FIN 351: lecture 4

Stock and Its Valuation

The application of the
present value concept

Todays agenda
Review what we have learned in the
last lecture
Stock and its valuation
Some terminology about a stock
Value a stock
Simple dividend discount model
Dividend growth model

What have we learned in the
last lecture
Bond?
How to value a bond?
Yield to maturity and spot rates?
Term structure of interest rates and yield
curve?


Some questions
A bond that pays annual coupon is
issued with a coupon rate of 4%,
maturity of 30 years, and a yield to
maturity of 7%, what will be the rate of
return if you buy it now and hold it for
one year and the yield to maturity in the
next year will be 8%?
What is a stock?
A (common) stock is a financial claim
that has the following properties:
A right to receive dividends after creditors
have been paid
A right to vote at the annual meeting
A limited liability security
Dividends are periodic cash flows to
share holders
Stocks & Stock Market
Primary Market - Place where the sale of new
stock first occurs.
Secondary market - market in which already
issued securities are traded by investors.
P/E ratio - Price per share divided by earnings
per share.
Dividend yield- Dividends per share divided by
the stock price

Values of stocks
Book Value of a stock- the value according
to the balance sheet in the accounting.
Market Value of a stock the value
according to the traded stock prices in
the market.
Stock valuation
When you want to invest in a stock, you are
very interested in whether the stock is under-
priced or over-priced. To find out, you need to
value the stock
Two simple approaches to price a stock
Simple dividend discount model
Dividend growth model
We will apply these two approaches to real
stocks, for example, IBM
Simple dividend discount model:
valuing IBM
We will first use the dividend discount model to value
the International Business Machine.
What does the company do?
http://finance.yahoo.com/
Symbol IBM
Trades on the NYSE
We see price is recently $180
hit detailed
we see the company is paying $3 dividend per share (we
will do an annualized problem for simplicity, here we
assume that all the earnings are paid out as dividends)

Valuing IBM (continue)
Lets suppose IBM is going to continue paying $3
dividend per share, forever
We are planning to buy the stock and hold it forever
Of course, we must be able to draw the cash flow
diagram



PV
???
$3 $3 $3 $3 $3 $3
Yr1 Yr2 Yr3 Yr4 Yr5 Time=infinity
Valuing IBM (continue)
How much is IBM worth?
Suppose the required rate of return by the
investor is 10%.

The present value of future dividend
cash flows should equal the price of IBM.

30 $
1 . 0
3
1
= = =
r
C
PV
Valuing IBM (3)
Clearly, the price calculated using this
simple model is below the current market
price
Why?
we have undervalued the stock
the market has overvalued the stock
Lets be humble and assume the former
where did we go wrong?

Valuing IBM (4)
Sensitivity of our answer to discount
rate:




Clearly, this is still not the answer
Discount rate
Price
7%
8%
9%
11%
$42.9
$37.5
$33.3
$27.27
Valuing IBM (5)
What if the dividend is not constant ?
Suppose the dividend were to grow at 4% per
year:
the next dividend will be $3
in two years we will receive $3.12
and so on
Can we derive the formula for a growing
perpetuity?
define g 4% the growth rate
define C 3 the dividend received in year one

Dividend growth model
When dividends grow at a rate of
g=4%, the cash flow diagram looks like
as follows:



PV
???
Yr1 Yr2 Yr3 Yr4 Yr5 Time=infinity
$3.0
$3*(1.04)

$3.12 $3.37 $3.24
Dividend growth model (2)
Based on the diagram, we have the
math equation:

+
+
+ +
+
+
+
+
+
+
+
=
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1
3
2
2
r
g C
r
g C
r
g C
r
C
PV
Dividend growth (continue)
To calculate the PV of dividend flows with a growth,
we can have some math exercise as follows:








g r
r
r
g
S
S S S
S
r g
r
g
i
i

+
=
+
+

=
o
=
= o + o + + o + o = o
o = o + + o + o + =
< <
+
+
= o

1
1
1
1
1
1
1
1 ;
1
, 1
1
1
2
0
2

because
Dividend growth (continue)
How to calculate dividend perpetuity with a growth:








g r
C
g r
r
r
C
S
r
C
r
C
r
g
r
C
r
g
r
g
r
C
r
g C
r
g C
r
C
PV
i
i
i
i

+
=
+
= o
+
=
|
.
|

\
|
+
+
+
=
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.
|

\
|
+
+
+ +
+
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=
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=


=

1
1
1 1 1
1
1
) 1 (
) 1 (
1
1
1
1
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
0 0
2 1

Dividend growth model (5)

Do you think that this formula makes sense ?


