Valuation of Stocks

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1. Valuation of Stocks How Common Stocks Are Traded

How Common Stocks Are Valued
Estimating The Cost Of Equity Capital
The Link Between Stock Price and
Earnings per Share
Valuing a Business by Discounted
Cash Flow

2. Primary Market Market for the sale of new securities by

corporations

3. Secondary Market Market in which previously issued se-

curities are traded among investors
-Transaction of existing shares in cor-
poration

4. Common Stock Ownership shares in a public corpora-

tion (equity shares)

5. Electronic Communication Net- -A number of computer networks that

works ( ECN s) connect traders with each other and
allow electronic trading.
-Rise of machines, algorithmic trading
platforms
-

6. Exchange-Traded Funds (ETFs) portfolios of stocks that can be bought

or sold in a single trade
-Goal of this is to provide exposure to
the markets rather than single equity

7. SPDRs (Standard & Poor's Deposi- ETFs, which are portfolios tracking
tory Receipts or "spiders") several Standard & Poor's stock mar-
ket indexes

8. Book Value Net worth of the firm according to the

balance sheet
-Firm assets - firm liability

9. Dividend
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Periodic cash distribution from the firm
to the shareholders
-Frequency of dividends are important
for assignment

10. P/E Ratio Price per share dividend by earnings

per share
-Measure as to how the share mar-
ket is valuing the corporation given its
earnings

11. Market Value Balance Sheet Financial statement that uses market
value of assets and liability

12. PV(stock)= PV(expected future dividends)

13. Market Value of a stock = Present Value of future cash flows

14. PV (asset) = PV (expected future cash flows)

15. PV (share) = PV (expected future dividends)

16. Investors will buy share given r, we cash invested (Po) + cash return re-
have quired(rPo) = cash expected to be re-
ceived (E[Div1] + E[P1]

Re arranged:
P0= EDiv + EP1 ALL OVER/ (1+R)

or

r= EDiv1 + EP1 - Po ALL OVER / Po

17. Expected Return The percentage yield that an investor

forecasts from a specific investment
Sometimes called the market capi- over a set period of time.
talisation rate.

18. Expected return = Dividend Yield + Capital Appreciation

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19. If Fledgling Electronics is selling for 5+110-100/100= .15
$100 per share today and is expect-
ed to sell for $110 one year from
now, what is the expected return if
the dividend one year from now is
forecasted to be $5.00?

20. Future Price overall formula Po= E[Divt]/(1+r)^t + E[Ph]/(1+r)^h

21. Fledgling Electronics is forecasted PV = 5/1.15^1 + 5.5 +121/ 1/15^2

to pay a $5.00 dividend at the end of
year one and a $5.50 dividend at the =100.00
end of year two. At the end of the
second year the stock will be sold
for $121. If the discount rate is 15%,
what is the price of the stock?

22. Current forecasts are for XYZ Com- PV = 3/1.12 + 3.24/1.12^2 + 3.5 +
pany to pay dividends of $3, $3.24, 94.48 / 1.12^3
and $3.50 over the next three years,
respectively. At the end of three = $75.00
years you anticipate selling your
stock at a market price of $94.48.
What is the price of the stock given
a 12% expected return?

23. As you increase investment hori- Declines; Increases

zon, the present value of the fu-
ture price _______ and the pre-
sent value of the stream of div-
idends __________. This is repre-
sented graphically.

24. Discounted Cash Flow (DCF) or Dis- In the limit recursive substitution for
counted Dividend Model for share price gives a model where share price
price is equated to the present value of all
expected future dividends.

25. Fixed; infinite

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Shares do not have a ________ ma-
turity; cash payments consist of
__________ stream of dividends:

26. Constant Growth DDM - We use growing perp formula

A version of the discounted dividend

growth model in which dividends grow
at a constant rate g% pa (Gordon
Growth Model).

P0= E[Div1]/(r-g)

27. The expected return, r, equals the cost of equity capital

dividend yield plus the expected
rate of growth in dividends. This is
also the

28. Growing perpetuity formula ex- r= (E[Div1] / P0) + g

plains P0 in terms of next year's ex-
pected dividend DIV1, the projected
growth trend g, and the expected
rate of return on other securities of
comparable risk r.

Show equation rearranged

29. Northwest Natural Gas stock was r= 1.68 / 42.45

selling for $42.45 per share at the
start of 2009. Dividend payments =.04
for the next year were expected to
be $1.68 a share. What is the cost of
equity, assuming no growth?

30. Northwest Natural Gas stock was r= 1.68/42.45 + .061

selling for $42.45 per share at the
start of 2009. Dividend payments =.101
for the next year were expected to
be $1.68 a share. What is the cost of

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equity capital, assuming a growth
rate of 6.1%?

