8/5/2019 Stock Valuation | A Matter of Course

A Matter of Course

Companion webage-cum-blog for PGP-1 Financial Markets class

Archive for the ‘Stock Valuation’ Category

[FM] Stock Valuation – II

leave a comment »

In this post we take a closer look at the source of growth rate .

In the previous post, we saw that by retaining a part of earnings ( ) and investing in available
opportunities the firm was able to generate growth in earnings ( ) which depended on the rate of
return on investment ( ).

We continue to use the same example, but instead of an opportunity presenting itself at time , we say
that the firm has been earning at a steady-state earning of per year ‘in the past’, and has been
distributing all of it as dividends, but at time the firm finds a market opportunity which it think it
can exploit by investing in some new products.

Let’s assume that the investment of in this opportunity will give the firm an extra earning of
per year in perpetuity. We assume that starting year it distributes all its earnings as dividends.

Pictorially we have a situation something like this:

(Click on the graph to zoom.)

That is, from a steady state of earning per year, by investing in an opportunity the firm has reached
a steady state of earning each year from the investment made at time .

The PV of the firm then is easily calculated as:

https://pgpfm.wordpress.com/category/stock-valuation/ 1/12
8/5/2019 Stock Valuation | A Matter of Course

where is the firm’s return on investment/equity. (Because in our example all the earnings have been
plowed-back, i.e. , it implies that ). That is, the firm value depends on how growth in
earning from investment opportunities relates to the opportunity cost of capital .

This means it doesn’t make sense to invest in all kinds of opportunities, but only in those which have
greater than the opportunity cost of capital, . In fact, only if is the firm value more than what it
starts out with. Even if , the firm value doesn’t increase but stays the same. That is, as far as the
shareholders are concerned, the firm might as well ignore opportunities which have .

And why is that? Because in that case the shareholders would rather receive the dividends (‘get their
money back’), and invest in assets in stock market/elsewhere which give return equal to the opportunity
cost of capital ( ). So, if the only opportunities available to the firm are the ones which have
, the firm is be er off giving the dividends.

So what is happening here? Let’s dig a li le deeper still.

Rewrite the above PV as:

(where, note, we have collected the and terms together, and added the term in the
first bracket and subtracted in the next.)

Look closely at the term:

The term has two parts: the PV of the investment at time , i.e.
, and the PV of the extra cash flows arising out of the investment, i.e.
. We call the sum, as
. When , you can (and should) do the algebra and check that , as it should be.

That is,
https://pgpfm.wordpress.com/category/stock-valuation/ 2/12
8/5/2019 Stock Valuation | A Matter of Course

In this simple case, thus, the firm value today can be wri en as a sum of the value that would have been
had the firm not invested in any investment opportunity (the steady state ), and the NPV of
Growth Opportunities .

Growth Opportunities

It turns out this result is more general and holds for investment across time periods in the future. We
now ‘prove’ it for the case where the firm retains a (constant) portion ( ) in each time period (that is
similar investment opportunities are taken up every year), and thereby adding to expected cash flows in
subsequent periods in perpetuity.

As earlier, pictorially this is represented as:

(Click on the graph to zoom.)

(This is what it means when we say that the dividends are growing at a constant rate : that the firm is
plowing back a constant ratio every year and investing in investment opportunities that make
earning/dividends grow by . )

And what do we end up with? Of course, just our constant growth perpetuity formula:

Investments

Upon closer look we see that growing sequence of dividends is coming from a sequence of investments
(second row of the above table) whose PV is:

https://pgpfm.wordpress.com/category/stock-valuation/ 3/12
8/5/2019 Stock Valuation | A Matter of Course

Earnings

PV of total earnings are given by the following perpetuity (second row of the above table):

It turns out we can we break this total earnings expression into parts as following (see below):

As the above table shows, and as it should be, the stock price (PV of dividends) is nothing but PV of
earnings minus PV of investments, so we must have:

where represents PV of sequence of extra cash flow from all investments. Showing so
economically (and mathematically) and where it is coming is a bit tedious algebraically, but I can tell
you the outline of it.

