Session 6 - NSV

Session 6 Equity valuation
30017 Corporate Finance
Session 6: Equity valuation
1
30017 1 Corporate Finance
Topics
Trading stocks
Valuing stocks
Estimating cost of equity capital
EPS and stock prices
Reading
BMA 4

Primary and secondary markets

• Primary markets: Sale of new shares to raise new
capital
• Secondary markets: Trading of secondhand shares

(no new capital raised)
• Stock markets can be organized in different ways:

› Exchanges (Auction markets)
- NYSE, Tokyo Stock Exchange, London Stock
Exchange
- Auctioneer matches buyers and sellers.
› OTC (Dealer markets)
- Trades take place between dealers and
investors. Frequent for bonds.

The different flavors of equity

• Common stocks (represent ownership positions in a corporation):
› Common stock have voting rights (in shareholder meetings) and cash
flow rights (dividends)
› Companies can issue more than one class of common stock with
differences in voting rights (ex Google, Facebook).
- Facebook dual class structure: Class B common stock has ten votes
per share, and Class A common stock has one vote per share.
• Preferred stocks
› Preferred stocks have no voting rights, but pay dividends (typically less
volatile than those paid for common stock)
• Exchange traded funds (ETFs)
• ADRs (American Depository Receipts): represent non-US firms traded in US

markets (cross-listed)
Stock market capitalization/GDP
Source: Worldbank

How to value a stock?
• By comparison with (comparable!) firms
• By applying the present value operator to all future dividends


Valuation by comparables


Stock prices and dividends
• Our NPV formula applies to the valuation of stocks
• Since shareholders receive dividends, an obvious approach to

value a stock is simply PV(stock)=PV(expected future dividends)
• This is always true, even if investors buy stocks not just for
dividends but for capital gains


The return of a stock between two periods can be

broken into two parts:
Div1 P1 - P0
Expected Return = r = +
P0 P0
Dividend Yield + Capital Appreciation


• Previous equation rewrites: DIV1 + P1

P0 =
1+ r
DIV2 + P2
• What determines P1? Well, P1 =
1+ r
DIV3 + P3
• Similarly P2 =
1+ r
• ...
DIV1 DIV2 DIVH + PH H
DIVt PH
P0 = + + ... + = +
1 + r (1 + r ) 2
(1 + r ) H
t =1 (1 + r ) t
(1 + r ) H

Dividend Discount Model - Computation of today’s stock price

which states that share value equals the present value of all
expected future dividends.
Div1 Div2 DivH + PH

P0 = 1
+ 2
+ ... + H
(1+ r ) (1+ r ) (1+ r )
H - Time horizon for your investment.

r – Cost of equity (or market capitalization rate)


Cost of equity capital
• How to find the cost of equity capital?

• We need to find stocks that have the same risk that
this stock has.
• These stocks belong to the same risk class.
• All the stocks in the same risk class must be priced to
offer the same expected rate of return. This is an
equilibrium condition.

Practice question
• Current Price P0=100, and expected to pay Dividend $5.
• Dividends increase 10% per year, capitalization rate is 15%.
Div1 Div2 DivH + PH
P0 = + + ... +
1
(1+ r ) (1+ r ) 2
(1+ r )H
For each holding period H, compute:
• Present value of cumulative dividends
• Present value of terminal price, pH


Practice question
Horizon Dividend Price PV(Cum PV(Future Total

Period Dividends) Price)
0 100 - - 100
1 5
2 ?
3 ?
4 ?
… …
100



0 100 - - 100
1 5 ?
2 5.5 ?
3 6.05 ?
4 6.66
… …
100 62639.15

To find P1, use formula: DIV1 + P1

P0 = ® P1 = P0 (1+ r ) - DIV1
1+ r
DIV2 + P2
To find P2, use formula: P2 = ® P2 = P1 (1+ r ) - DIV2
1+ r
…..

0 100 - - 100
1 5 110
2 5.5 121
3 6.05 133.1
4 6.66 146.41
… …
100 62639.15 1378061.2

Compute present value of:

• Cumulative dividends
• Price
0 100 - - 100
1 5 110 ? ?
2 5.5 121 ? ?
3 6.05 133.1 ? ?
4 6.66 146.41 ? ?
… …
100 62639.15 1378061.2

Compute present value of cumulative dividends :

5
HORIZON(H ) = 1, PV(Cum.Div.) = = 4.35
1.15
5 5.5
HORIZON(H ) = 2, PV(Cum.Div.) = + 2
= 8.51
1.15 1.15
0 100 - - 100
1 5 110 4.35 ?
2 5.5 121 8.51 ?
3 6.05 133.1 12.48 ?
4 6.66 146.41 16.29 ?
… …
100 62639.15 1378061.2 98.83

