Fundamental of Corporate Finance, chpt8

1
Chapter 8
Stock Valuation
Prepared and Taught by Lecturer : YIN SOKHNG
E-mail: yin_sokheng@yahoo.com
Tel: (855) 16889872 / 17989972
2 Instructed by YIN SOKHENG, Master in Finance
Chapter Outline
8.1 Common Stock Valuation
8.2 The Present Value of Common Stock
8.3 Estimates of Parameters in the Dividend-
Discount Model
8.4 Growth Opportunities
8.5 The Dividend Growth Model and the
NPVGO Model (Advanced)
8.6 Price Earnings Ratio
8.7 The Stock Markets
3
Valuation of Bonds and Stock
First Principles:
Value of financial securities = PV of expected future
cash flows
To value bonds and stocks we need to:
Estimate future cash flows:
Size (how much) and
Timing (when)
Discount future cash flows at an appropriate rate:
The rate should be appropriate to the risk presented by the
security.
Instructed by YIN SOKHENG, Master in Finance
2
4
Cash Flows to Stockholders
If you buy a share of stock, you can receive cash
in two ways
The company pays dividends
You sell your shares, either to another investor in the
market or back to the company
As with bonds, the price of the stock is the
present value of these expected cash flows
5
Common stock valuation for one period
P
0
= D
1
/(1 + r) + P
1
/(1 + r)
P
0
= Value of stock at time 0
P
1
= Price of stock at the end of the period
D
1
= Dividend at the end of the period
8.1 Common stock valuation
6
One Period Example
Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. and you expect it to pay a $2 dividend
in one year and you believe that you can sell the stock
for $14 at that time. If you require a return of 20% on
investments of this risk, what is the maximum you
would be willing to pay?
P
0
= D
1
/(1 + r) + P
1
/(1 + r)
P
0
= 2/(1.2) + 14/(1.2) = $13.33
3
7
Common stock valuation for two period
P
0
= D
1
/(1 + r) + D
2
/(1 + r)
t
+P
2
/(1 + r)
t
Now what if you decide to hold the stock for two
years? In addition to the dividend in one year,
you expect a dividend of $2.10 in and a stock
price of $14.70 at the end of year 2. Now how
much would you be willing to pay?
P
0
= 2/(1.2) + 2.1/(1.2)
2
+14.7/(1.2)
2
= $13.33
8
Three Period Example
Finally, what if you decide to hold the stock for three
periods? In addition to the dividends at the end of years
1 and 2, you expect to receive a dividend of $2.205 at
the end of year 3 and a stock price of $15.435. Now
how much would you be willing to pay?
PV = 2 / 1.2 + 2.10 / (1.2)
2
+ (2.205 + 15.435) / (1.2)
3
=
13.33
Or CF
0
= 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03
= 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33
9
Three Period Example
Finally, what if you decide to hold the stock for
three periods? In addition to the dividends at the
end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and a
stock price of $15.435. Now how much would
you be willing to pay?
P
0
= 2 / 1.2 + 2.10 / (1.2)
2
+ 2.205/ (1.2)
3
+ 15.435 /(1.2)
3
= $13.33
4
10
Multiple-Period Dividend Valuation Model
P
0
= D
1
/(1+R) + D
2
/(1+R)
2
+ D
3
/(1+R)
3
+..or
P
0
= D
1
/(1+R) + D
2
/(1+R)
2
+.+ D
n
/(1+R)
n
Suppose that the investor is considering purchasing a share of this stock
and holding it for 5 years. Assume that the investor's required rate of
return is still 14 %. Dividends from the stock are expected to be $1 in the
first year, $1 in the second year, $1 in the third year, $1.25 in the fourth
year, and $1.25 in the fifth year. The expected selling price of the stock at
the end of 5 years is $41.
P
0
= 1/ (1 + 0.14) + 1/ (1 + 0.14)
2
+ 1/ (1 + 0.14)
3
+ 1.25/ (1 + 0.14)
4
+
1.25/ (1 + 0.14)
5
+ 41/ (1 + 0.14)
5
P
0
= $24.99 or 25
11
8.2 The Present Value
of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth
12
Estimating Dividends: Special Cases
Zero growth /Constant dividend
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
Constant dividend growth
The firm will increase the dividend by a constant percent
every period
Differential /Supernormal growth
Dividend growth is not consistent initially, but settles
down to constant growth eventually
5
13
Case 1: Zero Growth
Assume that dividends will remain at the same level
forever
r r r
P
) 1 (
Div
) 1 (
Div
) 1 (
Div
3
3
2
2
1
1
0
+
+
+
+
+
+
=
L
L
= = =
3 2 1
Div Div Div
Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:
Suppose stock is expected to pay a $0.50 dividend
every quarter and the required return is 10% with
quarterly compounding. What is the price?
P
0
= .50 / (.1 / 4) = $20
r
Div
=
14
Case 2: Constant Growth
) 1 ( Div Div
0 1
g
+ =
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present
value of a growing perpetuity:
Assume that dividends will grow at a constant rate, g,
forever. i.e.
2
0 1 2
) 1 ( Div ) 1 ( Div Div g g
+ = + =
.
.
3
0 2 3
) 1 ( Div ) 1 ( Div Div g g
+ = + =
.
g - r
Div
g - r
g) 1 ( Div
P
1 0
0
=
+
=
15
CGDM Example 1
Suppose Big D, Inc. just paid a dividend of $.50.
It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on
assets of this risk, how much should the stock be
selling for?
P
0
= .50(1+.02) / (.15 - .02) = $3.92
6
16
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.
To value a Differential Growth Stock, 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.
17
) (1 Div Div
1 0 1
g
+ =
Assume that dividends will grow at rate g
1
for N
years and grow at rate g
2
thereafter
2
1 0 1 1 2
) (1 Div ) (1 Div Div g g
+ = + =
N
N N
g g ) (1 Div ) (1 Div Div
1 0 1 1
+ = + =
-
) (1 ) (1 Div ) (1 Div Div
2 1 0 2 1
g g g
N
N N
+ + = + =
+
18
Dividends will grow at rate g
1
for N years and grow at
rate g
2
thereafter
) (1 Div
1 0
g
+
2
1 0
) (1 Div g
+
0 1 2
N
g ) (1 Div
1 0
+
) (1 ) (1 Div
) (1 Div
2 1 0
2
g g
g
N
N
+ + =
+
N N+1

