FINA 2303 Chapter 7 - 10 Stocks Spring 2023

FINA 2303 Spring 2023
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Chapter 7 and 10
Stock Valuation
Ekkachai Saenyasiri Page 1 2/26/2023

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Stock Basics
Features of common stock (ordinary share)
 Investment with limited liability
 a share of ownership in the corporation
 gives its owner rights to vote on company matters (elect board of directors, merger
and acquisitions, etc)
 right to share the profits of the corporation through dividend payments
 residual claims on firm’s asset
 Priority lower than debt and preferred stock

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Common Stock Valuation: Constant Dividend Growth Model
 Assumes common stock dividends will grow at a constant rate into the future indefinitely
 Value of a stock is the present value of the future dividends expected to be generated
by the stock.
D1 D2 D3 … D
t =0 t =1 t =2 t=3 t =
D0(1+g) D0(1+g)2 D0(1+g)3 … D0(1+g)
t =0 t =1 t =2 t=3 t =

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D1 D2 D3 D
 
P0 = (1  r )1 (1  r ) 2 (1  r ) 3
 ... 
(1  r ) 
D0 (1  g )1 D0 (1  g ) 2 D0 (1  g )3 D0 (1  g ) 
P0 =    ...  Eq.1
(1  r )1
(1  r ) 2
(1  r ) 3
(1  r ) 
(1  r ) D0 (1  g )1 D0 (1  g ) 2 D0 (1  g )  1
* P0 =
D0    ...  Eq.2
(1  g ) (1  r )1
(1  r ) 2
(1  r )  1
Eq.2 – Eq.1 0
(1  r ) D0 (1  g ) 
* P0 - P0 = D0 + - - (1  r )  (assume r > g)
(1  g )
(1  r )
* P0 - P0 = D0
(1  g )

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(1  r )
* P0 - P0 = D0
(1  g )
(1  r )
( (1  g ) - 1) P0 = D0
D0 (1  g ) D1
P0 = (r  g ) = (r  g )
P0 = value or price of common stock at time 0
D1 = the dividend at the end of period 1
r = equity cost of capital = investors' required return on common stock
g = the constant dividend growth rate

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Example: XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at
10% per year indefinitely. What would we be willing to pay for this stock if the equity
cost of capital on XYZ stock is 15%?
5.5 6.05 6.655 D
t =0 t =1 t =2 t=3 t =
D1 = D0 (1+g)1 = 5 * (1 + 10%)1 = 5.5
D1 5.5
P0 = ( r  g ) (0.15  0.1)  $110

Note: D0  just paid, recently paid

D1  will pay, expect to pay, going to pay, plan to pay
Investors who buy the stock at time 0 will start to get first dividend at time 1 (D1)

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Expected Return on Common Stock
D1
From, P0 = ( r  g )
Expected return = Dividend yield + Growth Rate
D 
r   1   g
 P0 
Example: We know a stock will pay a $3.00 dividend at the end of year 1, the
stock price right now is $27 and expected growth rate is 5%. What is the
expected return?
 3
r     0.05  16.11%
 27 

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Stock price at different time under constant dividend growth model
P0
D1 D2 D3 … D
P0 = D1/(r-g)
t =0 t =1 t =2 t=3 t =
P1
D2 D3 … D
P1 = D2/(r-g)
t =0 t =1 t =2 t=3 t =
P2
D3 … D
P2 = D3/(r-g)
t =0 t =1 t =2 t=3 t =

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Note that based on this pricing model, stock intrinsic value also grows at the same rate
as growth rate of dividends.
D1
P0 = ( r  g )
D2 D1 (1  g )
P1 = ( r  g ) = ( r  g ) = P0 * (1+g)
What happen if g > r ?
 if g > r, the constant dividend growth formula leads to a negative stock

price, which does not make sense.
 The constant dividend growth model can only be used if r > g and g is
expected to be constant forever.