Compute present value of future prices:

110
HORIZON(H ) = 1, PV(P1 ) = = 95.65
1.15
121
HORIZON(H ) = 2, PV(P2 ) = 2
= 91.49
1.15
1378061.2
HORIZON(H ) = 100, PV(P2 ) = 100
= 1.17
1.15
0 100 - - 100
1 5 110 4.35 95.65 ?
2 5.5 121 8.51 91.49 ?
3 6.05 133.1 12.48 87.52 ?
4 6.66 146.41 16.29 83.71 ?
… …
100 62639.15 1378061.2 98.83 1.17 ?

You can check that the following formula is always true, i.e. for
any horizon period H:
H
DIVt PH
P0 = 100 =  t
+ H
t=1 (1+ r ) (1+ r )
As horizon period H approaches infinity, we can forget about the

terminal price component, which gives:
¥
DIVt
P0 =  t
t=1 (1+ r )

Constant dividend growth
• Assume we forecast a constant growth rate for a company‘s

dividends, that is: DIVt+1 = DIVt (1+ g)
› Does not impose growth to be constant for all years, only
expected growth
¥
DIVt
• Combined with the formula P0 =  t , we get:
t=1 (1+ r )
DIV1
P0 =
r-g
• ! We can use this formula only when g<r
Estimating the cost of equity capital
DIV1
P0 =
r-g
• Reverse and obtain an estimate of the cost of equity:
DIV1
r= +g
P0
-> expected return equals dividend yield (DIV/P) plus expected

rate of growth of dividends
Dividend growth rate=g=(1-payout ratio)*ROE
• Proof
› If payout ratio fixed over time, dividend growth rate should be equal to
earnings growth rate.
- DIVt=payout ratio*Earningst => gDIV=gEarnings

• Proof
› If ROE fixed over time, earnings growth rate should be equal to Book equity
growth rate
- ROE(%)=Earningst/BookEquityt => gEarnings=gEquity

• Proof
› If ROE fixed over time, earnings growth rate should be equal to Book equity
growth rate
- ROE(%)=Earningst/BookEquityt => gEarnings=gEquity
› By construction,
Equityt+1 = Equityt + (1- payout)* Earningst = Equityt + (1- payout)* ROE * Equityt
Equityt+1 - Equityt
Þ = (1- payout)* ROE
Equityt
Þ gDividends = gEarnings = gEquity = (1- payout)* ROE

Paying dividends versus reinvesting earnings

Practice question: Fledgling Electronics forecasts to pay a $8.33 dividend
next year, which represents 100% of its earnings. Suppose that Fledgling
Electronics capitalization rate is 15%. Instead, Fledgling Electronics can
decide to plow back 40% of the earnings at the firm’s current return on
equity of 25%. What is the value of the stock before and after the plowback
decision?


Practice question: Fledgling Electronics forecasts to pay a $8.33 dividend
next year, which represents 100% of its earnings. Suppose that Fledgling
Electronics capitalization rate is 15%. Instead, Fledgling Electronics decides
to plow back 40% of the earnings at the firm’s current return on equity of
25%. What is the value of the stock before and after the plowback decision?
Without growth With Growth
8 .33 g = .25  .40 = .10

P0 = = $ 55 .56
.15 5.00
P0 = = $100
.15 - .10


Present Value of Growth Opportunities (PVGO)
No Growth With Growth
g = .25  .40 = .10
8.33
P0 = = $55.56 5.00
.15 P0 = = $100.00
.15 - .10
The difference between these two numbers is called the Present

Value of Growth Opportunities (PVGO).
PVGO = 100 - 55.56 = 44.44


PVGO = 100 - 55.56 = 44.44
Possible to compute PVGO?
› By deciding to reinvest 40% of its earnings in year 1 (that is

$3.33), obtain perpetual earnings of 0.25*3.33=$0.83 from
date 2


› By deciding to reinvest 40% of its earnings in year 1 (that is
$3.33), obtain perpetual earnings of 0.25*3.33=$0.83 from
date 2
Y1 Y2 Y3 Y4 Y5
Plow-back -3.33 0.83 0.83 0.83 0.83 …
Year1
Plow-back
Year2
Plow-back
Year3
Plow-back
…
› this is a profitable strategy with NPV equal to:

› -3.33+0.83/0.15=$2.22

› Same decisions for each year in the future
Y1 Y2 Y3 Y4 Y5
Plow-back -3.33 0.83 0.83 0.83 0.83 …
Year1
Plow-back -3.33*1.1 0.83*1.1 0.83*1.1 0.83*1.1 …

