A B C D E F G H I

1 Tool Kit Chapter 2 12/8/2012

2
3 Valuation of Stocks and Corporations
4
5 7-4 Valuing Common Stocks
6
7 Stocks can be evaluated in two ways: (1) find the stock price directly by calculating the present
8 value of the expected future dividends, or (2) find the stock price indirectly by first calculating the
9 value of the entire corporation, which is the present value of the firm's expected future free cash
10 flows, and then subtracting the value of the debt and preferred stock to find the total value of the
common equity.
11
12
13
14 THE DISCOUNTED DIVIDEND APPROACH
15
16
The value of any financial asset is the present value of the future cash flows provided by the asset.
17 When an investor buys a share of stock, he or she typically expects to receive cash in the form of
18 dividends and then, eventually, to sell the stock and to receive cash from the sale. However, the
19 price the first investor receives is dependent upon the dividends the next investor expects to earn,
and so on for different generations of investors. Thus, the stock's value ultimately depends on the
20 cash dividends the company is expected to provide and the discount rate used to find the present
21 value of those dividends.
22
23
24
25 Here is the basic dividend valuation equation:
26
27 D1 + D2 + . . . . DN
P0 =
28 ( 1 + rs ) ( 1 + rs ) 2 ( 1 + rs ) N

29
30 The dividend stream theoretically extends on out forever, i.e., to n = infinity. Obviously, it would
31 not be feasible to deal with an infinite stream of dividends, but fortunately, a relatively simple
32 equation has been developed that can be used to find the PV of the dividend stream, provided it is
growing at a constant rate.
33
34
35 7-5 Valuing a Constant Growth Stock
36
37
38 In the constant growth model, we assume that the dividend and stock will grow forever at a
constant growth rate. Naturally, assuming a constant growth rate for the rest of eternity is a
39 rather bold assumption. However, considering the implications of imperfect information,
40 information asymmetry, and general uncertainty, the assumption of constant growth is often
41 reasonable. It is reasonable to guess that a given stock will experience ups and downs throughout
42 its life. By assuming constant growth, we are trying to find the average of the good times and the
bad times, and we assume that we will see both scenarios over the firm's life. In addition to a
43 constant growth rate, we also need the estimated long-term required return for the stock, and it
44 too must be constant. If these variables are constant, our price equation for common stock
45 simplifies to the following expression:
46
47
 A B C D E F G H I
48
49 P0 =
D1
50 ( rs – g )
51
52 In this equation, the long-run growth rate (g) can be approximated by multiplying the firm's
53 return on assets by the retention ratio. Generally speaking, the long-run growth rate of a firm is
likely to fall between 5% and 8% a year.
54
55
56 CONSTANT GROWTH MODEL
57 A firm just paid a $1.15 dividend and its dividend is expected to grow at a constant rate of 8%.
58 What is its stock price, assuming it has a required return of 13.4%?
59
60 D0 = $1.15
61 g= 8%
62 rs = 13.4%
63
64 P0 =
D1
=
D0 (1 + g)
=
$1.2420
65 ( rs – g ) ( rs – g ) 0.0540
66
67 P0 = $23.00
68
69
70 DO STOCK PRICES REFLECT LONG-TERM OR SHORT-TERM CASH FLOWS?
71
72 Managers often claim that stock prices are "short-term" in nature in the sense that they reflect
73 what is happening in the near-term and ignore the long-term. We can use the results for the
constant growth model to shed light on this claim.
74
75
76 The first step is to forecast the dividends for the next 5 years. Then we find the present value of
77 these dividends and compare that PV with the current stock price, which reflects the PV of all
future dividends.
78
79
80 P0 = $23.00
81 D0 = $1.15
82 g= 8%
83 rs = 13.4%
84
85 Year 0 1 2 3 4 5
86 Dividend $1.15 $1.24 $1.34 $1.45 $1.56 $1.69
87
88 PV of dividends in Years 1 through 5 = $4.98
89 Current stock price = $23.00
90 Percent of current stock price due to dividends
91 in Years 1 through 5 = 21.6%
92 Percent of current stock price due to dividends
93 beyond Year 5 = 78.4%
94
95 For most stocks, the percentage of the current price that is due to long-term cash flows is over 80%.
96
97
98 STOCK PRICE VOLATILITY
 A B C D E F G H I
99
100 How sensitive are stock prices to changes in the inputs to the constant growth model?
101
102 Inputs:
103 D0 = $1.15
104 g= 8%
105 rs = 13.4%
106
107 Growth Required Return: rs
108 Rate: g 11.4% 12.4% 13.4% 14.4% 15.4%
109 6% $22.57 $19.05 $16.47 $14.51 $12.97
110 7% $27.97 $22.79 $19.23 $16.63 $14.65
111 8% $36.53 $28.23 $23.00 $19.41 $16.78
112 9% $52.23 $36.87 $28.49 $23.21 $19.59
113 10% $90.36 $52.71 $37.21 $28.75 $23.43
114
115 Small changed in the growth rate or the required return cause big changes in the estimated stock price.
116
117
 A B C D E F G H I
118 EXPECTED RATE OF RETURN ON A CONSTANT GROWTH STOCK
119
120 Using the constant growth equation introduced earlier, we can re-work the equation to solve for
rs. In doing so, we are now solving for an expected return. The expression we are left is:
121
122
123 D1
+ g
124 𝐫 ̂ = P0
125
126
127 This expression tells us that the expected return on a stock comprises two components. First, it
consists of the expected dividend yield, which is simply the next expected dividend divided by the
128 current price. The second component of the expected return is the expected capital gains yield.
129 The expected capital gains yield is the expected annual price appreciation of the stock, and is
130 given by g. This shows us the dual role of g in the constant growth rate model. Not only does g
131 indicate expected dividend growth, but it is also the expected stock price growth rate.
132
133
134 EXAMPLE: EXPECTED RATE OF RETURN ON A CONSTANT GROWTH STOCK
135 You buy a stock for $23, and you expect the next annual dividend to be $1.242. Furthermore, you
136 expect the dividend to grow at a constant rate of 8%. What is the expected rate of return on the
stock, and what is the dividend yield of the stock?
137
138
139 Inputs:
140 P0 $23.00
141 D1 $1.242
142 g 8%
143
144 𝐫 ̂ = 13.40%