31. If a firm elects to pay a lower Increase; higher

dividend, and reinvest the funds,
the share price may _______ be-
cause future dividends may be
___________

32. An alternative approach to estimat- The payout ratio

ing long-run growth starts out with

33. Payout Ratio Fraction of earnings paid out as divi-

dends; ratio of dividends per share to
earnings per share (EPS)

Payout Ratio = Div/EPS

Dividends = Payout Ratio x [EPS]

34. Ploughback Ratio (Retention rate) Fraction of earnings retained by the

firm.
Ploughback Ratio = 1 - Payout Ratio
OR = 1 - Div/EPS

35. Return on equity (ROE) = EPS/book equity per share

36. Growth rate in dividends, g, can be applying the return on equity to the
derived from percentage of earnings ploughed back
into operations

g= ploughback ratio x ROE

= [1-payout ratio] x ROE

37. In the year ended 30 September Payout ratio= 102/131= 0.7786

2009, ANZ Banking Group (ANZ) g=(1-payout ratio) x ROE
generated EPS of 131 cents, paid a
dividend of 102 cents per share, and 1-.7786 x .103 = .0228 = 2.3%
its ROE was estimated at 10.3. What

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is the expected future earnings and
dividend growth rate?
38. Two-Stage DCF Formula
39. Valuing Non-Constant Growth:
Two-Stage DCF Formula
40. Phoenix produces dividends in
three consecutive years of 0, .31,
and .65, respectively. The dividend
in year four is estimated to be .67
and should grow in perpetuity at
4%. Given a discount rate of 10%,
what is the price of the stock??
41.
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1. Near-term dividends are forecasted
and valued;
2. Constant-growth DCF formula is
used to forecast the value of the
shares at the start of the long run.
The near-term dividends and the fu-
ture share value are then discounted
to present value in order to arrive at the
equilibrium value of the share of stock.
1. Near-term dividends are forecasted
and valued,
2. Constant-growth DCF formula is
used to forecast the value of the
shares at the start of the long run.
3. The near-term dividends and the fu-
ture share value are then discounted
to present value
Divh/(1+r)^H + Ph/(1+r)^H
PH= Divh+1/ (r-g)
H onwards is growing at g%
0/1.1^1 + .31/1.1^2 + .65/1.1^3
+ [1/1.1^3 x .67/.1-.04] =9.13
Second stage is working out the price
in year 3 = dividend in year 4 (.67) /
.1-.04 and then put it over 1.1^3
PV of growing perpetuity starting in yr
3 with first payment in yr 4 0.67 grow-
ing thereafter at 4% p.a.
 Valuation of Stocks
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Our company forecasts to pay a No growth
$8.33 dividend next year, which rep- P0=8.33/.15 = 55.56
resents 100% of its earnings. This
will provide investors with a 15% With Growth
expected return. Instead, we decide .25x.40 = .1
to plowback 40% of the earnings at P0=5.00/.15-.1= 100.00
the firm's current return on equi-
ty of 25%. What is the value of the
stock before and after the plowback
decision?

42. If the company did not plowback PVGO= 100.00 - 55.56 = $44.44
some earnings, the stock price
would remain at $55.56. With the EPS/P0= r(1-PVGO/P0)
plowback, the price rose to $100.00. or
P0= EPS/r + PVGO
The difference between these two
numbers is called the Present Value
of Growth Opportunities (PVGO).

43. Present Value of Growth Opportuni- Net present value of a firm's future
ties (PVGO) investments.

44. Sustainable Growth Rate Steady rate at which a firm can grow:
plowback ratio x return on equity

45. Share price = present value of level stream of earn-

ings + present value of growth oppor-
tunities

46. Free Cash Flows (FCF = revenue - costs - investment) is

the theoretical basis for all PV calcula-
tions.

47. PV (free cash flow) = PV (dividends)

48. FCF is a more fundamental mea- Divs or EPS

surement for PV than either

49. FCF
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When valuing a business for pur-
chase, try to use

50. The value of a business or Project the discounted value of FCF out to a
is usually computed as valuation horizon (H)

51. The valuation horizon is sometimes called the terminal value

and is calculated like PVGO

52. Given the cash flows for Concate-
nator Manufacturing Division, cal-
culate the PV of near term cash
flows, PV (horizon value), and the
total value of the firm. r=10% and g=
6%
PV(horizon value) = 1/(1.1)^6 x
(1.59/.1-.06) = 22.4
PV(FCF)= -.8/1.1 - .96/1.1^2 -
1.15/1.1^3 - 1.39/1.1^4 - .2/.1^5 -
.23/1.1^6 = -3.6

PV(business) = PV(FCF) + PV(hori-

zon value) = -3.6 + 22.4 =
$18.8

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