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Example: If D0 = $2 and the stock is expected to have negative growth (g = -
6%), would anyone buy the stock, and what is the value? Assuming that
required return = 13% (required return = equity cost of capital)
Answer: The firm still has earnings and pays dividends, even though dividends
may be declining they still have value.
D1 D0 (1  g ) 2(1  0.06) 1.88

P0 = (r  g ) = (r  g )
   $9.89
(0.13  ( 0.06)) 0.19
Capital gain yield = g = -6%
1.88
Dividend yield =  19%
9.89
Expected total return = - 6% + 19% = 13% = Required return

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Example: If D0 = $2 and g is a constant 0%, find the stock price today. Assuming that
required return = 13% (required return = equity cost of capital)
D1 D0 (1  g ) 2
  15.38
P0 = ( r  g ) = (r  g ) (0.13  0.00)

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Example:
If the firm just paid dividend $2 and g is a constant 6%, what is the stock’s
market value? Assuming that the required rate of return is 13%
D1 D0 (1  g ) 2(1  0.06)
P0 = (r  g ) = ( r  g )   $30.29
(0.13  0.06)
What is the expected market price of stock, one year from now? How about 7
years from now?
D2 D1 (1  g )
P1 = ( r  g ) = ( r  g ) = P0 * (1+g) = 30.29 * 1.06 = 32.11
D8 D1 (1  g ) 7
P7 = ( r  g ) = ( r  g ) = P0 * (1+g)7 = 30.29 * 1.067 = 45.54

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Example: From previous examples, what is the expected dividend yield, capital
gains yield, and total return during the first year?
P0 P1+ D1
t =0 t =1
D1  P1  P0 D1 P1  P0
Total return =  
P0 P0 P0
Total return = Dividend Yield + Capital gains yield
D1 2.12
Dividend Yield =   7%  How much return you get from dividend received.
P0 30.29
In the constant dividend growth
model, the growth rate of dividends
P1  P0 32.11  30.29
Capital Gain Yield = =  6%  turn out to be the same as the growth
P0 30.29 rate of stock price
Expected total return = 6% + 7% = 13% = Required return

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Application: The Subprime Financial Crisis and the Stock Market
D1
P0 = ( r  g )
• Financial crisis that started in August 2007 led to one of the worst bear
markets in 50 years.
• Downward revision of growth prospects: ↓g.
• Increased uncertainty: ↑r
• Constant dividend growth model predicts a drop in stock prices.

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Example: Given the information below, what is P3?
D3 = 4.394
Dividend growth rate = 6%
Required return = 13%
D4 D (1  g ) 4.394(1  0.06)
P3 = = 3 = = 66.54
(R  g) (R  g) ( 0. 13  0.06 )
Example: We expect a stock to pay
D1 = 2.6
D2 = 3.38
D3 = 4.394
At the end of year 3 you expect to sell this stock at P3 = $66.54. Suppose that your
required return = 13%. What is P0?
2.6 3.38 4.394 66.54

P0 =  2
 3
 3
= 54.106  If you pay 54.106 at time 0, you get 13%
1.13 1.13 1.13 1.13
expected rate of return

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Example: We expect a stock to pay
D1 = 2.6
D2 = 3.38
D3 = 4.394
At the end of year 3 you expect to sell this stock at P3 = $66.54. Suppose that stock price
right now is 54.106. What is the expected rate of return if you buy this stock?
2.6 3.38 4.394 66.54

54.106   
=
(1  r )1 (1  r ) 2 (1  r ) 3 (1  r ) 3
2.6 3.38 70.934

54.106   Find IRR = 13%
=
(1  r )1 (1  r ) 2 (1  r ) 3
CF0 = -54.106, C01 = 2.6, F01 = 1, C02 = 3.38, F02 = 1, C03= 70.934, F03 = 1 CPT
IRR = 13%
Expected rate of return of this stock = 13%