The way it is done by noting that investment at each time period generates a perpetuity. So, investment
at time creates a perpetuity of extra earning starting at time . The value of this perpetuity time
is . (Note that investment in each time period generates a perpetuity of extra income starting
from the ‘next’ time period.) So, the perpetuity starting at year because of retained earnings at year
is worth , and so on and so forth. The sum of all these perpetuities is itself a perpetuity
which sums as follows:

which is what we set out to show.

https://pgpfm.wordpress.com/category/stock-valuation/ 4/12
8/5/2019 Stock Valuation | A Matter of Course

We can now put it all together by writing:

The bo om line is that under some reasonable assumptions, we may interpret value of any common
stock as the sum of PV of earnings in absence of growth and , i.e:

To conclude, note that the above implies:

which means for any given level of earnings, market ascribes a high price ratio (called the price-
earnings multiple) to any stock only when it expects . Of course, future realized value of
could be anything, and if the firm doesn’t deliver on its promises, its price in the future would fall.

This completes our discussion of stock valuation.

https://pgpfm.wordpress.com/category/stock-valuation/ 5/12
8/5/2019 Stock Valuation | A Matter of Course
Advertisements

25% OFF 40% OFF

REPORT THIS AD

REPORT THIS AD
Wri en by Vineet

August 26, 2015 at 12:53 pm

Posted in FM, Stock Valuation

Tagged with FM-2015-16, Session 6, Stock Valuation

[FM] Stock Valuation – I

with 2 comments

Now we come to the first application of the theory we have developed so far – stock valuation.

Why should a rational investor buy a stock?

The intuitive answer seems to be that an investor buys a stock as she expects its value to rise – so that she
can get the capital gains out of it. But is the expectation warranted? Think about it. For the value of the
stock to rise, just her expectation/her isn’t enough. Others also must hope the same. Only if others
https://pgpfm.wordpress.com/category/stock-valuation/ 6/12
8/5/2019 Stock Valuation | A Matter of Course

believe so that the price would go up. Needless to say there is no guarantee that this will happen. So
then, why should a rational investor buy a stock?

The answer is that investor would consider what return does stock provide to him/her, irrespective of
whether or not other investors change their mind about it. And what does a stock return? Literally, this
is just the cash flows paid by the firm to the shareholders. These cash flows mostly take the form of
dividends, but can often be proceeds of takeover or liquidation. In short, a stock is worth only what it gives
you!

To quote a saying that John Burr Williams cites in his book:

A cow for her milk,

A hen for eggs,
And a stock, by heck,
for her dividends

Which, translated in our language, means:

Or,

(where denotes the expected dividend at time )

At this point you may say, that this ok, but really, come on, are you saying that a trader on the street
buys the stock for dividends? Isn’t it true that most people out there buy stocks for capital gain? Well, it
turns out that there is no discrepancy. Let’s ask the question, what determines next year’s price?

What determines next year’s price?

If our ‘model’ / theory of stock valuation is correct, then it should hold next year too, right? And what
would be the price next year be? It will be just the expected future dividends starting year 2 onwards. So
we have:

(In the second line we’ve just multiplied and divided by the fraction ).

This can be wri en as:

We had :

https://pgpfm.wordpress.com/category/stock-valuation/ 7/12
8/5/2019 Stock Valuation | A Matter of Course

To generalize then,

That is, saying that value of a stock is the discounted value of expected future dividends is akin to saying
that the value of a stock is the discounted value of expected future dividends and the terminal (final sale)
price. This has come to be known as the Dividend Discount Model (DDM).

But to solve the problem in practice, as you can see we need the values of variables –
dividends ( ), value for the discount rate ( ) and the terminal share price .

If we have a sense of the expected (future) values of these variables, then of course we are done. But
that’s asking for too much. Real world is uncertain, and at best we can have reasonable forecasts for the
next couple of years – hardly enough. Presented in this form, the problem clearly is daunting. What do
we do?