145
146 Dividend yield = 5.40%
147
148
149 What is the expected price of this stock in 1 year?
150
151 Application of Constant Growth Model at t=1
152
153 P1 =
D2
154 ( rs – g )
155 D2 = 1.34136
156
157 P1 = $24.84
158
159
160 7-6 Valuing Nonconstant Growth Stocks
161
162
163 For many companies, it is unreasonable to assume that they grow at a constant growth rate.
164 Hence, valuation for these companies proves a little more complicated. The valuation process, in
this case, requires us to estimate the short-run nonconstant growth rate and predict future
165 dividends. Then, we must estimate a constant long-term growth rate at which the firm is expected
166 to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a rather
167 constant rate. Of course, the difficulty in this framework is estimating the short-term growth rate,
168 how long the short-term growth will hold, and the long-term growth rate.
 For many companies, it is unreasonable to assume that they grow at a constant growth rate.
Hence, valuation for these companies proves a little more complicated. The valuation process, in
this case, requires us to estimate the short-run nonconstant growth rate and predict future
dividends. Then, we must estimate a constant long-term growth rate at which the firm is expected
to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a rather
constant rate. Of course, the difficulty in this framework is estimating the short-term growth rate,
A the short-term
how long B C will hold, D
growth E
and the long-term growthFrate. G H I
169
170
171
172 Figure 7-3
173 Illustrative Dividend Growth at Different Rates
174
175 $2.50
176
177
178 $2.00
179
180
181 $1.50 Declining
182 Zero
183
184 $1.00 Constant
185 Nonconstant
186
187 $0.50
188
189
190 $0.00
191 0 1 2 3 4 5 6
192
193
194
 A B C D E F G H I
195 Specifically, we will predict as many future dividends as we can and discount them back to the
196 present. Then we will treat all dividends to be received after the convention of constant growth
197 rate with the Gordon constant growth model described above. The point in time when the
198 dividend begins to grow constantly is called the horizon date. When we calculate the constant
growth dividends, we solve for a terminal value (or a continuing value) as of the horizon date.
199 The terminal value can be summarized as:
200
201
202
203 TVN = PN =
DN+1
=
DN (1 + g)
204 ( rs – g ) ( rs – g )
205
206 This condition holds true, where N is the terminal date. The terminal value can be described as
207 the expected value of the firm in the time period corresponding to the horizon date.
208
209
210 A company's stock just paid a $1.15 dividend, which is expected to grow at 30% the first year,
20% the second year, and 10% the third year. After three years the dividend is expected to grow
211 constantly at 8% forever. The stock's required return is 13.4%; what is the price of the stock
212 today?
213
214
215 Figure 7-4
216 Process for Finding the Value of a Nonconstant Growth Stock
217 INPUTS:
218 D0 = $1.15 Last dividend the company paid.
219 rs = 13.4% Stockholders' required return.
220 g0,1 = 30% Growth rate for Year 1 only.
221 g1,2 = 20% Growth rate for Year 2 only.
222 g2,3 = 10% Growth rate for Year 3 only.
223 gL = 8% Constant long-run growth rate for all years after Year 3.
224
225 Growth rate 30% 20% 10% 8% 8%