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Example: Supernormal growth; What if g = 30% for 3 years before achieving long-run
growth of 6%? Assume that D0 = $2 and required return = 13%. What is the stock price
right now?
We try to use our constant dividend growth model on the part of the time line that
satisfies the 3 assumptions 1. r > g 2. g is constant 3. and continue forever
g = 30% g = 30% g = 30% g = 6%

t =0 t =1 t =2 t=3 t=4 … t=
D1= 2.600 3.38 4.394 4.658
2.60/1.13 = 2.301
3.38/1.132 = 2.647
4.394/1.133 = 3.045
P3 = D4/(r-g)
66.54/1.133 = 46.113 = 4.658 / (0.13-0.06)
= $66.543
P0 = 2.301 + 2.647 + 3.045 + 46.113 = 54.106

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Example: A fast growing company paid a dividend this year (D0) of $1.50 per
share and is expected to grow at 25% for two years. Afterwards, the growth rate
will be 8%. If the required rate is 10%, what is this value of this stock?
Answer: Intrinsic value of this stock = $108.24 (right now)

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Share Repurchses and the Total Payout Model
Share Repurchases -- The firm uses excess cash to buy back its own stock
Consequences:
• The more cash the firm uses to repurchase shares, the less cash it has
available to pay dividends
• By repurchasing shares, the firm decreases its share count, which increases
its earnings and dividends on a per-share basis.

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Total Payout Model computes value of total payouts to all shareholders (both in the forms of
dividends and share repurchase) rather than a single share
𝑃𝑉 𝑎𝑙𝑙 𝑝𝑎𝑦𝑜𝑢𝑡𝑠 𝑡𝑜 𝑎𝑙𝑙 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠

𝑃
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑛𝑒𝑡 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

𝑃
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

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Example:
• 3M co. has 698 million shares outstanding and expects earnings at the end of this
year to be $2.96 billion
• 3M plans to payout 50% of its earnings in total, paying 35% as a dividend and using
15% to repurchase shares.
• If 3M's earnings are expected to grow by 9.2% per year and these payout rates
remain constant,determine 3M's share price assuming an equity cost of capital of
12%

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3M will have total payouts this year of 50% × $2.96 billion = $1.48 billion
Using the constant growth perpetuity formula, we have
$ .
PV (Future total dividends and repurchases) = = $52.86 billion
% . %
52.86 represents the total value of 3M's equity

(i.e., its market capitalization)
To compute the share price, we devide 52.86 by the current number of shares outstanding
$ .
𝑃 $75.73 per share
Note that -- Using the total payout method, we do not need to know how the firm splits
between dividends and share repurchases

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The Discounted Free Cash Flow Model
 The Discounted Free Cash Flow Model focuses on the cash flows to all of
the firm’s investors, both debt and equity holders  Enterprise value
• This model allows us to avoid the difficulties associated with estimating the
impact of the firm's borrowing decisions on earnings and firm's value
Free Cash Flow (FCF)
FCF = EBIT(1-t) + Depreciation - Cap Ex - Inc in NWC
Enterprise value0 = Total PV (Expected FCF)
Enterprise Value (V0) = Market Value of Equity + Debt - Cash
Remind that
Enterprise value = How much you have to pay to buy a company outright?
= Net cost of acquiring the firm's equity, paying off debt, and taking its cash

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Enterprise Value (V0) = Market Value of Equity0 + Debt0 - Cash0
Market Value of Equity0 = V0 + Cash0 - Debt0
Stock Price (P0) =

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Income Statement
Revenue
Cost of Goods Sold
Gross Profit
Depreciation
Operating Expenses
Earnings Before Interest and Taxes
Interest Expenses
Earnings Before Taxes
Income Taxes
Net Income

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Discounted Free Cash Flow Model

