Stock Valuation

By Dr. Chin, Phaik Nie

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} Understand how stock prices depend on future
dividends and dividend growth
} Be able to compute stock prices using the dividend
growth model
} Understand valuation comparables
} Understand the basics of the stock market

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9-1
9.1 The Present Value of Common Stocks
9.2 Estimates of Parameters in the Dividend
Discount Model
9.3 Comparables
9.4 Valuing Stocks Using Free Cash Flows
9.5 The Stock Markets

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9-2
} The value of any asset is the present value of its
expected future cash flows.
} Stock ownership produces cash flows from:
◦ Dividends
◦ Capital Gains (= selling price – purchase price)
} Valuation of Different Types of Stocks
◦ Zero Growth (g = 0, dividend is constant)
◦ Constant Growth (g remains the same from t1 to tn, t = period,
dividend grows but at a constant rate)
◦ Differential Growth (dividends will grow at different rates in the
foreseeable future and then will grow at a constant rate thereafter.)

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} Assume that dividends will remain at the same level
forever
D1 = D2 = D3 =!
• Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

D1 D2 D3
P0 = + 2
+ 3
+!
1+ R (1+ R) (1+ R)
D
P0 =
R
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} Suppose a stock is expected to pay a $2 dividend each
period, forever, and the required return is 10%. What is
the stock worth?

} P0 = $2/0.10 = $20
} N = 500, I/Y = 10, PMT = 2, FV = 0, CPT FV = -20

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9-5
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
D1 = D0 (1+ g)
2
D2 = D1 (1+ g) = D0 (1+ g)
D3 = D2 (1+ g) = D0 (1+ g)3
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
of a growing perpetuity:
D1
An amount that grows at a constant rate forever P0 =
R− g
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} If the current dividend is $2 and the expected growth
rate is 5%, what is D1? D5?
} D1 = D0 (1+g) = $2(1+.05) = $2.10
D5 = D0 (1+g)5 = $2(1+.05)5 = $2.55

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} Suppose Big D, Inc., just paid a dividend of $.50. It is
expected to increase its dividend by 2% per year. If
the market requires a return of 15% on assets of this
risk level, how much should the stock be selling for?
} D0 = 0.50
D1
} g = 0.02 P0 =
} R = 0.15 R− g
} D1 = D0(1+g)
} P0 = .50(1 + .02) / (.15 – .02) = $3.92

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9-8
} The Nearside Co. just paid a dividend of $3.59 per
share on its stock. The dividends are expected to grow
at a constant rate of 4.3 percent per year, indefinitely. If
investors require rate of return of 11 percent on the
stock, what is the current price? What will the price be
in 3 years? In 15 years?

9-9
} The Nearside Co. just paid a dividend of $3.59 per
share on its stock. The dividends are expected to grow
at a constant rate of 4.3 percent per year, indefinitely. If
investors require rate of return of 11 percent on the
stock, what is the current price? What will the price be
in 3 years? In 15 years?
} P0 = 3.59(1+0.043)1 / 0.11 – 0.043 = $55.89
} P3 = 3.59(1+0.043)4 / 0.11 – 0.043 = $63.41
} P15 = 3.59(1+0.043)16 / 0.11 – 0.043 = $105.09

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} Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
} To value a differential growth stock, we need to:
◦ Estimate future dividends in the foreseeable future.
◦ Estimate the future stock price when the stock becomes a
constant growth stock.
◦ Compute the total present value of the estimated future
dividends and future stock price at the appropriate discount
rate.

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9-11
} A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
} What is the stock worth? Assume the discount rate
is 12%.

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9-12
9-13
 } A common stock just paid a dividend of $2.89.
The dividend is expected to grow at 12% for the
first 3 years, 8% for the next 3 years and then it
will grow at 4% in perpetuity.
} What is the stock worth? Assume the discount rate
is 16%.
5.11474 (1 + 0.04)
2.89(1.12) 3.2368(1.12) 3.62522(1.12) 4.06024(1.08) 4.38406(1.08) 4.73587(1.08) 0.16 − 0.04
𝑃𝑉 = + + + + + +
(1 + 0.16) (1 + 0.16)! (1 + 0.16)" (1 + 0.16)# (1 + 0.16)$ (1 + 0.16)% (1 + 0.16)%

