STOCKS AND STOCKS

VALUATION
FINANCIAL MARKETS
STOCKS

 MEDIUM TO HIGH-RISK SECURITIES

 STOCK MARKET (SECONDARY) ARE WAY MORE EFFICIENT THAN BONDS MARKET
(INDEXES AND CENTRALIZED TRADING PLATFORM – NYSE, NASDAQ)
 UNLIKE BONDS – THE CASH FLOWS FOR THESE ARE USUALLY MUCH DIVERSE
AND “UNGUARANTEED”
 HAS A LOT OF PRICING / VALUATION MODELS
TYPES OF STOCKS

 COMMON STOCKS
 PREFERRED STOCKS
COMMON STOCKS
 REPRESENTS AN OWNERSHIP INTEREST
 RESIDUAL CLAIMANTS – LOWEST PRIORITY CLAIM OF FIRM’S
ASSETS
 NO FIXED DIVIDENDS
 HAS VOTING RIGHTS
 TRUE PERPETUITIES – HAVE NO MATURITY VALUE
PREFERRED STOCKS
 ALSO REPRESENTS AN OWNERSHIP INTEREST
 TAKE PRECEDENCE OVER COMMON STOCKHOLDERS IN THE
PAYMENT OF DIVIDENDS AND IN THE DISTRIBUTION OF
CORPORATE ASSETS IN THE EVENT OF LIQUIDATION
 HAS FIXED DIVIDENDS (BUT STILL UNGUARANTEED – STILL NOT
A CONTRACTUAL OBLIGATION UNLIKE INTEREST PAYMENTS ON
BONDS)
 HAS NO VOTING RIGHTS
 USUALLY NOT TRUE PERPETUITIES – HAVE NO MATURITY VALUE
 ALSO KNOWN AS A “HYBRID SECURITY”
STOCK VALUATION
STOCK VALUATION
 When stock prices rise or fall, how do investors or financial
managers know when it is time to buy or sell?

 How can they tell if the market price of stock reflects its value?

 You can’t just rely on your feeling or emotions, you need to have a
reasonable expectations regarding the value of the future cash
flows that ownership of stocks would entitle them to receive.
STOCK VALUATION

 One of the approach is to develop a stock-valuation model and

COMPARE the value of the estimated from the model with the
market price.

 From there, you can have better investment decisions because,

you have a reasonable basis to determine of the stock is
OVERVALUED or UNDERVALUED.
 In valuing bonds we emphasized that the value of any asset is the
present value of its future cash flows. The steps in valuing an asset
are as follows:

1. Estimate the future cash flows.

2. Determine the required rate of return, or discount rate, which
reflects the riskiness of the future cash flows.
 THE CHALLENGE:

It is relatively straightforward to apply these steps in

valuing a bond because the cashflows are stated as part of
the bond contract and the required rate of return or
discount rate is just the yield to maturity on bonds with
comparable risk. However, common stock valuation is
MORE DIFFICULT for several reasons
BRAIN EXERCISE

Given the characteristics of a stock, what

could be the possible challenges in valuing a
stock?
REASON #1
While the expected cash flows for bonds are well documented and easy
to determine, common stock dividends are much less certain.

Dividends are declared by the board of directors, and a board may or

may not decide to pay a cash dividend at a particular time. Thus, the
size and the timing of dividend cash flows are less certain
REASON #2

Common stocks are true perpetuities in that they have no

final maturity date. Thus, firms never have to redeem
them. In contrast, bonds have a finite maturity
REASON #3

Finally, unlike the rate of return, or yield, on

bonds, the rate of return on common stock is not
directly observable. Thus, grouping common stocks
into risk classes is more difficult than grouping
bonds
TYPES OF STOCK VALUATION

1. ABSOLUTE
2. RELATIVE
WATCH THIS VIDEO

https://
www.investopedia.com/articles/fundamental-analysis/11/choosing-valuation-me
thods.asp
 ABSOLUTE VALUATION
Absolute valuation models attempt to find the intrinsic or "true" value of an
investment based only on fundamentals.