7
19
To value a Differential Growth Stock, we can use
Or we can cash flow it out.
N T
T
r
g r
r
g
g r
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 N
1
1
+
\
|
+
(
+
+
=
+
\

20
A Differential Growth Example
A common stock just paid a dividend of $2.
The dividend is expected to grow at 8% for 3
years, then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is
12%.
21
With the Formula
N T
T
r
g r
r
g
g r
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 N
1
1
+
.
|
\
|
+
(
+
+
=
+
3
3
3
3
) 12 . 1 (
04 . 12 .
) 04 . 1 ( ) 08 . 1 ( 2 $
) 12 . 1 (
) 08 . 1 (
1
08 . 12 .
) 08 . 1 ( 2 $ .
|
\
|
+
(
x
=
P
| |
( )
3
) 12 . 1 (
75 . 32 $
8966 . 1 54 $
+ x =
P
31 . 23 $ 58 . 5 $
+ =
P 89 . 28 $
=
P

8
22
A Differential Growth Example (continued)
08) . 2(1 $
2
08) . 2(1 $
0 1 2 3 4
3
08) . 2(1 $ ) 04 . 1 ( 08) . 2(1 $
3
16 . 2 $ 33 . 2 $
08 .
62 . 2 $
52 . 2
+
89 . 28 $
) 12 . 1 (
75 . 32 $ 52 . 2 $
) 12 . 1 (
33 . 2 $
12 . 1
16 . 2 $
3 2 0
=
+
+ + =
P
75 . 32 $
08 .
62 . 2 $
3
= = P
The constant
growth phase
beginning in year 4
can be valued as a
growing perpetuity
at time 3.
$
23
Supernormal Growth Problem Statement
Suppose a firm is expected to increase
dividends by 20% in one year and by 15% in
two years. After that dividends will increase at
a rate of 5% per year indefinitely. If the last
dividend was $1 and the required return is
20%, what is the price of the stock?
Remember that we have to find the PV of all
expected future dividends.
24
Supernormal Growth Example Solution
Compute the dividends until growth levels off
D
1
= 1(1.2) = $1.20
D
2
= 1.20(1.15) = $1.38
D
3
= 1.38(1.05) = $1.449
Find the expected future price
P
2
= D
3
/ (R g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future
cash flows
P
0
= 1.20 / (1.2) + 1.38/ (1.2)
2
+ 9.66/ (1.2)
2
= $8.67
9
25
Using the DGM to Find R
Start with the DGM:
g
P
D
g
P
g) 1 ( D
R
R for solve and rearrange
g - R
D
g - R
g) 1 ( D
P
0
1
0
0
1 0
0
+ = +
+
=
=
+
=
26
Finding the Required Return - Example
Suppose a firms stock is selling for $10.50.
They just paid a $1 dividend and dividends are
expected to grow at 5% per year. What is the
required return?
R = [1(1.05)/10.50] + .05 = 15%
What is the dividend yield?
1(1.05) / 10.50 = 10%
What is the capital gains yield?
g =5%
27
8.3 Estimates of Parameters in the
Dividend-Discount Model
The value of a firm depends upon its growth
rate, g, and its discount rate, r.
Where does g come from?
Where does r come from?
Where does g come from?
g = Retention ratio Return on retained earnings
10
28
Where does r come from?
The discount rate can be broken into two
parts.
The dividend yield
The growth rate (in dividends)
In practice, there is a great deal of estimation
error involved in estimating r.
29
8.4 Growth Opportunities
Growth opportunities are opportunities to
invest in positive NPV projects.
The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100-percent of its earnings as dividends and
the net present value of the growth
opportunities.
NPVGO
r
EPS
P
+ =