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9-14
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9-15
Storico Co. just paid a dividend of $3.85 per share.
The company will increase its dividend by 20 percent
next year and will then reduce its dividend growth
rate by 5 percentage points per year until it reaches
the industry average of 5 percent dividend growth,
after which the company will keep a constant growth
rate forever. If the required return on Storico stock is
13 percent, what will a share of stock sell for today?
5.8443(1 + 0.05)
3.85(1.20) 4.62(1.15) 5.313(1.10) 0.13 − 0.05
𝑃𝑉 = + + +
(1 + 0.13) (1 + 0.13)! (1 + 0.13)" (1 + 0.13)"

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9-16
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} In addition to the current dividend, the value of a firm
also depends upon its growth rate, g, and its discount
rate, R.
◦ Where does g come from?
g = Retention ratio × Return on retained earnings
◦ Where does R come from?
– R = dividend yield + growth rate (in dividends)
!!
𝑅= +𝑔
"

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9-18
} Comparables are used to value companies based
primarily on multiples of earnings, sales, book
value, etc.
} Common multiples include:
◦ Price-Earnings Ratios
◦ Enterprise Value Ratios

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9-19
} The price-earnings ratio is calculated as the current
stock price divided by annual EPS.
◦ The Wall Street Journal uses last four quarters’ earnings

Price per share

P/E ratio =
EPS

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9-20
} The PE ratio focuses on equity, but what if we want the value of
the firm?
} Use enterprise value:
◦ EV = market value of equity + market value of debt – cash
} Like PE, we compare the value to a measure of earnings. From
a firm level, this is EBITDA, or earnings before interest, taxes,
depreciation, and amortization.
◦ EBITDA represents a measure of total firm cash flow
} The Enterprise Value Ratio = EV / EBITDA

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9-21
} In Chapters 5 and 6 you learned that the value of a
project (i.e., its NPV) was the discounted value of the
cash flows it generates.
} The firm value is the consolidated present value of the
future cash flow from all of its projects.
} Read textbook page 284 and 285, then try Exercise I.

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9-22
Full Boat Manufacturing has projected cash sales of
$115 million next year. Costs are expected to be $67
million and net investment is expected to be $12
million. Each of these values is expected to grow at
14 percent the following year, with the growth rate
declining by 2 percent per year until the growth rate
reaches 6 percent, where it is expected to remain
indefinitely. There are 5.5 million shares of stock
outstanding and investors require a return of 13
percent on the company’s stock. The corporate tax
rate is 21 percent. What is your estimate of the
current stock price?

9-23
9-24
} Dealers vs. Brokers
} New York Stock Exchange (NYSE)
◦ License holders (formerly “members”)
– Entitled to buy or sell on the exchange floor
◦ Operations
◦ Floor activity

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9-25
} Market orders:
◦ You specify ticker and quantity
◦ Immediate execution at best available price
– Market buy will be executed at lowest ask
– Market sell will be executed at highest bid

} Limit orders:
◦ You specify ticker, quantity, and price
◦ The order will be executed only if trade can be made at the limit price or
better
– Limit buy can only be executed at limit price or lower
– Limit sell can only be executed at limit price or higher

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9-26
} The stop price is the trigger or activation point.
◦ If the stop price is reached or passed, the order
becomes a market order to be executed at the best
available price.
◦ Risk: price suddenly plummets or rises and the
execution price is much different than expected.

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9-27
} Not a physical exchange—computer-based quotation
system
} Multiple market makers
} Electronic communications networks
} Three levels of information
◦ Level 1—timely, accurate quotes, freely available
◦ Level 2—view quotes from all NASDAQ market makers,
small fee
◦ Level 3—view and update quotes, market makers only
} Large portion of technology stocks

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9-28
 52 WEEKS YLD VOL NET
HI LO STOCK SYM DIV % PE 100s CLOSE CHG
35.68 21.02 Gap Inc GPS 0.92 2.77 15 88298 31.61 0.45
Gap pays a
dividend of 92
Gap has cents/share. Gap ended trading at
been as high $31.61, which is up 45
as $35.68 in cents from yesterday.
Given the current
the last year. price, the dividend
yield is 2.77%.

8,829,800 shares traded

Gap has been as Given the current hands in the last day’s
low as $21.02 in price, the PE ratio is trading.
the last year. 15 times earnings.

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9-29