BASIC STOCK VALUATION

Common stock valuation

Common stock provides an expected future cash flow stream, and a stock's value is found in the same manner as the values of other financial assets: as the present value of the expected future cash flow stream. The expected cash flow consists of two elements: 1) the dividends expected in each year 2) the price investors expect to receive when they sell the stock The expected price includes the return of the original investment plus an expected capital gain. Definitions of Terms: Dt = dividend the stockholder expects to receive at the end of Year t D0 = the most recent dividend, which has already been paid Po = actual market price of the stock today = expected price of the stock at the end of each year t D1/ Po =expected dividend yield during the coming year = expected capital gain yield during the coming year g = expected growth rate in dividends as predicted by a marginal investor r s = minimum acceptable, or required rate of return = expected rate of return =(D1/ Po)+g = actual or realized, after-the-fact rate of return = actual dividend yield + actual capital gains yield Example: (Tool Kit 5.4.) If D1 = $3.00, P0 = $50, and the expected P at t=1 is equal to $52, what is the stocks expected dividend yield, expected capital gains yield, and total expected return for the coming year? Expected Dividend yield = (D1/ Po)=(3/50)=0.06 6% Expected Capital gains yield =

Expected total return = Expected Dividend yield + Expected Capital gains yield = 6%+4% = 10% 1. Dividend Discount Models (DDM) The basic model The basic model of discounted dividends is elementary common stock valuation model, which starts from the assumption that the value of common stocks equal to the present value of expected future dividends, with the intention of holding it forever. Value of stock = =

= 0.04 4%

But what is the value of when we expect to hold the stock for a finite period and then sell it? The value of the stock is again determined by the same equation. Namely, for an individual investor, the expected cash flows consist of expected dividends plus the expected price of the stock. However, the sale price the current investor receives will depend on the dividends some future investor expects. Therefore, for all present and future investors, expected cash flows must be based on expected future dividends. Example: What if we plan to hold stock only for two years? In this case our model becomes: = (1 + ) + (1 + ) + (1 + )

(1 +

(1 +

(1 +

+ +

(1 +

(1 +

1.1. Zero growth stock

This model provide a constant dividend forever, meaning D1 = D2 =.... = D and g = 0. =

Example: (Tool Kit 5.5.) A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is rs = 12%. What would the stocks price be if the growth rate were 0%? D1 = $2.00 g = 0% rs = 12% 2 = = = 16.67 0.12 1.2. Constant growth model (Gordon model) It starts from the assumption that future dividends grow at a constant rate of growth - g from period to period, indefinitely. (1 + ) = = A necessary condition for the validity of this equation is that greater than g.

Expected rate of return on constant growth stock = Expected dividend yield + Expected capital gains yield = Expected dividend yield + Expected growth rate = +

Example: (Tool Kit 5.5.) A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is rs = 12%. What would the stocks price be if the growth rate were 4%? D1 = $2,00 g = 4% rs = 12% 2 = = = 25 0.12 0.04

Example: (Tool Kit 5.6.) If D0 = $4.00, rs = 9 % and g = 5 % for a constant growth stock, what is the stocks price, the stocks expected dividend yield, capital gains yield, and total expected return for the coming year? D0 = $4.00 rs = 9 % g=5% (1 + ) 4 (1 + 0.05) 4.2 = = = = 105 0.09 0.05 0.04 Expected Dividend yield = (D1/ Po)=(4.2/105)=0.04 4% Expected Capital gains yield = growth rate = 5% Expected total return = Expected Dividend yield + Expected Capital gains yield = 4%+5% = 9% Exercise: 1 Boehm Incorporated is expected to pay $1.50 per share dividend at the end of the year (D1=1.50).The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on the stock, rs, is 15%. What is the value per share of the company's stock? Exercise: 2 Brushy Mountain's sales are falling and its costs are rising. As a result, the company's earnings and dividends are declining at the constant rate of 4% per year. If D0=$5 and rs=15%, what is the value of this company stock? Exercise: 3 The beta coefficient for Stock C i bc=0,4, whereas that for Stock D is bd=-0,5. a) if the risk-free rate is 9% and the expected rate of return on an average stock is 13%, what are required rates of return on stocks C and D?