First thing to do is ask the question – can we simplify it somehow, but still learn something about stock
valuation? Say, somehow by reducing the dimensionality/number of variables in the problem?

It turns out it is possible, but we need to make some assumptions.

Cash Flows: Dividends and the Terminal Price

Let’s deal with the terminal price first. We noted earlier that the stock valuation formula with an
expected terminal price is equivalent to one with an infinite stream of expected dividends. That is,
assuming that in the limit the PV of the expected price at infinity is 0, i.e. , we can
write DDM as:

https://pgpfm.wordpress.com/category/stock-valuation/ 8/12
8/5/2019 Stock Valuation | A Matter of Course

What do we about dividends? If we look carefully, our DDM formula for stock valuation doesn’t look
too different from an annuity. The difference is that unlike an annuity, the cash flows are not same
throughout the year. But if the expected dividend were indeed the same every year we could use the
annuity formula. Won’t it be wonderful if we could make this assumption. Could we? Well, as Obama
famously popularized it back then, yes, we can!

That basically means we have two options. Model expected dividends as a:

1. Perpetuity: Assume dividends to be the same forever

2. Growing perpetuity: Assume dividends to grow at a constant rate forever

Dividends as a Perpetuity

This clearly is the simplest case. If we are willing to assume that expected dividends will be the same
forever, then we are down to just ( and ) variables from our original , and our stock
valuation formula simplifies to:

Dividends as a Growing Perpetuity

The second case of a growing perpetuity is not any more difficult, and in this case we end up with (
, and ) variables, and our stock valuation formula is:

where is the assumed growth rate in dividends. Of course, use of this formula requires that .

What if, ? We know that we can’t use the infinite GP formula in this case as the common ratio that
is involved in a growing perpetuity would be greater than . Maths is one thing, but
we have to understand what it means.

What we are saying is that the growth rate of expected dividends forever exceeds the opportunity cost of
capital – which, loosely speaking, is another way of saying that the company is able to find investment
opportunities that return a rate more than the opportunity cost of capital ( ) forever. But
neither are all companies are like Facebook, nor is everybody like Mark Zuckerberg. (Even Facebook is
not growing at a rate that it has for the past 7-8 years, funding from Microsoft notwithstanding.)

So clearly, even economically the case of forever seems unreasonable. But then, are we saying
that we cannot consider companies like Facebook in our set-up?

We can consider high growth firms in our set-up as long as we’re willing to allow for multiple growth
rates. A firm can enjoy monopoly profits for some time when it has a new product / service that beats
everything else, but in a free market eventually the competition catches up, and the margins starts to go
down. And it’s reasonable to say, that at some stage when the industry becomes mature (like the
passenger car or ‘online messaging’ industry is now), when the challenge is just to sustain one’s existing
position in the market (an ‘equilibrium’, when ). So, yes, if we allow for multiple growth rates in
our set-up we can very well think about valuing firms like Facebook.
https://pgpfm.wordpress.com/category/stock-valuation/ 9/12
8/5/2019 Stock Valuation | A Matter of Course

If you’ve read the Chapter 2 of your book, you may be able to guess where we are heading now. We just
consider a growing perpetuity that grows at a high rate for some time, and then at a slower
‘equilibrium’ rate for the remaining. (We can easily include as many stages of growths as we like, as
long the last stage is an ‘equilibrium’ stage by which time we say that the competition has caught up.)

Notice that starting with some reasonable first approximations we’ve ended up with a model that has
only finite number of variables to estimate. Even if we consider three stages of growth, we still have only
variables to figure out – clearly an improvement over variables we started out with.

If we consider two stages of growth (a very reasonable assumption in most cases), we just need one extra
variable, i.e. . That is, we have able been to reduce the complexity of the problem from finding
variables to just . This gives us the following valuation formulas:

Dividends as Normal Perpetuity:

Dividends as Growing Perpetuity:

Dividends as a Perpetuity with Multiple Growth Rates (with growth rate , perhaps , for
years after the first year, and till perpetuity thereafter):

The last formula above is sometimes also referred to as Multi-stage DDM (you should check on your
own to make sure that the expression is ok). Of course, the formula becomes complicated as you have
multiple growth rates, but the basic PV logic of DDM remains.