 Enterprise value (V0) = Total PV (Expected Free Cash Flow of Firm)
 Since we are discounting the cash flows to all investors (both debt and equity holders), we
use the weighted average cost of capital (WACC), denoted by rwacc
FCF1 FCF2 FCF3 FCF4
t =0 t =1 t =2 t=3 t=4 … t=
𝐹𝐶𝐹 𝐹𝐶𝐹 𝐹𝐶𝐹 𝐹𝐶𝐹 𝐹𝐶𝐹

𝑉 ⋯
1 𝑟 1 𝑟 1 𝑟 1 𝑟 1 𝑟

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Discounted Free Cash Flow Model

g =constant %
FCF1 FCF2 FCF3 FCF4
t =0 t =1 t =2 t=3 t=4 … t=

 Step 1: Forecast free cash flow (FCF), together with a terminal value of the enterprise.
 Terminal value = PV at the future point in time of all future cash flows when we expect
stable growth rate forever.
 Estimate the terminal value by assuming a constant long-run growth rate of FCF
 From the time line above, assume that growth rate is constant after year 3, terminal value
=𝑉
 𝑉
 Stock Price (P0) =

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Example:
 Nike had sales of $19.2 billion in 2009. Suppose you expect its sales to
grow at rate of 10% in 2010, but then slow down by 1% per year to 5% in
2015.
 EBIT is expected to be 10% of sales
 Increases in net working capital requirement = 10% of increase in sales
 Capital expenditures = Depreciation
 If NIKE has $2.3 billion in cash, $32 million in debt, 486 million shares
outstanding, tax rate of 24% and rwacc = 10%, What is your estimate of the
value of Nike's stock at the beginning of 2010? Assuming that FCF grows at
a rate of 5% after 2015

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Compute Nike's stock price -- Discounted Free Cash Flow Model
21,120 = 19,200 * (1+10%) 192 = 10% (21,120 - 19,200) 29,609.0 = 28,199 * (1+5%)
Because cap ex = depreciation, line 7 and 8 above cancel out.
1,413.1 1,559.5 1,705.3 1,847.8 1,983.5 2,109.3 g =5%
0 1 2 3 4 5 6 7
2009 2010 2011 2012 2013 2014 2015 2016 ... ∞

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1,413.1 1,559.5 1,705.3 1,847.8 1,983.5 2,109.3 g =5%
0 1 2 3 4 5 6 7
2009 2010 2011 2012 2013 2014 2015 2016 ... ∞
44,295
1,413.1 1,559.5 1,705.3 1,847.8 1,983.5 2,109.3
g =5%
0 1 2 3 4 5 6 7
2009 2010 2011 2012 2013 2014 2015 2016 ... ∞
𝐹𝐶𝐹 𝐹𝐶𝐹 ∗ 1 𝑔 2109.3 ∗ 1 5% = 2,214.765
, .
Terminal enterprise value at time 6 = 𝑉 44,295
% %
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Enterprise value at time 0 (V0)
1,413.1 1,559.5 1,705.3 1,847.8 1,983.5 2,109.3 44,295

32,542.4 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1.1 1.1 1.1 1.1 1.1 1.1 1.1
, . ,
Nike's stock price = (P0) = $71.63 per share

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What if EBIT is 11% of sales, instead of 10%
Table below shows the revised FCF estimates
Year 2010 2011 2012 2013 2014 2015
FCF 1,573.6 1,734.5 1,894.3 2,050.0 2,197.8 2,334.3
 Follow the procedure in the previous page The new estimate for stock price = $78.82
 Nike's stock price is sensitive to changes in the assumptions about its profitability
 1% change in operating profit margin affects the firm's stock price by 10%

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Estimating the Growth Rate
The growth rate of dividends (g) can be estimated in a number of ways:
– Using the company’s historical average growth rate
– Using an industry median or average growth rate.
– Using the sustainable growth rate.
– Sometime we know D-1 and D0

