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Stock Valuation

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

**Key Concepts and Skills
**

Understand how stock prices depend on future

dividends and dividend growth

Be able to compute stock prices using the

dividend growth model

Understand how growth opportunities affect

stock values

Understand the PE ratio

Understand how stock markets work

9-2

3 Growth Opportunities 9.Chapter Outline 9.5 The Stock Markets 9-3 .1 The Present Value of Common Stocks 9.2 Estimates of Parameters in the Dividend Discount Model 9.4 Price-Earnings Ratio 9.

Stock ownership produces cash flows from: Dividends Capital Gains Valuation of Different Types of Stocks Zero Growth Constant Growth Differential Growth 9-4 .1 The PV of Common Stocks The value of any asset is the present value of its expected future cash flows.9.

Case 1: Zero Growth Assume that dividends will remain at the same level forever Div1 Div 2 Div 3 Since future cash flows are constant. the value of a zero growth stock is the present value of a perpetuity: Div1 Div 2 Div 3 P0 (1 R ) (1 R ) (1 R) 1 2 3 Div P0 R 9-5 .

g. . Div1 Div 0 (1 g ) Div 2 Div1 (1 g ) Div 0 (1 g ) 2 Div 3 Div 2 (1 g ) Div 0 (1 g ) 3 .e. the value of a constant growth stock is the present value of a growing perpetuity: Div P0 1 Rg 9-6 . forever.Case 2: Constant Growth Assume that dividends will grow at a constant rate. Since future cash flows grow at a constant rate forever.. i..

15 .50.Constant Growth Example Suppose Big D..92 9-7 . It is expected to increase its dividend by 2% per year.. Inc. just paid a dividend of $.50(1+.02) = $3.02) / (. If the market requires a return of 15% on assets of this risk level. how much should the stock be selling for? P0 = .

we need to: Estimate future dividends in the foreseeable future. Estimate the future stock price when the stock becomes a Constant Growth Stock (case 2). Compute the total present value of the estimated future dividends and future stock price at the appropriate discount rate.Case 3: Differential Growth Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter. 9-8 . To value a Differential Growth Stock.

9-9 .Case 3: Differential Growth Assume that dividends will grow at rate g1 for N years and grow at rate g2 thereafter. .. Div1 Div 0 (1 g1 ) Div 2 Div1 (1 g1 ) Div 0 (1 g1 ) 2 .. . Div N Div N 1 (1 g1 ) Div 0 (1 g1 ) N Div N 1 Div N (1 g 2 ) Div 0 (1 g1 ) (1 g 2 ) N .

Case 3: Differential Growth Dividends will grow at rate g1 for N years and grow at rate g2 thereafter Div 0 (1 g1 ) Div 0 (1 g1 ) 2 … 0 1 2 Div N (1 g 2 ) Div 0 (1 g1 ) N Div 0 (1 g1 ) (1 g 2 ) N … … N N+1 9-10 .

Case 3: Differential Growth We can value this as the sum of: a T-year annuity growing at rate g1 C (1 g1 ) T PA 1 T R g1 (1 R) plus the discounted value of a perpetuity growing at rate g2 that starts in year T+1 Div T 1 R g2 PB (1 R)T 9-11 .

we can “cash flow” it out.Case 3: Differential Growth Consolidating gives: Div T 1 C (1 g1 ) R g 2 T P 1 T R g1 (1 R) (1 R ) T Or. 9-12 .

The dividend is expected to grow at 8% for 3 years. What is the stock worth? The discount rate is 12%. 9-13 .A Differential Growth Example A common stock just paid a dividend of $2. then it will grow at 4% in perpetuity.

12) P $5.12 .89 9-14 .75 3 (1.8966 $32.58 $23.04 P 1 3 .08) 3 (1.31 P $28.12) 3 P $54 1 .With the Formula $2(1.12) (1.12 .08 (1.08) (1.08) 3 .04) $2 (1.

12 (1.52 growth phase .08) $2(1. $2.33 $2.62 The constant $2.89 1.52 $32.62 P3 $32.08) (1.33 $2.12) $2.12) (1.16 $2.04 beginning in year 4 can be valued as a 0 1 2 3 growing perpetuity at time 3.75 P0 2 3 $28.08) 2 $2(1.75 .04) … 0 1 2 3 4 $2.08 9-15 .12 .16 $2. With Cash Flows 3 3 $2(1.08) $2(1.

R.9. Where does g come from? g = Retention ratio × Return on retained earnings 9-16 . g. and its discount rate.2 Estimates of Parameters The value of a firm depends upon its growth rate.

The dividend yield The growth rate (in dividends) In practice. there is a great deal of estimation error involved in estimating R.Where Does R Come From? The discount rate can be broken into two parts. 9-17 .

Using the DGM to Find R Start with the DGM: D 0 (1 g) D1 P0 R -g R -g Rearrange and solve for R: D 0 (1 g) D1 R g g P0 P0 9-18 .

EPS P NPVGO R 9-19 . The value of a firm can be conceptualized as the sum of the value of a firm that pays out 100% of its earnings as dividends plus the net present value of the growth opportunities.9.3 Growth Opportunities Growth opportunities are opportunities to invest in positive NPV projects.

NPVGO must be: $75 .75 9-20 .$31. a discount rate of 16%.NPVGO Model: Example Consider a firm that has forecasted EPS of $5. and is currently priced at $75 per share.25 = $43. We can calculate the value of the firm as a cash cow. EPS $5 P0 $31.25 R .16 So.

then increased retention increases firm value since reinvested capital earns more than the cost of capital.Retention Rate and Firm Value An increase in the retention rate will: Reduce the dividend paid to shareholders Increase the firm’s growth rate These have offsetting influences on stock price Which one dominates? If ROE>R. 9-21 .

The Wall Street Journal uses last 4 quarter’s earnings Price per share P/E ratio EPS 9-22 .9. The price-earnings ratio is calculated as the current stock price divided by annual EPS.4 Price-Earnings Ratio Many analysts frequently relate earnings per share to price.

P NPVGO R Dividing every term by EPS provides the following description of the PE ratio: 1 NPVGO PE R EPS So. a firm’s PE ratio is positively related to growth opportunities and negatively related to risk (R) 9-23 .PE and NPVGO EPS Recall.

Brokers New York Stock Exchange (NYSE) Largest stock market in the world License Holders (formerly “Members”) Entitled to buy or sell on the exchange floor Commission brokers Specialists Floor brokers Floor traders Operations Floor activity 9-24 .5 The Stock Markets Dealers vs.9.

brokers & dealers Level 3 – view and update quotes.NASDAQ Not a physical exchange – computer-based quotation system Multiple market makers Electronic Communications Networks Three levels of information Level 1 – median quotes. registered representatives Level 2 – view quotes. dealers only Large portion of technology stocks 9-25 .

Stock Market Reporting Gap pays a dividend of 34 Gap has cents/share. the last year.06. Gap ended trading at been as high $11. 9-26 . 8 times earnings.1%.89 in cents from yesterday. Given the current price.41 in price. which is up 45 as $21. 8.829. the last year. the PE ratio is trading. the dividend yield is 3.800 shares traded Gap has been as Given the current hands in the last day’s low as $9.

Discuss the importance of the PE ratio.Quick Quiz What determines the price of a share of stock? What determines g and R in the DGM? Decompose a stock’s price into constant growth and NPVGO values. What are some of the major characteristics of NYSE and Nasdaq? 9-27 .

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