Year2
Plow-back -3.33*(1.1)2 0.83*(1.1)2 0.83*(1.1)2 …

Year3
Plow-back … … …
…
2.22 2.22 *1.1 2.22 *1.12

TotalNPV = PVGO = + 2
+ 3
+ ...
1.15 1.15 1.15


› Same decisions for each year in the future
Y1 Y2 Y3 Y4 Y5
Plow-back -3.33 0.83 0.83 0.83 0.83 …
Year1
Plow-back -3.33*1.1 0.83*1.1 0.83*1.1 0.83*1.1 …
Year2
Plow-back -3.33*(1.1)2 0.83*(1.1)2 0.83*(1.1)2 …

Year3
Plow-back … … …
…
2.22 2.22 *1.1 2.22 *1.12

TotalNPV = PVGO = + 2
+ 3
+ ...
1.15 1.15 1.15
2.22
Þ PVGO = = 44.44
0.15 - 0.1
Present Value of Growth Opportunities

Summary
Stock price has two components:
• Present value of earnings under a no-growth policy
• Present value of growth opportunities
EPS1
P0 = + PVGO
r
• (If ROE>required capitalization rate, shareholders gain by reinvesting part of

the earnings, that is PVGO>0)
• “Growth stocks” are stocks for which PVGO represent a large share of the
current price.
› In other words, when large fraction of market value comes from NPV of
future investments

Earnings-price ratio and r
• No growth: (Constant stream of dividends and no earnings

plowback)
› Expected return r = DIV1/P0 = EPS1/P0
• With growth (PVGO>0)
› EPS1/P0= r (1-PVGO/P0)
› EPS1/P0 < r

Be careful with constant growth assumptions
• Do not overly rely on the simple DCF constant growth formula.

It is unlikely to be accurate.
• Long-term growth is very hard to maintain for almost any

company.
• Short-term versus long-term growth

› Better: DCF models with two stages of growth

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Session 6 Equity valuation

30017 Corporate Finance

Session 6: Equity valuation

Estimating cost of equity capital

EPS and stock prices

30017 2 Corporate Finance

Primary and secondary markets

• Secondary markets: Trading of secondhand shares

• Stock markets can be organized in different ways:

30017 3 Corporate Finance

The different flavors of equity

• Exchange traded funds (ETFs)

• ADRs (American Depository Receipts): represent non-US firms traded in US

Stock market capitalization/GDP

30017 8 Corporate Finance

How to value a stock?

• By comparison with (comparable!) firms

• By applying the present value operator to all future dividends

30017 9 Corporate Finance

How to value a stock?

30017 10 Corporate Finance

How to value a stock?

• Our NPV formula applies to the valuation of stocks

• Since shareholders receive dividends, an obvious approach to

30017 11 Corporate Finance

How to value a stock?

The return of a stock between two periods can be

Dividend Yield + Capital Appreciation

30017 12 Corporate Finance

How to value a stock?

• Previous equation rewrites: DIV1 + P1

30017 13 Corporate Finance

How to value a stock?

Dividend Discount Model - Computation of today’s stock price

Div1 Div2 DivH + PH

H - Time horizon for your investment.

30017 14 Corporate Finance

How to value a stock?

• How to find the cost of equity capital?

30017 15 Corporate Finance

How to value a stock?

30017 18 Corporate Finance

How to value a stock?

Horizon Dividend Price PV(Cum PV(Future Total

30017 19 Corporate Finance

• Current Price P0=100, and expected to pay Dividend $5.

Horizon Dividend Price PV(Cum PV(Future Total

30017 20 Corporate Finance

To find P1, use formula: DIV1 + P1

Horizon Dividend Price PV(Cum PV(Future Total

100 62639.15 1378061.2

30017 21 Corporate Finance

Compute present value of:

100 62639.15 1378061.2

30017 22 Corporate Finance

Compute present value of cumulative dividends :

100 62639.15 1378061.2 98.83

30017 23 Corporate Finance

Compute present value of future prices:

100 62639.15 1378061.2 98.83 1.17 ?

30017 24 Corporate Finance

As horizon period H approaches infinity, we can forget about the

How to value a stock?

Plow-back -3.331.1 0.831.1 0.831.1 0.831.1 …

Plow-back -3.33(1.1)2 0.83(1.1)2 0.83*(1.1)2 …

2.22 2.22 1.1 2.22 1.12

Plow-back -3.33(1.1)2 0.83(1.1)2 0.83*(1.1)2 …

2.22 2.22 1.1 2.22 1.12