==> Compute g, if D-1 = 1 and D0 = 1.08  g = (1.08-1)/1 = 8%

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Firm's internal growth comes from retaining some of the firm’s profits for reinvestment
in the firm, in turn resulting in the growth of future earnings.
It is this internal growth that matters to the present common stockholders.
Cash
Corporation Investors
Securities (Bonds, IPOs)
Reinvest
Secondary
markets
Cash flow
dividends, etc.
tax
Government
tax

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g = retention rate * return on new investment
when
g = the growth rate of earnings and the growth rate of dividends
Retention rate = the company’s percentage of profits retained. If retention rate is 0% then
all company’s earnings will be paid out as dividends. If retention rate is 100% then the
company does not pay dividend.
Dividend Payout Ratio = dividends / earnings
Retention Rate = 1- dividend payout rate
g = (1- payout rate) * return on new investment

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Suppose that
• at t= 0, investors invest $100 in the firm.

• the firm can earn 10% on investments
• Assume retention rate = 100%
NI = 10 NI = 11 NI = 12.1

100 110 121 133.1

0 1 2 3


= 100%* 10% = 10%

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Suppose that

D =5 D =5.25 D = 5.5125
NI = 10 NI = 10.5 NI = 11.025

100 105 110.25 115.7625

0 1 2 3


= 50%* 10% = 5%

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Suppose that

D =10 D =10 D = 10
NI = 10 NI = 10 NI = 10

100 100 100 100

0 1 2 3


= 0%* 10% = 0%

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Example: Suppose that return on new investment = 16% and company

retains 25% of its profits, find g
g = 16% * 25% = 4%
Example: Suppose that return on new investment = 20% and payout

30% of its profits, find g
g = 20% * (1-30%) = 14%
If retention rate = 0% then all company’s earnings will be paid out as

dividends. Growth rate = 0.
If retention rate = 100% then the company does not pay dividend.
Growth rate = Return on new investment.

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Example:
American Electric Power (AEP) usually earns 14.59% from its investment.
The company expects its earnings per share to be $2.94, and will pay
dividend $1.40 per share. What is AEP’s:
• Retention rate?
• Growth rate?
Payout ratio = $1.40 / $2.94 = 0.476
So, retention rate = 1 – 0.476 = 0.524 or 52.4%
Therefore, AEP’s growth rate = .1459  52.4% = 7.645%

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Example: Firm X expects to have EPS = $6 in the coming year. The firm plans to payout
all the earnings as dividends. If currently its stock is trading at $60, what is firm's x cost
of capital? (assume market in equilibrium  Cost of capital = expected rate of return).
D1 = EPS1 = $6
g = 0% because retention rate = 0%
RE = D1/P0 + g = 6/60 + 0% = 10%  Cost of capital
Firm X plans to cut its dividend payout rate to 75% and use the retained earnings to
expand its business. Assuming that the return on its investments in new business is
expected to be 12%. What will be the stock price after dividend cut and reinvestment?
D1 will be reduced to 75% * EPS1 = 75%*6 = 4.5

g = retention rate * return on new investment = 25% * 12% = 3%
New stock price = D1/(r-g) = 4.5/(10%-3%) = $64.29
In this case, it is a good idea to cut dividend and reinvest in new projects
Cutting dividend to reinvest is a good idea only if Return on investment > Cost of capital
12% > 10%
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Evaluate the result
Crane’s share price should rise from $60 to $64.29 if the company cuts its dividend
in order to increase its investment and growth, implying that the investment has
positive NPV. By using its earnings to invest in projects that offer a rate of return
(12%) greater than its equity cost of capital (10%), Crane has created value for its
shareholders.

