLE growth periods.

Different stages in the life of a company: Accelerated growth for

a number of years, tapering off and becoming stable, steady
growth along with the entire economy → logistical
growth pattern.

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 STOCK VALUATION:

VALUATION = YEAR BY YEAR and ASSUMING CONSTANT

GROWTH IN THE STEADY/STABLE STATE:

𝐷1 𝐷2 𝐷𝑛 𝑃𝑛 𝐷𝑛+1
P*0 = + + ⋯+ + 𝑎𝑛𝑑𝑃𝑛 =
1+𝐾𝑠 1 1+𝐾𝑠 2 1+𝐾𝑠 𝑛 1+𝐾𝑠 𝑛 𝐾𝑠−𝑔

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STOCK VALUATION:
LINK BETWEEN DIVIDENDS & CORPORATE CASH FLOWS:

AFTER-TAX EARNINGS + DEPR. – CAPEX -- ∆NWC = DIVIDENDS

Dividing DIVIDENDS by the # of shares outstandingDPS

GROWTH OPPORTUNITIES
1. VALUE OF A SHARE IF ALL EARNINGS ARE PAID OUT AS
DIVIDENDS (“CASH COW”):
EPS/Ks = DIV/Ks

2. VALUE OF A FIRM WITH GROWTH OPPORTUNITIES:

EPS/Ks + NPVGO

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STOCK VALUATION:
LINK BETWEEN DIVIDENDS & CORPORATE CASH FLOWS:

THERE ARE 2 CONDITIONS THAT MUST BE MET IN ORDER TO

INCREASE VALUE:
(1).EARNINGS MUST BE RETAINED SO THAT PROJECTS CAN BE
FUNDED OR NEW LT- FINANCING (i.e., STOCKS & DEBT) MUST
BE OBTAINED;
(2).THE PROJECTS MUST HAVE POSITIVE NPV.

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STOCK VALUATION
What do we value, ASSETS or Equity?
• We normally value Equity. However, we must take into consideration that if we
buy a firm´s equity (i. e., # stocks in circulation times their market value +
premium) we also must take care of their liabilities/debt.
What exactly do we want to value, minority participation or a controlling equity
stake? Valuation will be very different in both cases!

For a minority stake we simply multiply the number of stocks we want to buy by their
current market price. It may well be that the market price goes up a bit if we buy a
substantial number of stocks—simple supply and demand dynamics—but this is
essentially the way to acquire and value a minority participation in a firm.
If we aim at acquiring a controlling equity stake, the situation changes dramatically. In
the first place, a stock´s market value reflects the price at which small numbers of
stocks are being traded and is, therefore, not a good indicator of the value at
which a controlling stake in the target firm will be negotiated. More important, a
majority stake transfers control to the acquiring company; if synergies exist or if
the buying firm thinks it may improve operations considerably, they will be willing
to pay a premium over the prevailing price to obtain this control.
THE “FREE CASH FLOW, FCF,” APPROACH:
This approach is somewhat similar to the Capital Budgeting decision, a CAPEX decision.
We begin by estimating the FCF´s, as follows:

FCF = EBIT*(1 – t) + Depreciation – CAPEX  ∆ in Net Working Capital

EBIT = Income provided by (normal business) operations of the firm without considering how
these operations are being financed  EBIT*(1 – taxes) = after-tax operating income
(aka: Net Operating Profits after Taxes, NOPAT) excluding financing effects.

Adding depreciation (and other items like “amortization” that do not imply a cash-outflow)
gives a number similar to the Net Cash Flows that we use in the Capital Budgeting
Decision.

In a normally operating business, firm´s commonly retain part of this cash flow to replace
equipment or to capitalize on growth opportunities, CAPEX and to increase working
capital. Reductions in working capital are also possible and this will increase FCF.

Note: Companies that rely heavily on the use of fixed assets tend to use EBITDA * (1 – t) as a
measure of their capacity to generate cash from operations (hence they do NOT add
depreciation afterwards).
TERMINAL VALUE

While most investment projects do have well-specified economic life, companies do

not. To account for the possibly indefinite future of companies, we normally
consider two (2) periods: 1) for the next 5 to 10 years we estimate their annual FCF
taking into account the near future of the company, its growth opportunities,
strategic plans, ongoing projects, etc., and 2) we estimate a Terminal Value
representing all FCF´s after the first period.
TERMINAL VALUE
There are several candidates for the TV:

▪ Liquidation Value: Sell all assets at the end of the first period and pay off all outstanding debt. The
net is TV. This would be a lower limit.
▪ Book value: Take the Book Value at the end of the first period. This is also a very conservative TV.
▪ Use “Multiples”: P/E  Estimate earnings for T + 1 and divide them by the number of stocks;
subsequently multiply this number by a representative P/E multiple, for example that of another
mature firm from the same industry. Finally we add debt. Other multiples may also be used, for
example Market-to-Book value, Price / Sales ratio, etc. As we have seen, this procedure is also used
to value companies directly: Using comparable public companies (i.e., ones that are listed on
formal stock exchanges).
▪ Perpetuity: Assuming no further growth over and above the cost of capital  TV = FCF T+1 / WACC
▪ Growing Perpetuity: TV = FCF T+1 / {WACC – g} where g = sustainable growth rate of the company
(not exceeding the average long term growth of the economy: 2 o 3% + inflation as a max.). A
slightly more realistic estimate may be obtained as follows:
TERMINAL VALUE
TV = EBIT*(1 – t)*(1 – g/r) / {WACC – g) where r = the return on new investments. An
advantage of this last expression is that it takes into account that an investment
doesn´t add value if it doesn´t exceed the cost of capital. To see this, put WACC = r
 the expression becomes a (non-growing) perpetuity. A 2nd advantage is that it
shows that growth has its cost: if g increases so does CAPEX and Working Capital.
In this expression a higher g, reduces the numerator and, hence, the FCF.