226
227
Year
Dividends
0 1
$1.4950
2
$1.7940
3
$1.9734
4
$2.1313⟶ ∞
228 ↓ ↓ ↓ ↓
229 D1 D2 D3 ↓
230 ────── ────── ────── ↓
231 (1+rs)1 (1+rs)2 (1+rs)3 ↓
232 ↓ ↓ ↓ ↓
233 ↓ ↓ ↓ ⤷⟶ D4
𝐏 ̂_𝟑
234 $1.318 ⤶ ↓ ↓ ──── =
PVs of
235 dividends $1.395 ⟵⟵⟵⟵ ⤶ ↓ (rs− gL)
236 $1.353 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⤶ ↓
237 PV of HV3 $27.065 ⟵⟵⟵ $39.468 ↖ $2.131
238 ⟵⟵⟵⟵ = ───── = 𝐏 ̂_𝟑
↲

↓ $39.468 = ────
239 𝐏 ̂_𝟎 = $31.132 (1+rs) 3 5.40%

240
241
242 7-7 The Free Cash Flow Valuation Model
243
244 The free cash flow model does not require dividends, so it can be used to estimate the value of a
private company, a division, or a company that does not pay dividends.
 A cash flow B
The free model doesC not require D
dividends, soEit can be used
F to estimate
G the valueHof a I
245 private company, a division, or a company that does not pay dividends.
246
247 OPERATING ASSETS VERSUS NONOPERATING ASSETS
248
249
250 The value of a company is the sum of: (1) the value of its assets-in-place, including their
associated growth opportunities, which is called the value of operations and (2) the value of its
251 nonoperating assets, such as marketable securities and investments in non-controlled affiliates.
252 The value of operations is the present value of the free cash flows produced by the assets-in-place
253 and their associated growth opportunities.
254
255 ESTIMATING THE VALUE OF OPERATIONS
256
257 You are given the current and projected FCF of MagnaVision. Growth is expected to be 5% for
258 each year after the projections. If the WACC is 10.84%, what is the value of operations?
259
260
261 Figure 7-5
262 MagnaVision's Value of Operations (Millions of Dollars)
263 INPUTS:
264 gL = 5.00%
265 WACC = 10.84% Projections
266 Year 2012 2013 2014 2015 2016
267 FCF −$18.00 −$23.00 $46.40 $49.00 ⟶↴
268 ↓ ↓ ↓ ↓ ↓
269 FCF2013 FCF2014 FCF2015 FCF2016 ↓
270 ────── ────── ────── ────── ↓
271 (1+WACC)1 (1+WACC)2 (1+WACC)3 (1+WACC)4 HV = Vop(12/31/16)

272 ↓ ↓ ↓ ↓ ↓

273 ↓ ↓ ↓ ↓ FCF2016(1+gL)
274 −$16.240 ⤶ ↓ ↓ ↓ ─────────
275 PVs of FCFs −$18.721 ⟵⟵⟵⟵ ⤶ ↓ ↓ (WACC− gL)

276 $34.074 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⤶ ↓ ↓

277 $32.465 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⤶ ↓
278 PV of HV $583.696 $880.993↰ $51.450
279 ↓ = ────── = ──────
↲

(1+WACC)4 5.84%
280 Vop = $615.27

281
282
283
284 ESTIMATING THE PRICE PER SHARE
285
286
287 Figure 7-6
Estimating the Value of MagnaVision’s Stock Price (Millions,
288 Except for Per Share Data)
289 INPUTS:
290 Value of operations = $615.27
291 Value of nonoperating assets = $63.00
292 All debt = $247.00
293 Preferred stock = $62.00
294 Number of shares of common stock = 100.00
 A B C D E F G H I
295 Estimating Price Per Share
296 Value of operations $615.27
297 + Value of nonoperating assets 63.00
298 Total estimated value of firm $678.27
299 − Debt 247.00
300 − Preferred stock 62.00
301 Estimated value of equity $369.27
302 ÷ Number of shares 100.00
303 Estimated stock price per share = $3.69
304
305
306
307
308 Figure 7-7
309 MagnaVision's Sources of Value and Claims on Value (Millions of Dollars)
310
311 Sources of Value Claims on Value
312
313 Fin
314 anc De
315 ial bt =
ass Esti $2
316 mat 47
317 ets
Val = ed
318 ue $6 Pre
equ ferr
319 of 3 ity
320 ope ed
rati val sto
321 ons ue ck =
322 = = $6
323 $6 $3 2
324 15 69
325
326
327
328 7.9 Preferred Stock
329
330 Consider an issue of preferred stock that pays an $8 dividend and has a required return of 8%.
331 What is the value of this preferred stock?
332
333 Vps = Dps ÷ rps

