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Valuing Stocks

Session 3
Stock Exchange
It is an institution, organization or association that
serves as a market for trading financial instruments
such as stocks, bonds and their related derivatives.

Large companies arrange their stocks to be traded on
a stock exchange


Firms that wish to raise new capital
May borrow money or
Bring new partners by selling shares of
common stock
Components for buying stocks
Price change
Volume
Dividend yield
Price-earning (P/E) ratio









Valuing a Company and Its Future
The single most important issue in the stock
valuation process is what a stock will do in the
future.
Value of a stock depends upon its future returns
from dividends and capital gains/losses.
We use historical data to gain insight into the future
direction of a company and its profitability.
Past results are not a guarantee of future results.
The Valuation Process
Valuation is a process by which an investor uses risk and
return concepts to determine the worth of a security.
Valuation models help determine what a stock ought to be worth
If expected rate of return equals or exceeds our target yield, the stock
could be a worthwhile investment candidate
If the intrinsic worth equals or exceeds the current market value, the
stock could be a worthwhile investment candidate
There is no assurance that actual outcome will match
expected outcome
Required Rate of Return
Required Rate of Return is the return
necessary to compensate an investor for the
risk involved in an investment.
Used as a target return to compare forecasted
returns on potential investment candidates
Required
rate of return
=
Risk-free
rate
+
Stock's
beta


Market
return
|
\


Risk-free
rate
|
.
|
(

(
Required Rate of Return (contd)
Example: Assume a company has a beta of
1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?
Required return = 5.5% + 1.30 15.0% 5.5% ( )
| |
= 17.85%
Common Stock Valuation
These methods are grouped into two
categories:

Dividend discount models
Price ratio models

The Dividend Discount Model
The Dividend Discount Model (DDM) is a method to
estimate the value of a share of stock by discounting all
expected future dividend payments. The DDM
equation is:




In the DDM equation:
V(0) = the present value of all future dividends
D(t) = the dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate

( )
( ) ( ) ( ) ( )
T T 3 2
k 1
P(T)
k 1
D(T)
k 1
D(3)
k 1
D(2)
k 1
D(1)
V(0)
+
+
+
+
+
+
+
+
+
=
Example: The Dividend Discount Model
Suppose that a stock will pay three annual dividends of $200
per year, and the appropriate risk-adjusted discount rate, k, is
8%. Terminal price $ 1200.
In this case, what is the value of the stock today?

( )
( ) ( ) ( )
( )
( ) ( ) ( )
$1,468.01
0.08 1
$1,200
0.08 1
$200
0.08 1
$200
0.08 1
$200
V(0)
k 1
P(3)
k 1
D(3)
k 1
D(2)
k 1
D(1)
V(0)
3 3 2
3 3 2
=
+
+
+
+
+
+
+
=
+
+
+
+
+
+
+
=
The Dividend Discount Model:
the Constant Growth Rate Model
Assume that the dividends will grow at a constant growth rate
g.

Then, the dividend next period (t + 1) is:


In this case, the DDM formula becomes:




( ) ( ) ( ) g 1 t D 1 t D + = +
( )
T
T
k 1
P(T)

k 1
g 1
1
g k
g) D(0)(1
V(0)
+
+
(
(

|
.
|

\
|
+
+

+
=
Example: The Constant Growth Rate
Model
Suppose the current dividend is $10, the dividend growth rate is 10%, there will be
20 yearly dividends, and the appropriate discount rate is 8%. Terminal value $200.

What is the value of the stock, based on the constant growth rate model?


( )
( )
( )
( )
$286.77
.08 1
200
1.08
1.10
1
.10 .08
1.10 $10
0 V
k 1
P(T)

k 1
g 1
1
g k
g) D(0)(1
V(0)
20
20
T
T
=
+
+
(
(

|
.
|

\
|

=
+
+
(
(

|
.
|

\
|
+
+

+
=
The Dividend Discount Model:
the Constant Perpetual Growth Model.
Assuming that the dividends will grow forever
at a constant growth rate g.

In this case, the DDM formula becomes:




( )
( )

g k
1 D
0 V

=
Example: Constant Perpetual Growth
Model
Think about the electric utility industry.

In mid-2003, the dividend paid by the utility company, American Electric
Power (AEP), was $1.40.

Using D(0)=$1.40, k = 6.5%, and g = 1.5%, calculate an estimated value for
AEP.







( )
( )
$28.42
.015 .065
1.015 $1.40
0 V =

=
The Sustainable Growth Rate






Return on Equity (ROE) = Net Income / Equity

Payout Ratio = Proportion of earnings paid out as dividends

Retention Ratio = Proportion of earnings retained for
investment

Ratio) Payout - (1 ROE
Ratio Retention ROE Rate Growth e Sustainabl
=
=
Example: Calculating and Using the
Sustainable Growth Rate
In 2003, AEP had an ROE of 10%, projected earnings per share of $2.20,
and a per-share dividend of $1.40. What was AEPs
Retention rate?
Sustainable growth rate?

Payout ratio = $1.40 / $2.20 = .636

So, retention ratio = 1 .636 = .364 or 36.4%

Therefore, AEPs sustainable growth rate = 10% .364 = 3.64%


Example: Calculating and Using the
Sustainable Growth Rate, Cont.

What is the value of AEP stock, using the
perpetual growth model, and a discount rate
of 6.5%?






( )
( )
$50.73
.0364 .065
1.0364 $1.40
0 V =

=
Price Ratio P/E Ratio
Price-earnings ratio (P/E ratio)
Current stock price divided by annual earnings per share (EPS)


Intel Corp (INTC) - Earnings (P/E) Analysis

Current EPS $0.48
5-year average P/E ratio 38.72
EPS growth rate 5.50%

Expected stock price = historical P/E ratio projected EPS

$19.61 = 38.72 ($0.48 1.055)


Thank You