30
8.5 The Dividend Growth Model and the
NPVGO Model (Advanced)
We have two ways to value a stock:
The dividend discount model.
The price of a share of stock can be calculated as
the sum of its price as a cash cow plus the per-
share value of its growth opportunities.
11
31
Consider a firm that has EPS of $5 at the end of the
first year, a dividend-payout ratio of 30%, a discount
rate of 16-percent, and a return on retained earnings of
20-percent.
The dividend at year one will be $5 .30 = $1.50 per
share.
The retention ratio is .70 ( = 1 -.30) implying a growth
rate in dividends of 14% = .70 20%
From the dividend growth model, the price of a share is:
75 $
14 . 16 .
50 . 1 $ Div
1
0
=
=
g r
P
32
The NPVGO Model
First, we must calculate the value of the firm as a
cash cow.
25 . 31 $
16 .
5 $ Div
1
0
= = =
r
P
Second, we must calculate the value of the growth
opportunities.
Finally,
75 $ 75 . 43 25 . 31
0
= + =
P
75 . 43 $
14 . 16 .
875 $. 16 .
20 . 50 . 3
50 . 3
0
=
x
+
=
g r
P
33
8.6 Price Earnings Ratio
Many analysts frequently relate earnings per share to
price.
The price earnings ratio is a.k.a. the multiple
Calculated as current stock price divided by annual EPS
The Wall Street Journal uses last 4 quarters earnings
EPS
share per Price
ratio P/E
=
12
34
Other Price Ratio Analysis
Many analysts frequently relate earnings per
share to variables other than price, e.g.:
Price/Cash Flow Ratio
cash flow = net income + depreciation = cash flow
from operations or operating cash flow
Price/Sales
current stock price divided by annual sales per share
Price/Book (a.k.a. Market to Book Ratio)
price divided by book value of equity, which is
measured as assets liabilities
35
8.7 Stock Market Reporting
52 WEEKS YLD VOL NET
HI LO STOCKSYM DIV % PE 100s HI LOCLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap has
been as
high as
$52.75 in
the last
year.
Gap has been
as low as
$19.06 in the
last year.
Given the current
price, the PE ratio
is 15 times earnings
6,517,200 shares
traded hands in the
last days trading
Gap ended trading
at $19.25, down
$1.75 from
yesterdays close
Gap pays a
dividend of 9
cents/share
Given the
current price,
the dividend
yield is %
36
Stock Market Reporting
52 WEEKS YLD VOL NET
HI LO STOCKSYM DIV % PE 100s HI LOCLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap Incorporated is having a tough year, trading near their 52-
week low. Imagine how you would feel if within the past year you
had paid $52.75 for a share of Gap and now had a share worth
$19.25! That 9-cent dividend wouldnt go very far in making
amends.
Yesterday, Gap had another rough day in a rough year. Gap
opened the day down beginning trading at $20.50, which was
down from the previous close of $21.00 = $19.25 + $1.75
Looks like cargo pants arent the only things on sale at Gap.

Fundamental of Corporate Finance, chpt8

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Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

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