Valuing Stocks

Session 3
 Stock Exchange
• It is an institution, organization or association that
serves as a market for trading financial instruments
such as stocks, bonds and their related derivatives.

• Large companies arrange their stocks to be traded on

a stock exchange
• Firms that wish to raise new capital
– May borrow money or
– Bring new ‘partners’ by selling shares of
common stock
• Components for buying stocks
– Price change
– Volume
– Dividend yield
– Price-earning (P/E) ratio
 Valuing a Company and Its Future

• The single most important issue in the stock

valuation process is what a stock will do in the
future.
• Value of a stock depends upon its future returns
from dividends and capital gains/losses.
• We use historical data to gain insight into the future
direction of a company and its profitability.
• Past results are not a guarantee of future results.
 The Valuation Process
• Valuation is a process by which an investor uses risk and
return concepts to determine the worth of a security.
– Valuation models help determine what a stock ought to be worth
– If expected rate of return equals or exceeds our target yield, the stock
could be a worthwhile investment candidate
– If the intrinsic worth equals or exceeds the current market value, the
stock could be a worthwhile investment candidate
– There is no assurance that actual outcome will match
expected outcome
 Required Rate of Return
• Required Rate of Return is the return
necessary to compensate an investor for the
risk involved in an investment.
– Used as a target return to compare forecasted
returns on potential investment candidates

R equired R isk-free Stock's M arket R isk-free

rate of return rate beta return rate
 Required Rate of Return (cont’d)
• Example: Assume a company has a beta of
1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?

R equired return 5.5% 1.30 15.0% 5.5% 17.85%

 Common Stock Valuation
• These methods are grouped into two
categories:

– Dividend discount models

– Price ratio models
 The Dividend Discount Model
• The Dividend Discount Model (DDM) is a method to
estimate the value of a share of stock by discounting all
expected future dividend payments. The DDM
equation is:
D(1) D(2) D(3) D(T) P(T)
V(0) 2 3
 T T
1 k 1 k 1 k 1 k 1 k

• In the DDM equation:

– V(0) = the present value of all future dividends
– D(t) = the dividend to be paid t years from now
– k = the appropriate risk-adjusted discount rate
 Example: The Dividend Discount Model

• Suppose that a stock will pay three annual dividends of $200

per year, and the appropriate risk-adjusted discount rate, k, is
8%. Terminal price $ 1200.
• In this case, what is the value of the stock today?

D(1) D(2) D(3) P(3)

V(0) 2 3 3
1 k 1 k 1 k 1 k

$200 $200 $200 $1,200

V(0) 2 3 3
$1,468.01
1 0.08 1 0.08 1 0.08 1 0.08
 The Dividend Discount Model:
the Constant Growth Rate Model
• Assume that the dividends will grow at a constant growth rate
g.

• Then, the dividend next period (t + 1) is:

D t 1 D t 1 g

• In this case, the DDM formula becomes:

T
D(0)(1 g) 1 g P(T)
V(0) 1 T
k g 1 k 1 k
 Example: The Constant Growth Rate
Model
• Suppose the current dividend is $10, the dividend growth rate is 10%, there will be
20 yearly dividends, and the appropriate discount rate is 8%. Terminal value $200.

• What is the value of the stock, based on the constant growth rate model?

T
D(0)(1 g) 1 g P(T)
V(0) 1 T
k g 1 k 1 k

20
$10 1.10 1.10 200
V 0 1 20
$286.77
.08 .10 1.08 1 .08
 The Dividend Discount Model:
the Constant Perpetual Growth Model.
• Assuming that the dividends will grow forever
at a constant growth rate g.

• In this case, the DDM formula becomes:

D1
V 0
k g
 Example: Constant Perpetual Growth
Model
• Think about the electric utility industry.

• In mid-2003, the dividend paid by the utility company, American Electric

Power (AEP), was $1.40.

• Using D(0)=$1.40, k = 6.5%, and g = 1.5%, calculate an estimated value for

AEP.

$1.40 1.015
V 0 $28.42
.065 .015
 The Sustainable Growth Rate

Sustainabl e Growth Rate ROE Retention Ratio

ROE (1 - Payout Ratio)

• Return on Equity (ROE) = Net Income / Equity

• Payout Ratio = Proportion of earnings paid out as dividends

• Retention Ratio = Proportion of earnings retained for

investment
 Example: Calculating and Using the
Sustainable Growth Rate
• In 2003, AEP had an ROE of 10%, projected earnings per share of $2.20,
and a per-share dividend of $1.40. What was AEP’s
– Retention rate?
– Sustainable growth rate?

• Payout ratio = $1.40 / $2.20 = .636

• So, retention ratio = 1 – .636 = .364 or 36.4%

• Therefore, AEP’s sustainable growth rate = 10% .364 = 3.64%

 Example: Calculating and Using the
Sustainable Growth Rate, Cont.

• What is the value of AEP stock, using the

perpetual growth model, and a discount rate
of 6.5%?

$1.40 1.0364
V 0 $50.73
.065 .0364
 Price Ratio – P/E Ratio
• Price-earnings ratio (P/E ratio)
– Current stock price divided by annual earnings per share (EPS)

Intel Corp (INTC) - Earnings (P/E) Analysis

• Current EPS $0.48

• 5-year average P/E ratio 38.72
• EPS growth rate 5.50%

Expected stock price = historical P/E ratio projected EPS

$19.61 = 38.72 ($0.48 1.055)

Thank You