Lecture 3 - Stocks

BE-410 – Corporate Finance

Date: August 31, 2021

 Overview

1) Introduction
2) The dividend discount model
3) Free cash flow valuation model
4) Valuation based on comparable firms

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INTRODUCTION

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 The balance sheet
If interested - See chapter 2 for full analysis

Outstanding stocks: 3.6 mill Market capitalization:

Stock price: $14 $14 x 3.6 = $50.4 mill
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 The income statement

2.0 $14
𝐸𝑃𝑆 = = $0.556 𝑃/𝐸 = = 25.2
3.6 0.556
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THE DIVIDEND DISCOUNT
MODEL (DDM)

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 Dividend discount model (DDM)

DDM estimates the value of a single stock (or total

equity) by focusing exclusively on dividends

Simple model,
but difficult in
practice to
forecast future
dividends

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 One year investor

§ Cash Flow for investor with one year investment horizon

i. Buy stock today
ii. Receive dividend in one year (if any)
iii. Sell the stock just after dividend payment

§ We discount risky equity cash flow at the equity cost of

capital - 𝒓𝑬 .

æ Div1 + P1 ö Div1 + P1 Div1 P1 - P0

rE = - 1 = +
P0 = ç ÷ P0
!
P0 P
!0
è 1 + rE ø Dividend Yield Capital Gain Rate

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 A Multi-Year Investor

§ What is the price if we plan on holding the stock for two

years?

𝐷𝑖𝑣" 𝐷𝑖𝑣$ + 𝑃$
𝑃! = +
1 + 𝑟# 1 + 𝑟# $

§ Investment horizon: Forever

'
𝐷𝑖𝑣" 𝐷𝑖𝑣$ 𝐷𝑖𝑣% We need a forecast
𝑃! = + $+⋯= 5 1+𝑟 % for future dividends
1 + 𝑟# 1 + 𝑟# #
%&" to use this formula

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 Dividend discount model (DDM) with
constant dividend growth
§ The simplest forecast for the firm’s future dividends states that
they will grow at a constant rate, g, forever

𝐷𝑖𝑣"
𝑃! =
𝑟# − 𝑔

EXAMPLE: AT&T plans to pay $1.44 per share in dividends in the

coming year. If its equity cost of capital is 8% and dividends are
expected to grow by 4% per year in the future, estimate the value
of AT&T’s stock.

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§ Solution
§ If dividends are expected to grow perpetually at a rate of
4% per year, we can calculate the price of a share of AT&T
stock:

Div1 $1.44
P0 = = = $36.00
rE - g .08 - .04

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 Growing dividends?

§ Company board decision: how much dividend to pay out

and how much to retain for reinvestment?

Ø Decision depends on the profitability of the firm’s investment

opportunities.

i. Cutting the firm’s dividend to increase investment will raise the

stock price if, and only if, the new investments have a positive
NPV. (If return on new investment opportunities are
high).

ii. Cutting investment to increase dividend will lower the stock

price if, and only if, new investments have a negative NPV. (If
return on new investment opportunities are low).

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 Simple model for growth
Define payout rate as fraction of earnings paid out as dividends. The
dividend per share can be written as:
𝑇𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠(
𝐷𝑖𝑣( (𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒) = ×𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑒
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
#)*!

Retention rate = 1 – Payout rate

If the firm keeps its retention rate constant, then the growth rate in
dividends will equal the growth rate of earnings.

g = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒×𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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 Exercise 9.10
DFB, Inc., expects earnings this year of $4.19 per share, and it plans to pay a
$2.43 dividend to shareholders. DFB will retain $1.76 per share of its earnings to
reinvest in new projects with an expected return of 15.1% per year. Suppose DFB
will maintain the same dividend payout rate, retention rate, and return on new
investments in the future and will not change its number of outstanding shares.
a) What growth rate of earnings would you forecast for DFB?
b) If DFB’s equity cost of capital is 12.2%, what price would you estimate for DFB
stock?
c) Suppose DFB instead paid a dividend of $3.43 per share this year and retained
only $0.76 per share in earnings. That is, it chose to pay a higher dividend
instead of reinvesting in as many new projects. If DFB maintains this higher
payout rate in the future, what stock price would you estimate now? Should
DFB raise its dividend?