While we’ve managed to reduce the dimensionality of our problem, we still haven’t quite solved the
problem yet. We still need to figure how to estimate the variables of interest – , and .

As it happens dividends of firms typically don’t change much year-on-year, and for , last year’s
dividends is not a bad first estimate.

Where does come from?

More often than not, in practice, the best way to get a sense of is to just ‘ask’ the equity research
experts in your bank, or if you are not working in one, perhaps just buy a subscription to the sector/firm
equity research reports from one, or from those boutique equity research ‘shops’.

https://pgpfm.wordpress.com/category/stock-valuation/ 10/12
8/5/2019 Stock Valuation | A Matter of Course

But what if you are that equity research professional, or what if the investment-banking desk/consulting
firm you work for want you to provide that estimate? (Perhaps because they don’t rely on other’s
opinions, or just feel uncomfortable that all assumptions in outside equity research reports are not
properly spelled out. This is not just a hypothetical situation, these concerns are sometimes very relevant
and important). In this post we try to learn the textbook way of how to think about the growth rate .

So how do we think about finding ? First of all, think what really means? Loosely speaking, when
we say that the firm is able to ‘grow’ its dividends at a rate year-on-year, it’s like saying that the
company is able to find just enough investment opportunities to grow at the same rate every
year (if even that were not possible, we would have the case of dividends growing as a normal
perpetuity – the firm just about surviving to maintain the same dividends every year.)

Consider a firm (selling electric bulbs?) that’s earning a steady-state/equilibrium amount ( )

per year – just about able to recover its depreciation and generating enough revenue to retain its position
in the market. Now, say, it finds an investment opportunity (recall our CFL example), which
it believes has a positive NPV.

Let’s say that in year (with earning ), the firm finds this opportunity and retains a portion
portion of that, say, amount to invest, and pays the remaining amount as dividend
. Now since the firm’s steady state operations (electric bulb business) are not affected, it’ll
earn the same amount from that even next year. If the investment produces a revenue of amount
in period , then the total expected earnings in period would be:

Or alternatively,

and if is the growth in earnings, i.e. , and we call as the ratio

of retained earnings (or as it sometimes called the ‘plow-back’ ratio), and as the
return on investment (and if you have not raised any debt, return on equity), then we can write the
growth rate in earnings as:

If we assume that the firm is able to find similar investment opportunities in each period ( ),
and the plow-back ratio is constant ( ), we end up with our growth rate formula as:

Note that if the earnings growth rate is constant because the plow-back ratio and the return on
investment are constant, the dividend growth rate would be constant ( ) too. To see this, write:

In the next post we take a closer look at where this growth is coming from and introduce the idea of
NPV of Growth Opportunities.
https://pgpfm.wordpress.com/category/stock-valuation/ 11/12
8/5/2019 Stock Valuation | A Matter of Course

Caveats

1. Note that here we are considering as the growth in earnings because of the positive
opportunities. If the firm is giving extra dividends by investing in opportunities that are growing at a
rate lower than the opportunity cost of capital, then the firm is reducing value for the
shareholders despite the growth rate in dividends. We take a look at it in a stylized se ing in the next
post.
2. This should be probably obvious, but worth mentioning nonetheless. When you rely on equity
research reports to get a sense of , beware that security analysts are subject to behavioural biases
and their forecasts tend to be over-optimistic.
3. Our results above are for a single/constant growth rate (dividends as a constant growth perpetuity)
case, so, again, remember that the analysis will have to modified slightly (though nothing changes
much in terms of the logic) if you are considering multiple growth rates.

Wri en by Vineet

August 26, 2015 at 12:39 pm

Posted in FM, Stock Valuation

Tagged with Dividend Discount Model, Session 5, Stock Valuation

Create a free website or blog at WordPress.com.

https://pgpfm.wordpress.com/category/stock-valuation/ 12/12