334 = $8.00 ÷ 8.00%

335 = $100.00
336
337
 A B C D E F G H I
338 Some preferred stock has a maturity date. Consider a firm whose preferred stock matures in 50
339 years, pays a $8 annual dividend, has a par value of $100, and has a required return of 6%. What
is the price of this preferred stock?
340
341
342 Years to Maturity (N): 50
343 Annual Dividend (PMT): $8
344 Par value (FV): $100
345 Required return, rd (I/YR): 6%
346
347 Vps = $131.52
348
349
SECTION 7-4
SOLUTIONS TO SELF-TEST

If D1 = $3.00, P0 = $50, and the expected P at t=1 is equal to $52, what are the stock’s expected
dividend yield, capital gains yield, and total return for the coming year?

D1 $3.00
P0 $50.00
Expected P1 $52.00

Exp. dividend yield 6.0% =B6/B7

Exp. capital gains yield 4.0% =(B8-B7)/B7
Exp. total return 10.0% =C10+C11
SECTION 7-5
SOLUTIONS TO SELF-TEST

A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is r s = 12%.
What would the stock’s price be if the growth rate were 4%?

D1 $2.00
g 4%
rs 12%

Stock price $25.00

A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is r s = 12%.
What would the stock’s price be if the growth rate were 0%?

D1 $2.00
g 0%
rs 12%

Stock price $16.67

If D0 = $4.00, rs = 9%, and g = 5% for a constant growth stock, what are the stock’s
expected dividend yield and capital gains yield for the coming year?

D0 $4.00
g 5%
rs 9%

Expected D1 $4.20

Stock price $105.00

Expected dividend yie 4.00%

Expected capital gains 5.00%

Alternatively, you know that the capital gains yield is equal to the growth rate.

Expected capital gains yield = growth rate = 5.00%

Because the total return is rs, the dividend yield is rs minus the capital gains yield:

Expected dividend yield 4.00%

eturn is r s = 12%.

eturn is r s = 12%.
SECTION 7-6
SOLUTIONS TO SELF-TEST
Suppose D0 = $5.00 and rs = 10%. The expected growth rate from Year 0 to Year 1
(g0 to 1) = 20%, the expected growth rate from Year 1 to Year 2 (g1 to 2) = 10%, and the
constant rate beyond Year 2 is gL = 5%. What are the expected dividends for Year 1 and
Year 2? What is the expected horizon value price at Year 2? What is the expected price
at Time 0?
D0 $5.00
g0 to 1 20%
g1 to 2 10%
gL 5%
rs 10%
Year
1 2
D1 D2
Expected dividends $6.00 $6.60

Expected HVP,2 ###

PV of expected dividends $10.91

PV of expected HVP,2 $114.55

Expected price at Time 0 $125.45

SECTION 7-7
SOLUTIONS TO SELF-TEST

A company expects a FCF of -$10 million at Year 1 and a FCF of $20 million at Year 2.
FCF is expected to grow at a 5% rate after Year 2. If the WACC is 10%, what is the
horizon value of operations; i.e., Vop(Year 2)? What is the current value of operations;
i.e., Vop(Year 0)?

Long-term growth rate 5%

WACC 10%
Year
1 2
FCF1 FCF2
Expected FCF -$10.00 $20.00

Vop(Year 2) ###

PV of expected FCF $7.44

PV of expected Vop(Year 2) $347.11

Vop(Year 0) $354.55

A company has a current value of operations of $800 million. The company has $100
million in short-term investments. If the company has $400 million in debt and has 10
million shares outstanding, what is the price per share?

Vop $800
ST investments $100
Total value $900
Debt $400
Value of equity $500
Number of shares 10

Price per share $50.00

SECTION 7-9
SOLUTIONS TO SELF-TEST

A preferred stock has an annual dividend of $5. The required return is 8%. What is the V ps?