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 Exercise 9.10

Solution
a) growth rate of earnings
!.#$
𝑔 = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑥 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡. = 𝑥 15.1 % =
%.!&
6.34 %
b) Estimate for DFB stock price

$ 2.43
P= = $ 41.46
(0.122 − 0.0634)
c) Should dividends be raised?
'.#$ (.%(
g= X 15.1= 2.73%, 𝑃 = = $ 36.21 NO!
%.!& '.!))*'.')#(

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 DDM with non-constant growth

DivN + 1
PN =
rE - g
𝐷𝑖𝑣YZV
𝐷𝑖𝑣V 𝐷𝑖𝑣X 𝐷𝑖𝑣X + 𝑟W − 𝑔
𝑃U = + X + ⋯+
1 + 𝑟W 1 + 𝑟W 1 + 𝑟W Y

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 Exercise 9.12

Procter & Gamble paid an annual dividend of $2.87 in 2018.

Analysts expect this dividend to grow by 8% per year for the
next five years (through 2023) and thereafter by 3% per year.
If the appropriate equity cost of capital for Procter and
Gamble is 8% per year, use the dividend-discount model to
estimate its value per share at the end of 2018.

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 Solution
§ Since dividends are growing at the cost of capital over the
next 5 years, the present value of the next 5 years’
dividends are:
2.87 ´1.08 2.87 ´1.082 2.87 ´1.085
PV1-5 = + 2
+ ... + 5
= 5 ´ 2.87 = $14.35.
1.08 1.08 1.08
§ Value on date 5 of the rest of the dividend payments:
2.87(1.08)5 1.03
PV5 = = 86.87
0.08 - 0.03
§ Discounting this value to the present gives
86.87
PV0 = = $59.12
(1.08 )
5

§ So the value of P&G is: P = PV1-5 + PV0 = 14.35 + 59.12 = $73.47.

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FREE CASH FLOW MODEL

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 Discounted free cash flow model

Discounted free cash flow model estimates the total

value of the firm to all investors (bond and equity)

Allows the
valuation of a
firm without
explicit
forecasting its
dividends,
share
repurchases or
use of debt

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 Discounted free cash flow model

Discounted free cash flow model estimates the

enterprise value
Enterprise value = Equity + Debt - Cash

Enterprise Value can be

interpreted as the net cost of
acquiring the firm’s equity, taking
its cash, paying off all debt, and
owning the unlevered business.

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 Discounted free cash flow model

First ingredient: Free cash flow prognosis

Unlevered net income

(from Pro Forma income statement)

𝑼𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆

𝑭𝒓𝒆𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 = 𝑹𝒆𝒗𝒆𝒏𝒖𝒆𝒔 − 𝒄𝒐𝒔𝒕𝒔 − 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 × 𝟏 − 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆
𝑬𝑩𝑰𝑻
+ 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 − 𝑪𝒂𝒑𝑬𝒙 − 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝒏𝒆𝒕 𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

Adjust for net investment and

change in net working capital

See Chap. 8.2 for detailed discussion of FCF

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 Discounted free cash flow model

Second ingredient: discount rate

Free cash flow to both equity and debt holders

should be discounted at the firm’s weighted
average cost of capital (WACC)

𝑟W = 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝑟[ = 𝑑𝑒𝑏𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝑟\]^^ = 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑟W 𝑎𝑛𝑑 𝑟[

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 Discounted free cash flow model

Enterprise Value:

𝑽𝟎 = 𝑷𝑽(𝑭𝒖𝒕𝒖𝒓𝒆 𝒇𝒓𝒆𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒐𝒇 𝒇𝒊𝒓𝒎)