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Unprofitable Growth
Suppose Crane cuts its dividend payout rate to 75% to inveest in projects that offer only
8% rate of return
g = retention rate * return on new investment = 25% * 8% = 2%
D1 4.5
The new share price = ( r  g ) = (10%  2%) = $56.25 < $60
If Crane cuts its dividend to make new investments with a return of only 8%. By
reinvesting its earnings at a rate of return (8%) that is lower than its equity cost of capital
(10%), Crane has reduced shareholder value. Its stock price will fall from $60 to $56.25


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Berk, Demarzo, Harford, “Fundamentals of Corporate Finance,” Global Edition,
4th edition, page 616


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Valuation Ratio

• Buy or Sell? How could you know whether an asset is cheap or expensive?

• The price level alone does not give you enough information whether an
asset is expensive or not. You will have to compare the price you pay with
the value you receive.

• For example: If I want to sell you 3 things below. Which one is expensive?

1. A new 2,000 square feet condominium in Hong Kong, HKD 2,000,000
2. A new car (Honda) = HKD 80,000
3. A new iPhone = HKD 20,000


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Which firm is more expensive?

Firm A: Current Stock price $10

Firm B: Current Stock price $15


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Firm A: Current Stock price $10, EPS = 1  P/E =10

Firm B: Current Stock price $15, EPS = 1  P/E =15

Note that expensive in the context referring to ‐‐ stock price (the market cap) is
higher than the value of the company.


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Suppose that

• Firm A’s expected EPS growth rate = 10%
• Firm B’s expected EPS growth rate = 50%

Current stock price of firm A = $10
Firm A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Expected EPS $1.00 $1.10 $1.21 $1.33 $1.46 $1.61

Current stock price of firm B = $15
Firm B Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Expected EPS $1.00 $1.50 $2.25 $3.38 $5.06 $7.59

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PEG Ratio

• P/E ratios can vary widely across industries and tend to be higher for
industries with higher growth rates.

• One way to capture the idea that a higher P/E ratio can be justified by higher
expected earnings growth.
/
PEG  Lower number is better

• If PEG ≤ 1, the stock may be worthy of investment attention and possible
purchase

• PEG firm A = 10/10 = 1  Note that for PEG calculation, growth rate is not in % term

• PEG firm B = 15/50 = 0.3  Based on PEG, firm B seems to be more attractive to buy

• In real practice, we must also evaluate a stock from many other different criteria.
P/E and PEG ignore a lot of important information.
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Valuation Based on Comparable Firms
 Estimate the value of the firm based on the value of other comparable firms
 We can adjust for scale differences using valuation multiples.
 Price-earnings ratio (P/E)  𝐸 𝑃
 Price-to-book value of equity (P/B)  𝐵 𝑃
 Price-to-sales ratio (P/S)
 Enterprise value multiple (Enterprise Value / EBITDA)

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Price-Earnings Ratio
P/E = Share price divided by earnings per share
𝑃 𝐸
Example:
Suppose furniture manufacturer Herman Miller, Inc., has earnings per share of $1.38.
If the average P/E of comparable furniture stocks is 21.3, estimate a value for Herman
Miller’s stock using the P/E as a valuation multiple.
P0 = 21.3 × 1.38 = 29.39
This estimate assumes that Herman Miller will have similar future risk, payout rates, and
growth rates to comparable firms in the industry.  We must evaluate whether these
assumptions are reasonable or not.

______________________________________________________
Trailing P/E vs. Forward P/E
• We can compute a firm’s P/E ratio using:

– Trailing earnings (using earnings over prior 12 months)
– Forward earnings (using expected earnings over the coming 12 months)
• The resulting ratio is either:

– Trailing P/E = P0/E0
– Forward P/E = P0/E1
• For valuation purposes, the forward P/E is generally preferred, as we are most
concerned about future earnings.