b) for stock C, suppose the current price, is $25; the next expected dividend D1 is $1,5 and the stock's expected constant growth rate is 4%. Is the stock in equilibrium? Explain, and describe what will happen if the stock is not in equilibrium. Exercise: 4 Woidtke Manufacturing's stock currently sells for $20 a share. The stock just paid a dividend of $1.00 a share. The dividend is expected to grow at a constant rate of 10% a year. What stock price is expected 1 year from now? What is the required rate of return on the company's stock? Exercise: 5 A stock is trading at $80 per share. The stock is expected to have a year-end dividend of $4 per share, which is expected to grow at some constant rate g throughout time. The stock's required rate of return is 14%. If you are an analyst who believes in efficient markets, what is your forecast of g? Exercise: 6 You are considering an investment in the common stock of Cookware. The stock is expected to pay a dividend of $2 a share at the end of the year. The stock has a beta equal to 0.9. The risk-free rate is 5.6% and the market risk premium is 6%. The stock's dividend is expected to grow at some constant rate g. the stock is currently sells for $25 a share. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? Exercise: 7 You buy a share of LC corporation for $21.40. You expect it to pay dividends of $1.07, $1.1449 and $1.2250 in Years 1, 2 and 3, respectively, and you expect to sell it at a price of $26.22 at the end of 3 years. a) calculate the growth rate in dividends b) calculate the expected dividend yield c) assuming that the calculated growth rate is expected to continue, you can add the dividend yield to the expected growth rate to get the expected total rate of return. What is this stock's expected total rate of return? Exercise: 8 Suppose a firm's common stock paid a dividend of $2 yesterday. You expect the dividend to grow at the rate of 5% per year for the next 3 years and if you buy the stock, you plan to hold it for 3 years and then sell it: a) find the expected dividend for each of the next 3 years b) given that the appropriate discount rate is 12% and that the fisrt of these dividend payment will occur 1 year from now. Find the present value of the dividens stream; that is calculate the PV of D1, D2 adn D3 and then sum these PVs c) you expect the price of the stock 3 years from now to be $34.73; that is you expect to equal $34.73 d) if you plan to buy the stock, hold it for 3 years, and then sell it for $34.73, what is the most you should pay for it ? e) calculate present value of this stock, assume that g = 5%, and it is constant. f) is the value of this stock dependent on how long you plan to hold it ?

1.3. Stocks that have a non-constant growth rate Companies that generate above-average growth rates over a number of years cannot be evaluated based on the model of constant growth dividend because the periods of super normal growth are inconsistent with the assumptions of this model. Two-phase and three phase models of growth imply that after several years of exceptional growth period, ie above average growth is expected that the growth rate falls and return to average growth rates, and to stabilize at a level consistent with the model of constant growth. Two-stage growth model: we have one an above-average growth rate of dividends = whereby: (1 + ) (1 + ) = + (1 + ) 1 ) (1 + ) )

gs = rate of growth during the supernormal growth period N = years of supernormal growth gn = rate of normal, constant growth after the supernormal period Exercise: 9 Thress Industries just paid a dividend of $1.50 a share (D0=1.50). The dividend is expected to grow 5% a year for the next 3 years, and then 10% a year thereafter. What is the expected dividend per share for each of the next 5 years? Exercise: 10 Simpkins Corporation is expanding rapidly, and it currently needs to retain all of its earnings; hence it does not pay any dividends. However, investors expect Simpkins to begin paying dividends, with the first dividend of $1.0 coming 3 years from today. The dividend should grow rapidly - at a rate of 50% per year-during Years 4 and 5. After Year 5, the company should grow at a constant rate of 8% per year. If the required return on the stock is 15%. What is the value of the stock today? Exercise: 11 A company currently pays a dividend of $2 per share. It is estimated that the company's dividend will grow at a constant rate of 20% per year for the next 2 years, and then the dividend will grow at a constant rate of 7% thereafter. The company's stock has a beta equal 1.2, the risk-free rate is 7.5% and the market risk premium is 4%. What is your estimate of the stock's current price?