Dps $5.00
rps 8%

Vps $62.50
 ###

MagnaVision's Financial Statements

MagnaVision, Inc.: Income Statements for Years Ending December 31 (millions of

dollars)
Actual Projected
2012 2013 2014a 2015 2016
Net Sales $700.0 $850.0 $1,000.0 $1,100.0 $1,155.0
Costs (except depreciation) 599.0 734.0 911.0 935.0 982.0
Depreciation 28.0 31.0 34.0 36.0 38.0
Total operating costs $627.0 $765.0 $945.0 $971.0 $1,020.0
Earning before int. & tax (EBIT) $73.0 $85.0 $55.0 $129.0 $135.0
Less: Net interestb 13.0 15.0 16.0 17.0 19.0
Earning before taxes $60.0 $70.0 $39.0 $112.0 $116.0
Taxes (40%) 24.0 28.0 15.6 44.8 46.4
Net income before pref. div. $36.0 $42.0 $23.4 $67.2 $69.6
Preferred div. 6.0 7.0 7.4 8.0 8.3
Net income avail. for com. div. $30.0 $35.0 $16.0 $59.2 $61.3
Common dividends $0.0 $0.0 $0.0 $44.2 $45.3
Addition to retained earnings $30.0 $35.0 $16.0 $15.0 $16.0

Number of shares 100 100 100 100 100

Dividends per share $0.000 $0.000 $0.000 $0.442 $0.453
a
Net income is projected to decline in 2014. This is due to the projected cost for a
one-time marketing program in that year.

b
“Net interest” is interest paid on debt minus interest earned on marketable
securities. Both items could be shown separately on the income statements, but
for this example we combine them and show net interest. MagnaVision pays more
interest than it earns; hence its net interest is subtracted.

MagnaVision Inc.: December 31 Balance Sheets (millions of dollars)

Actual Projected
Assets 2012 2013 2014 2015 2016
Cash $17.0 $20.0 $22.0 $23.0 $24.0
Marketable Securitiesa 63.0 70.0 80.0 84.0 88.0
Accounts receivable 85.0 100.0 110.0 116.0 121.0
Inventories 170.0 200.0 220.0 231.0 243.0
Total current assets $335.0 $390.0 $432.0 $454.0 $476.0
Net plant and equipment 279.0 310.0 341.0 358.0 376.0
Total Assets $614.0 $700.0 $773.0 $812.0 $852.0

Liabilities and Equity

Accounts Payable $16.0 $20.0 $22.0 $23.0 $24.0
Notes payable 123.0 140.0 160.0 168.0 176.0
Accruals 44.0 50.0 55.0 58.0 61.0
Total current liabilities $183.0 $210.0 $237.0 $249.0 $261.0
Long-term bonds 124.0 140.0 160.0 168.0 176.0
Preferred stock 62.0 70.0 80.0 84.0 88.0
Common Stockb $200.0 $200.0 $200.0 $200.0 $200.0
Retained earnings 45.0 80.0 96.0 111.0 127.0
Common equity $245.0 $280.0 $296.0 $311.0 $327.0
Total liabilities and equity $614.0 $700.0 $773.0 $812.0 $852.0
a
All assets except marketable securities are operating assets required to support
sales. The marketable securities are financial assets not required in operations.
b
Par plus paid-in capital.

Calculating MagnaVision's Expected Free Cash Flow (Millions of Dollars)

Actual Projected
Step 1: Calculate FCF 2012 2013 2014b 2015 2016
a
1. Net operating working capital $212.0 $250.0 $275.0 $289.0 $303.0 Note: Net operating working capital is o
2. Net plant and equipment 279.0 310.0 341.0 358.0 376.0
3. Net operating capital $491.0 $560.0 $616.0 $647.0 $679.0 Note: Net operating capital is the sum of
4. Investment in operating cap 69.0 56.0 31.0 32.0 Note: Investment in capital is the increa
5. NOPAT $43.8 $51.0 $33.0 $77.4 $81.0 Note: NOPAT is net operating profit afte
6. Less: Investment in op. capit 69.0 56.0 31.0 32.0
7. Free cash flow -$18.0 -$23.0 $46.4 $49.0
a
We use the terms “total net operating capital,” “operating capital,” and “net
operating assets” interchangeably.
b
NOPAT declines in 2014 because of a marketing expenditure projected for that
year.
ing working capital is operating current assets (cash + accounts receivable + inventories) minus (operating current liabilities (account

ing capital is the sum of net operating working capital and net PPE.
t in capital is the increase in capital from the previous year.
net operating profit after taxes. It is equal to the profit a company would have if it had no debt. This is EBIT*(1-Tax rate).
g current liabilities (accounts payable + accruals).

T*(1-Tax rate).