Looking at fundamentals simply means you would only focus on such things as
dividends, cash flow, and the growth rate for a single company—and not worry
about any other companies.

Valuation models that fall into this category include the dividend discount
model, discounted cash flow model, residual income model, and asset-based
model.
 RELATIVE VALUATION
Relative valuation models, in contrast, operate by comparing the company in
question to other similar companies. These methods involve calculating 
multiples and ratios, such as the price-to-earnings (P/E) ratio, and comparing
them to the multiples of similar companies.

For example, if the P/E of a company is lower than the P/E of a comparable
company, the original company might be considered undervalued.

Typically, the relative valuation model is a lot easier and quicker to

calculate than the absolute valuation model, which is why many investors and
analysts begin their analysis with this model.
 HEADS UP…
In all models below, we assume that:
1. The current dividend has just been paid (immediately before we buy the
stock) and our first dividend received will be one year from today.
2. We also assume that dividends are paid annually instead of quarterly or
semi-annually. These assumptions make the application of time value of
money simpler.

While they may not be realistic, they do not greatly alter the results and
therefore are worthwhile simplifications.
NO GROWTH

If we have a stock with no growth in its dividends over time, the

infinity issue is solved with a perpetuity. The stockholder will
receive the same dividend every year (an annuity) that lasts
forever.

This is the perpetuity concept that was introduced in the Time

Value of Money chapter. The most common example of a no
growth stock is a PREFERRED STOCK.
According to the no-growth model, to find the value of the stock, we just take
the current dividend and divide by the required return (remember, it’s just a
perpetuity — an infinite annuity — since the stock has no maturity date and the
dividend is not expected to increase or decrease in value).
You may have concerns about the assumption
of an infinite time horizon. In practice,
though, it does not present a problem. It is
true that most companies do not live on
forever.

We know, however, that the further in the

future a cash flow will occur, the smaller its
present value.
Thus, far-distant dividends have a
small present value and contribute
very little to the price of the stock
While we designate next year’s dividend in the formula, this is just to
be consistent with the later models. Since there is no growth, all the
dividends are the same regardless of which year we are referring to.
SAMPLE

Consider the following example with a preferred

stock. Assuming that a preferred stock has a par
value of $75, pays a 10% dividend and you have an
8% required return, what is this stock worth to you?
SAMPLE

Consider the following example with a preferred

stock. Assuming that a preferred stock has a par
value of $75, pays a 10% dividend and you have an
8% required return, what is this stock worth to you?
CONSTANT GROWTH – ( GORDON
GROWTH MODEL – GGM)
 While it is possible for a common stock to have a constant dividend over
time, it is not likely. Companies tend to grow and expand, which usually
results in dividends growing over time. However, if dividends don’t remain
constant we can no longer use a perpetuity formula.

 The Gordon growth model (GGM) assumes that a company exists forever and
that there is a constant growth in dividends when valuing a company's stock.

 The GGM works by taking an infinite series of dividends per share and
discounting them back into the present using the required rate of return .
SAMPLE

 Fora quick example, consider a stock that just

paid a dividend (D0) of $5.00 per share with
dividends growing at a constant 4% per year. If my
required return is 13%, what is the stock worth to
me?
SAMPLE
 For a quick example, consider a stock that just paid a
dividend (D0) of $5.00 per share with dividends growing at
a constant 4% per year. If my required return is 13%, what
is the stock worth to me?
 LIMITATIONS
 Growth rates rarely remain constant over time. However if growth
rates are relatively stable, this can be a close approximation.

 This model only works when the required return exceeds the growth
rate. This is not usually critical as it is impossible to maintain a growth
rate higher than the required return indefinitely, but if you try
applying this model when the growth rate exceeds the required return,
you will get a negative value – which does not make sense as stock
prices will not fall below $0.00 due to the limited liability concept
Supernormal (Non-Constant) Growth

This is where things get a little

tricky. However, it is the most
common situation. The solution is
not a simple formula, but instead a
three-step process.
 The 3-Step Solution
 Step 1 – Forecast the dividends during the non-constant growth
period up to the first year at which dividends grow at a constant
rate.

