Stocks and Their Valuation

 Features of Common Stock

 Determining Common Stock Values
 Preferred Stock

9-1
Facts about Common Stock

 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price

9-2
Common stock valuation

 Pay out ratio = D/EPS

 Retention ratio = (1 - Pay Out Ration)
 Sustainable growth rate = ROE x Retention
ratio .
 Ie. = ROE x (1 - pay out ratio )
 Fundamental Analysis :- Examination of
Financial and economic information to assess
the economic value of a firm.

9-3
application

 What is the sustainable growth rate in profits

of a company that has EPS of $2,-- , out of
which the company has distributed a dividend
of $1,-- per share if knowing that the average
cost of capital ( Return on Equity-ROE) of said
company is 20%
 Answer: * pay out ratio =$1/$2 = 50%
ie: retention ratio=(1-,50)= 50%
* sustainable growth rate =,20 x ,50= ,10
( ie g = 10% )
9-4
Different Approaches for Estimating the
Intrinsic Value of a Common Stock

 Discounted dividend model

 Corporate valuation model
 Using the multiples of comparable firms

9-5
Use the SML to Calculate the Required
Rate of Return (rs)

 If rRF = 7%, rM = 12%, and b = 1.2, what is the

required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b
= 7% + (12% – 7%)1.2
= 13%

9-6
 Example :
7
What is the stock’s intrinsic value?

Using the constant growth model:

D1 $2.12
P̂0  
rs  g 0.13  0.06
$2.12

0.07
 $30.29

9-8
What would the expected price today
be, if g = 0?
The dividend stream would be a perpetuity.

0 1 2 3
rs = 13%

2.00 2.00 2.00

PMT $2.00
P̂0    $15.38
r 0.13

9-9
Common stock valuation

 1- no growth model : P0 = D1 / I
 2-constant perpetual growth :
P0 = D0(1+g ) / K – g
P0 = D1 / K-g

3- two stage dividend growth model :

P0 = D0(1+g1)/k-g * (1- 1+g/1+k) +
(1+g)/1+k * ( D0 (1+g2) / k-g2

9-10
Common stock valuation

9-11
Common stock valuation

9-12
Common stock valuation

 RIM is the same approach of constant

growth model However it is more flexible
because it could also be applied in no
dividend payment cases.

 P0 = EPS(t1) – B(t0) *G/ K-G

 = D(t1) / K-G

9-13
Common stock valuation/RI Model
 Example: find the present value of a common stock
in light of the following information:-
 EPS t0 (present earning per share)= $5,--
 Constant rate of growth in profit g = 5%
 The ROE (Return 0n equity) K = 25%
 Present book value per share B(t0)= $ 20,--
 Solution:EPS(t1)= 5x1,05= $5.25
 & B(t0)xg =20x,05= $1,-
 P0=(EPS(T1) – B(t0)x g/K-g )
 P0= 5.25-1/,20 =4.25/,20 = $21,25

9-14
Corporate Valuation Model

 Also called the free cash flow method.

Suggests the value of the entire firm equals
the present value of the firm’s free cash
flows.
 Remember, free cash flow is the firm’s after-
tax operating income less the net capital
investment.
FCF = EBIT(1 – T) – Net capital investment

9-15
Firm Multiples Method

 Analysts often use the following multiples to

value stocks.
 P/E
 P/CF
 P/Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate of
the stock price.

9-16
Applications /Common Stock Valuation

 Example 1-: what is the fair value of a common

stock presently traded in the stock exchange at $
30,-- and has an earning per share EPS of $2,--
knowing that average P/E ratio of shares of
similar companies listed in stock exchange is 12X
.
 Answer : -
 * P/E of stock in question=30/2 =15X
( overpriced Growth Stock compared to average)
 Fair value =30x12 / 15 = $24,--

9-17
Applications common stock valuation

 Example 2- in the previous example what

should be the faire price of stock if knowing
that the average market P/E multiplier of
stocks of similar business activities is 16X
 Answer:
 Since given P/E of stock in question is 15X
 (ie value stock –underpriced compared to
average)
 Then faire price is 30x16/15 = $ 32,--

9-18
Common stock valuation

 Price Ratio Analysis

 High P/E Ratio ( Growth Stock)
 Low P/E Ratio ( Value Stock)
 P/CF = current stock price/cash flow per
share.
 P/Sales = current stock price/sales per share
 P/Book ratio =current stock price/book value
per share

9-19
Common stock valuation

 Expected price per share P0 =

 Historical P/E * Current EPS*(1+EPS growth
Rate (G)).
 Historical P/CFPS*Current CFPS*(1+CFPS
growth rate)
 Historical P/S *current SPS*(1+projected
sales growth rate
 Historical price ratio X Current X (1+
projected growth

9-20
If preferred stock with an annual dividend of $5
sells for $50, what is the preferred stock’s
expected return?

D
Vp 
rp
$5
$50 
rp

$5
r̂p 
$50
 0.10  10%

9-21