______________________________________________________
P/E and Dividend Discount Model
𝐷
𝑃
𝑟 𝑔
Dividing both sides by EPS1
𝐷
𝑃 𝐸
𝐸 𝑟 𝑔
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃/𝐸
𝑟 𝑔

______________________________________________________
Example
• Amazon.com and Macy’s are both retailers. In 2010, Amazon had a price of $138.71
and forward earnings per share of $2.61.
• Macy’s had a price of $20.87 and forward earnings of $1.87 per share.
• Calculate their forward P/E ratios and explain the difference.
• Forward P/E for Amazon = $138.71/$2.61 = 53.1
• Forward P/E for Macy’s = $20.87/$1.87 = 11.16
• Amazon’s P/E ratio is higher because investors expect its earnings to grow more
than Macy’s. Investors in Amazon.com are willing to pay 53 times this year’s
expected earnings because they are also buying the present value of high future
earnings created by expected growth.

______________________________________________________
Limitations of Multiples
1. Firms are not identical
 Usefulness of a valuation multiple will depend on the nature of the differences

and the sensitivity of the multiples to the differences.
 Differences in multiples can be related to differences in

- Expected future growth rate
- Risk (cost of capital)
- Differences in accounting conventions between countries
- Talented managers
- More efficient manufacturing processes
- Patents on new technology
2. Comparables provide only information regarding the value of the firm relative to
other firms in the comparison set
 Cannot help determine whether an entire industry is overvalued.

- Example -- Internet boom 1990s
______________________________________________________
Stock Prices and Multiples for the Footwear Industry (excluding Nike), May 2010

______________________________________________________
Stock Valuation Techniques: The Final Word
 No single technique provides a final answer regarding a stock’s true value
 Practitioners use a combination of these approaches
 Confidence comes from consistent results from a variety of these methods
Valuations from multiples

based on the low, high, and
average values of comparable
firms
Nike's actual share price =

$76.43

______________________________________________________
Information, Competition, and Stock Prices
 For a publicly traded firm, market price should already provide very accurate
information, aggregated from all investors, regarding the true value of its shares.
 Only in the relatively rare case in which we have some superior information that
other investors lack would it make sense to second-guess the stock price.

______________________________________________________
Competition and Efficient Markets
Efficient markets hypothesis implies that securities will be fairly priced given all
information that is available to investors.
According to EMH, market prices always equal fair values and reflect new information
instantaneously  No arbitrage

______________________________________________________
Three Forms of Efficiency by Information Type
Strong Form Efficiency -- price immediately

incorporate all information (private, public and
historical info). Market prices always equal fair values
and market prices reflect new information
instantaneously. Expected rate of return reflects the
riskiness of the stock
Semistrong Form Efficiency -- price reflects all public

information (public and historical info). Market prices
always equal fair values and market prices reflect new
information instantaneously. Expected rate of return
reflects the riskiness of the stock
 Implies that trading folows news will not make you
earn extra rate of returns
 Technical analysis is useless
 CEO still can use insiderr information to earn extra
profits
Weak Form Efficiency -- price reflects only past

information (only historical info). Market prices always
equal fair values and market prices reflect new
information instantaneously. Expected rate of return
reflects the riskiness of the stock
-- Implies that techical analysis is useless
______________________________________________________
Based on the empirical data  market is not strong form efficient
Consequences for Investors -- To outperform others, investors must have some

competitive advantage
 Gain expertise to interprete public but difficult-to-interpret information
 Gain access to information known to only a few people
 Have lower trading costs than others
 If stocks are fairly priced according to valuation models, then investors who buy
stocks can expect fair compensation for the risk they take.

______________________________________________________
Example: Stock Price Reactions to Public Information
• Myox Labs announces that it is pulling one of its leading drugs from the market,
owing to the potential side effects associated with the drug.
• As a result, its future expected free cash flow will decline by $85 million per year
for the next 10 years.
• Myox has 50 million shares outstanding, no debt, and an equity cost of capital of
8%.
• If this news came as a complete surprise to investors, what should happen to
Myox’s stock price upon the announcement?
Using the annuity formula, the decline in expected free cash flow will reduce Myox's
1  1 
enterprise value by $85 million   1    $570 million
1.08  1.0810 
Thus the share price should fall by $570/50 = $11.40 per share
Because the news is public and its effect on FCF is clear, we would expect the stock
price to drop by $11.40 per share nearly instantaneously.