(1 +

Three-stage growth model: we have two above-average growth rates of dividends = (1 + ) (1 + ) + (1 + ) (1 + ) 1 + (1 + ) ( ) (1 + ) = (1 + ) (1 + ) (1 +

whereby:

gs = first rate of growth during the supernormal growth period which takes for N years gb = second rate of growth during the supernormal growth period which takes for (B-N) years gn = rate of normal, constant growth after the supernormal period Example: (Tool Kit 5.7.) Suppose D0 = $5.00 and rs = 10 percent. The expected growth rate from Year 0 to Year 1 (g0 to 1) = 20 percent, the expected growth rate from Year 1 to Year 2 (g1 to 2) = 10 percent, and the constant rate beyond Year 2 is gn = 5 percent. What are the expected dividends for Year 1 and Year 2? What is the expected horizon value price at Year 2? What is the expected P0? D0 = $5.00 rs = 10% g1 = 20% N=1 g2 = 10% B=1 gn = 5% Expected dividends for Year 1 and Year 2: D1 = D0 (1 + ) = 5 (1 + 0.2) = 6 D2 = D0 (1 + ) (1 + ) = 5 (1 + 0.2) (1 + 0.1) = 6.6 Horizon value = Expected Po = = =
( )

. ( ( .

=138.60

D (1 + ) D (1 + ) (1 + ) D (1 + ) (1 + ) (1 + ) 1 + + (1 + rs) (1 + rs) (1 + ) (rs ) 5 (1 + 0.2) 5 (1 + 0.2) (1 + 0.1) 5 (1 + 0.2) (1 + 0.1) (1 + 0.05) = + + (1 + 0.1) (1 + 0.1) (0.1 0.05) 1 = 5.454 + 5.454 + 114.55 = 125.45 (1 + 0.1) 6

Exercise: 12 Assume that the average firm in your company's industry is expected to grow at a constant rate of 6% and its dividend yield is 7%. Your company is about as risky as the average firm in the industry, but it has just successfully completed some R&D work that leads you to expect that its earnings and dividends will grow at a rate of 50% this year and 25% the following year, after which growth should match the 6% industry average rate. The last dividend paid was $1. What is the value per share of your firm's stock? D0 = $1, rS = 7% + 6% = 13%, g1 = 50%, g2 = 25%, gn = 6%

2. Stock valuation by the free cash-flow approach = ( + )

FCF = the cash flow available for distribution to all of the firm's investors, not just the shareholders WACC = the average rate of return required by all of the firm's investors, not just shareholders. V = the value of the entire firm's operations Example: Suppose a firm had a free cash flow of $200 million at the end of the most recent year. Let's assume that the firm's FCFs are expected to grow at a constant rate of 5% per year forever. Let's assume that the firm's WACC is 9%. (1 + ) 200 (1.05) = = = $5.250 million 0.09 0.05 If the firm had any non-operating assets, such us short-term investments, we would add them to V to find the total value.

This company has no non-operating assets. If the value of debt and preferred stock equals $2.000 million, then the firm's equity has value of $5.250-$2.000 = $3.250 million. If 325 million shares of stock are outstanding, then the intrinsic value $3.250/325 = $10 per share.

3. Market multiple analyses This method of stock valuation applies a market-determined multiply to net income, earnings per share (EPS), sales, and book value or, for business such as cable TV or cellular telephone systems, the number of subscribers. = ( 1)

Market multiple shows how much investor is willing to pay per unit of earnings meaning how many times the stock price is higher than the earnings per share.

Preferred stock valuation

Preferred stock is a hybrid it is similar to bonds in some respects and to common stock in others. It has a par value and a fixed amount of dividends that must be paid before dividends can be paid on the common stock. Although, preferred stock has a fixed payment like bonds, a failure to make this payment will not lead to bankruptcy. =

= the value of the preferred stock =the preferred dividend = required rate of return = expected rate of return

Example: (Tool Kit 5.10.) A preferred stock has an annual dividend of $5. The required return is 8 percent. What is the Vps? Dps=$5.00 Rps=8% = 5 = 62.50 0.08

Exercise: 13 Nick's Incorporated has a preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred stock sells for $50 a share. What is the preferred stock's required rate of return?

Exercise: 14 What will be the nominal rate of return on a preferred stock with a $100 par value, a stated dividend of 8% of par and a current market price of: a) $60 b) $80 c) $100 d) $140 Exercise: 15 Rolen Ridders issued preferred stock with a stated dividend of 10% of par. Preferred stock of this type currently yields 8% and the par value is $100. Assume dividends are paid annually: a) what is the value of Rolen's preferred stock? b) suppose interest rate levels rise to the point where the preferred stock now yields 12%,What would be the value of Rolen's preferred stock?