When g increases, what will happen to the
stock price?
When r increases, what will happen to the
stock price?
When g =0, what happens?
When g>r, what will happen to the stock price?
In order to use the formula, r must be greater than g.

g r
C
PV

=
Back to the valuation of IBM
Sensitivity of our answer to growth rate of dividends
Next years dividend is still $3.0
Discount rate is constant at 10%





Certainly, we are close,
but g=5% is reasonable?

Growth rate
Stock price
1%
2%
3%
4%
5%
$33.3
$37.5
$50.0
$60.0
$75.0



Sensitivity analysis with respect
to discount and growth rates
Discount rate
Dividend
Growth rate
1%
2%
3%
4%
5%
5.5%
6% 7% 8% 9% 10% 11% 12%
60
75
75 100
60 50 43 38 33 30
27 30 33 38 43 50
300
150
600
100
200
150
60
50
75
100
120
43
50
43
43
38
55
33
38
46
60
67
86
75
60 50
Stock price
Another way of looking at stock
valuation
Suppose stock A pays dividend of $3 every year,
with a discount rate of 10%. What is the stock price
now in the following three cases
(a) hold it for ever
(b) hold for five years
(c) hold it for twenty years


Another example
Suppose stock A pays dividend of $3 next year, with
a constant dividend growth rate of 5% and a
discount rate of 10%. What is the stock price now in
the following three cases
(a) hold it for ever
(b) hold for one year
(c) hold it for two years


More on the dividend discount
model
So far, we have used the dividend cash
flows to calculate the stock price.
In the real world, can we apply this
formula to figure out the stock prices for
all the stocks? How?
How to decide on the growth
rate
If a firm chooses to pay a lower
dividend, and reinvest the funds, the
stock price may increase because
future dividends may be higher.
Payout Ratio - Fraction of earnings paid
out as dividends
Plowback Ratio - Fraction of earnings
retained by the firm.
More on the dividend growth
Growth can be calculated by the return
on equity times the plowback ratio

Let g= the dividend growth rate

g = return on equity X plowback ratio
Example
Our company forecasts to pay a
$5.00 dividend next year, which
represents 100% of its earnings.
This will provide investors with a
12% expected return. Instead, we
decide to plow back 40% of the
earnings at the firms current return
on equity of 20%. What is the
value of the stock before and after
the plowback decision?
Solution
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors
with a 12% expected return. Instead, we decide to plow back
40% of the earnings at the firms current return on equity of
20%. What is the value of the stock before and after the
plowback decision?
P
0
5
12
67 = =
.
$41.
No Growth With Growth
Solution
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors
with a 12% expected return. Instead, we decide to plow back
40% of the earnings at the firms current return on equity of
20%. What is the value of the stock before and after the
plowback decision?
P
0
5
12
67 = =
.
$41.
No Growth
With Growth
g
P
= =
=

=
. . .
. .
$75.
20 40 08
3
12 08
00
0
The present value of growth
opportunities
If the company did not plowback some
earnings, the stock price would remain at
$41.67. With the plowback, the price rose to
$75.00.

The difference between these two numbers
(75.00-41.67=33.33) is called the Present
Value of Growth Opportunities (PVGO).
PVGO again
Present Value of Growth Opportunities
(PVGO) - Net present value of a firms
future investments.

Valuing Common Stocks
Expected rate of return - The percentage yield
that an investor forecasts from a specific
investment over a set period of time.
Sometimes called the holding period return
(HPR).
Expected return
Expected Return the ratio of the profit over the
initial cost



Here, P1 is the expected price in period 1, P0 is
the current price and Div1 is the expected
dividend payment in period 1.
Expected Return = =
+
r
Div P P
P
1 1 0
0
An example
Example: A stock pays dividend of $3
every year. The current stock price is
$100. The expected price is $110 for the
next year. If you hold the stock this year,
what is the expected rate of return?

My solution
The expected return is 13/100=13%
P0=$100
P1=$110
Div=$3
Another example
Imagine Corporation has just paid a
dividend of $0.40 per share. The
dividends are expected to grow at 30%
per year for the next two years and at
5% per year thereafter. If the required
rate of return in the stock is 15%,
calculate the current stock price.
Solution
Answer:
First: visualize the cash flow pattern;
C1, C2 and P2
Then, you know what to do?
P
0
= [(0.4 *1.3)/1.15] + [(0.4 *
1.3^2)/(1.15^2)] +
[(0.4 * 1.3^2*1.05)/((1.15^2 * (.15 -.05))]
= $6.33