𝑭𝑪𝑭𝟏 𝑭𝑪𝑭𝟐
𝑽𝟎 = + 𝟐
+⋯
𝟏 + 𝒓𝑾𝑨𝑪𝑪 𝟏 + 𝒓𝑾𝑨𝑪𝑪

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 Exercise 9.21 (modified)
Consider the following projected free cash flow for the next
four years for Sora Industries:
Year 0 1 2 3 4
Earnings and FCF Forecast ($ million)
1 Sales 433,0 468,0 516,0 547,0 574,3
2 Growth versus Prior Year 8,1% 10,3% 6,0% 5,0%
3 Cost of Goods Sold (313,6) (345,7) (366,5) (384,8)
4 Gross Profit 154,4 170,3 180,5 189,5
5 Selling, General, and Administrative (93,6) (103,2) (109,4) (114,9)
6 Depreciation (7,0) (7,5) (9,0) (9,5)
7 EBIT 53,8 59,6 62,1 65,2
8 Less: Income Tax at 40% (21,5) (23,8) (24,8) (26,1)
9 Plus: Depreciation 7,0 7,5 9,0 9,5
10 Less: Capital Expenditures (7,7) (10,0) (9,9) (10,4)
11 Less: Increase in NWC (6,3) (8,6) (5,6) (4,9)
12 Free Cash Flow 25,3 24,6 30,8 33,3

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 Exercise 9.21 (cont’d)

a) Suppose Sora’s free cash flows are expected to grow at a

5% rate beyond year 4. If Sora’s weighted average cost of
capital is 10%, what is the enterprise value of Sora
Industries?

𝑇𝑖𝑚𝑒𝑙𝑖𝑛𝑒 𝐹𝐶𝐹

0 1 2 3 4 5

25.3 24.6 30.8 33.3 33.965

FCF+ = 33.3× 1.05 = 33.965

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 Exercise 9.21 (cont’d)

0 1 2 3 4 5

25.3 24.6 30.8 33.3 33.965

1. Terminal value at time 3:

𝟑𝟑. 𝟑
𝑽𝟑 = = 𝟔𝟔𝟔
𝟎. 𝟏 − 𝟎. 𝟎𝟓
2. Total Enterprise value at time 0:

𝟔𝟗𝟔.𝟖
𝟐𝟓. 𝟑 𝟐𝟒. 𝟔 𝟑𝟎. 𝟖 + 𝟔𝟔𝟔
𝑽𝟎 = + 𝟐 + 𝟑 = 𝟓𝟔𝟔. 𝟖𝟓
𝟏. 𝟏 𝟏. 𝟏 𝟏. 𝟏

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 Exercise 9.21 (cont’d)
b) Sora Industries has 60 million outstanding shares, $120
million in debt, $40 million in cash. What is Sora’s implied stock
price?

𝑉⏟1 = 𝑃1 ×𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔1 + 𝑑𝑒𝑏𝑡1 − 𝑐𝑎𝑠ℎ1

2345676895 :;<=5! >;6?54 @;<=5 AB 5C=84D!

𝑉1 − 𝑑𝑒𝑏𝑡1 + 𝑐𝑎𝑠ℎ1
𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒: 𝑃1 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔1

$𝟓𝟔𝟔. 𝟖𝟓 − $𝟏𝟐𝟎 + $𝟒𝟎

𝑺𝒕𝒐𝒄𝒌 𝒑𝒓𝒊𝒄𝒆 𝑺𝒐𝒓𝒂: 𝑷𝟎 = = $𝟖. 𝟏𝟏
𝟔𝟎

See also example 9.7: Valuing Kenneth Cole Using Free Cash Flow p.326

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VALUATION BASED ON
COMPARABLE FIRMS

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 Method of comparables (Comps)

§ Estimate the value of the firm based on the value of other,

comparable firms or investments that we expect will
generate very similar cash flows in the future. (Law of one
price: Identical firms that produce identical cash flows, are
equally valuable.)

1. P/E multiple

2. Enterprise value multiple

3. P/book

4. ….