______________________________________________________
IBM raised forecasted earnings by 5 cents per share on February 26, 2008

FINA 2303 Chapter 7 - 10 Stocks Spring 2023

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FINA 2303 Chapter 7 - 10 Stocks Spring 2023

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FINA 2303 Spring 2023

Ekkachai Saenyasiri Page 1 2/26/2023

Features of common stock (ordinary share)

 Investment with limited liability

 a share of ownership in the corporation

 right to share the profits of the corporation through dividend payments

 residual claims on firm’s asset

 Priority lower than debt and preferred stock

Ekkachai Saenyasiri Page 2 2/26/2023

Common Stock Valuation: Constant Dividend Growth Model

D0(1+g) D0(1+g)2 D0(1+g)3 … D0(1+g)

Ekkachai Saenyasiri Page 3 2/26/2023

Ekkachai Saenyasiri Page 4 2/26/2023

P0 = value or price of common stock at time 0

D1 = the dividend at the end of period 1

r = equity cost of capital = investors' required return on common stock

g = the constant dividend growth rate

Ekkachai Saenyasiri Page 5 2/26/2023

5.5 6.05 6.655 D

D1 = D0 (1+g)1 = 5 * (1 + 10%)1 = 5.5

Note: D0  just paid, recently paid

Ekkachai Saenyasiri Page 6 2/26/2023

Expected return = Dividend yield + Growth Rate

Ekkachai Saenyasiri Page 7 2/26/2023

Stock price at different time under constant dividend growth model

Ekkachai Saenyasiri Page 8 2/26/2023

What happen if g > r ?

 if g > r, the constant dividend growth formula leads to a negative stock

Ekkachai Saenyasiri Page 9 2/26/2023

D1 D0 (1  g ) 2(1  0.06) 1.88

Capital gain yield = g = -6%

Expected total return = - 6% + 19% = 13% = Required return

Ekkachai Saenyasiri Page 10 2/26/2023

Ekkachai Saenyasiri Page 11 2/26/2023

Ekkachai Saenyasiri Page 12 2/26/2023

Expected total return = 6% + 7% = 13% = Required return

Ekkachai Saenyasiri Page 13 2/26/2023

Application: The Subprime Financial Crisis and the Stock Market

Ekkachai Saenyasiri Page 14 2/26/2023

Example: We expect a stock to pay

2.6 3.38 4.394 66.54

Ekkachai Saenyasiri Page 15 2/26/2023

2.6 3.38 4.394 66.54

2.6 3.38 70.934

Expected rate of return of this stock = 13%

Ekkachai Saenyasiri Page 16 2/26/2023

g = 30% g = 30% g = 30% g = 6%

D1= 2.600 3.38 4.394 4.658

P0 = 2.301 + 2.647 + 3.045 + 46.113 = 54.106

Ekkachai Saenyasiri Page 17 2/26/2023

Answer: Intrinsic value of this stock = $108.24 (right now)

Ekkachai Saenyasiri Page 18 2/26/2023

Share Repurchses and the Total Payout Model

Ekkachai Saenyasiri Page 19 2/26/2023

𝑃𝑉 𝑎𝑙𝑙 𝑝𝑎𝑦𝑜𝑢𝑡𝑠 𝑡𝑜 𝑎𝑙𝑙 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠

𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑛𝑒𝑡 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

Ekkachai Saenyasiri Page 20 2/26/2023

Ekkachai Saenyasiri Page 21 2/26/2023

Using the constant growth perpetuity formula, we have

52.86 represents the total value of 3M's equity

Ekkachai Saenyasiri Page 22 2/26/2023

The Discounted Free Cash Flow Model