 Step 2 – Once a constant growth rate is reached, use the constant

growth pricing model to forecast the stock price. This stock price
represents the PV of all dividends beyond the non-constant growth
period.

 Step 3 – Discount the cash flows (dividends found in step one and
price found in step two) back to year zero at the appropriate
discount rate. This is the current value of the stock.
SEATWORK – BY PAIR

Consider a firm that just paid a dividend of $2.60.

They plan to increase dividends by 5% in year one,
10% in year two, 20% in year three, 20% in year
four, and then 3% per year thereafter. You feel
that a 16% required return is appropriate. What is
this stock worth to you?
SOLUTION
CONCLUSION
The dividend discount model is one of the most basic techniques
of absolute stock valuation. The DDM is based on the assumption
that the company’s dividends represent the company’s cash flow
to its shareholders.

Essentially, the model states that the intrinsic value of the

company’s stock price equals the present value of the company’s
future dividends. Note that the dividend discount model is
applicable only if a company distributes dividends regularly and
the distribution is predictable.
Discounted Cash Flow Model (DCF)

The discounted cash flow model is another popular method of

absolute stock valuation. Under the DCF approach, the intrinsic
value of a stock is calculated by discounting the company’s free
cash flows to its present value.

The main advantage of the DCF model is that it does not require any
assumptions regarding the distribution of dividends. Thus, it is
suitable for companies with unknown or unpredictable dividend
distributions. However, the DCF model is more sophisticated from a
technical perspective.
Discounted Cash Flow Model (DCF)

 DCF analysis attempts to determine the value of an

investment today, based on projections of how much money that
investment will generate in the future.

 It can help those considering whether to acquire a company or buy

securities make their decisions. Discounted cash flow analysis can
also assist business owners and managers in making capital
budgeting or operating expenditures decisions.
 STEP BY STEP PROCESS

1. Make a projections of the expected future cash flows.

2. Discount such cash flows using the appropriate discount rate (WACC) to get
the enterprise value.
3. Deduct the firm’s debt from the enterprise value to get the Fair Value of the
Equity component.
4. Divide such fair value by the total outstanding shares and compare it to the
prevailing market price.
5. Decide if the stock is worth buying. Depending if it is underpriced or
overpriced.
OTHER USE OF DCF
ADVANTAGES

 Discounted cash flow analysis can provide investors and

companies with an idea of whether a proposed investment is
worthwhile.
 It is analysis that can be applied to a variety of investments and
capital projects where future cash flows can be reasonably
estimated.
 Its projections can be tweaked to provide different results for
various what if scenarios. This can help users account for
different projections that might be possible.
 DISADVANTAGES

 Once you have a system for evaluating whole businesses or individual stocks or
projects or whatever your application may be, the math is easy. The hard part is
predicting the future.
 The major limitation of discounted cash flow analysis is that it involves estimates,
not actual figures. So the result of DCF is also an estimate. That means that for DCF
to be useful, individual investors and companies must estimate a discount rate and
cash flows correctly.
 Furthermore, future cash flows rely on a variety of factors, such as market demand,
the status of the economy, technology, competition, and unforeseen threats or
opportunities. These can't be quantified exactly. Investors must understand this
inherent drawback for their decision-making.
KEY TAKEAWAYS

 Discounted cash flow analysis helps to determine the value of an

investment based on its future cash flows.

 The present value of expected future cash flows is arrived at by using a

projected discount rate. – usually WACC

 If the DCF is higher than the current cost of the investment, the
opportunity could result in positive returns and may be worthwhile.
KEY TAKEAWAYS
 Companies typically use the weighted average cost of
capital (WACC) for the discount rate because it accounts
for the rate of return expected by shareholders.

 A disadvantage of DCF is its reliance on estimations of

future cash flows, which could prove inaccurate.