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 Exercise 9.24
You notice that PepsiCo (PEP) has a stock price of $74.02 and EPS of
$3.82. Its competitor, the Coca-Cola Company (KO), has EPS of $2.36.
Estimate the value of a share of Coca-Cola stock using only this data.

The “valuation-by-comparables” principle (versus similar company):

Same (P/E) ratio for two similar companies

𝑷𝒆𝒑𝒔𝒊 𝑷𝒆𝒑𝒔𝒊
𝑷𝑪𝒐𝒄𝒂 𝑪𝒐𝒍𝒂 𝑷 𝑷
= 𝑷𝒆𝒑𝒔𝒊 ⇒ 𝑷𝑪𝒐𝒄𝒂 𝑪𝒐𝒍𝒂 = 𝑬𝑷𝑺𝑪𝒐𝒄𝒂 𝑪𝒐𝒍𝒂 × 𝑷𝒆𝒑𝒔𝒊
𝑬𝑷𝑺𝑪𝒐𝒄𝒂 𝑪𝒐𝒍𝒂 𝑬𝑷𝑺 𝑬𝑷𝑺

𝑪𝒐𝒄𝒂 𝑪𝒐𝒍𝒂 $𝟕𝟒. 𝟎𝟐

𝑷 = $𝟐. 𝟑𝟔× = $𝟒𝟓. 𝟕𝟐
$𝟑. 𝟖𝟐
𝑷
𝑬&𝟏𝟗.𝟑𝟕

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 Example: EV/EBITDA multiple
𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆𝑨𝒗𝒈 𝑬 𝑽𝑨𝒗𝒈
Average industry multiple: 𝑬𝑩𝑰𝑻𝑫𝑨𝑨𝒗𝒈
= 𝑬𝑩𝑰𝑻𝑫𝑨𝑨𝒗𝒈
= 𝟕. 𝟕

BEST BUY (BBY) EBITDA of $2,766,000,000

Debt $1,963,000,000
Cash $509,000,000
410,000,000 shares outstanding

What is BBY stock price based on the industry average EV/EBITDA ratio?

Step 1: Compute enterprise value for BBY:

𝑬𝑽𝑩𝑩𝒀 𝑬𝑽𝑨𝒗𝒈 𝑬𝑽𝑨𝒗𝒈

𝑩𝑩𝒀 = 𝑨𝒗𝒈 ⇒ 𝑬𝑽𝑩𝑩𝒀 = 𝑬𝑩𝑰𝑻𝑫𝑨𝑩𝑩𝒀×
𝑬𝑩𝑰𝑻𝑫𝑨 𝑬𝑩𝑰𝑻𝑫𝑨 𝑬𝑩𝑰𝑻𝑫𝑨𝑨𝒗𝒈

𝑬𝑽𝑩𝑩𝒀 = $𝟐, 𝟕𝟔𝟔 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 ×𝟕. 𝟕 = $𝟐𝟏, 𝟐𝟗𝟖. 𝟐𝟎

Step 2: Compute stock price via EV-definition:
𝐸𝑉 − 𝑑𝑒𝑏𝑡 + 𝑐𝑎𝑠ℎ $𝟐𝟏, 𝟐𝟗𝟖. 𝟐 − $𝟏, 𝟗𝟔𝟑 + $𝟓𝟎𝟗
𝑃6 = = = $𝟒𝟖. 𝟒𝟎
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝟒𝟏𝟎
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 Limitations and comparisons of methods

§ Comparables
ü Easy, first approach to valuation
ü BUT
ü Vary a great deal across firms, even in the same industry (exercise 9.28)
ü How to adjust for differences in expected future growth rates and/or risk
ü Relative valuation not useful if an entire industry is overvalued

§ Discounted cash flows methods

ü Can incorporate specific information about the firm’s cost of capital or future
growth. Have the potential to be more accurate than the use of a valuation
multiple.

§ No single technique provides a final answer regarding a stock’s true value.

ü Most real-world practitioners use a combination of these approaches and

gain confidence if the results are consistent across a variety of methods.

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