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Stock Valuation
1. 2. 3. 4. 5. Objectives for this session : Introduce the dividend discount model (DDM) Understand the sources of dividend growth Analyse growth opportunities Examine why Price-Earnings ratios vary across firms Introduce free cash flow model (FCFM)
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div1 P 1 P0 1 r
Back to example. Assume r = 10%
2 50 P0 47.27 1 0.10
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P1
div2 P2 1 r
P0
div1 div2 P2 1 r (1 r ) 2 (1 r ) 2
P0
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Forecasting dividends up to infinity is not an easy task. So, in practice, simplified versions of this general formula are used. One widely used formula is the Gordon Growth Model base on the assumption that dividends grow at a constant rate. DDM with constant growth g Note: g < r
div1 P0 rg
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6
7 8 9 10
7.30
7.59 7.90 8.21 8.54
0.5645
0.5132 0.4665 0.4241 0.3855
126.53
131.59 136.86 142.33 148.02
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Differential growth
Suppose that r = 10% You have the following data:
Year Dividend Growth rate 1 2 2 2.40 20% 3 2.88 20% 4 to 3.02 5%
P0
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A formula for g
Dividend are paid out of earnings: Dividend = Earnings Payout ratio Payout ratios of dividend paying companies tend to be stable. Growth rate of dividend g = Growth rate of earnings Earnings increase because companies invest. Net investment = Retained earnings Growth rate of earnings is a function of: Retention ratio = 1 Payout ratio Return on Retained Earnings
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Example
Data: Expected earnings per share year 1: EPS1 = 10 Payout ratio : 60% Required rate of return r : 10% Return on Retained Earnings RORE: 15% Valuation: Expected dividend per share next year: div1 = 10 60% = 6 Retention Ratio = 1 60% = 40% Growth rate of dividend g = (40%) (15%) = 6% Current stock price: P0 = 6 / (0.10 0.06) = 150
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1,000.00 1,000.00
1,160.00 1,160.00
1,336.00 1,336.00
1,526.08 1,526.08
1,526.08 1,526.08
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Why is A more valuable than B or C? Why do B and C have same value in spite of different investment policies
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NPVGO
Cy C is a cash cow company Earnings = Dividend (Payout = 1) No net investment Cy B does not create value Dividend < Earnings, Payout <1, Net investment >0 But: Return on Retained Earnings = Cost of capital NPV of net investment = 0 Cy A is a growth stock Return on Retained Earnings > Cost of capital Net investment creates value (NPV>0) Net Present Value of Growth Opportunities (NPVGO) NPVGO = P0 EPS1/r = 150 100 = 50
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Source of NPVG0 ?
Additional value if the firm retains earnings in order to fund new projects
P0 EPS PV ( NPV1 ) PV ( NPV2 ) PV ( NPV3 ) ... r
where PV(NPVt) represent the present value at time 0 of the net present value (calculated at time t) of a future investment at time t
In previous example: Year 1: EPS1 = 10 div1 = 6 Net investment = 4 EPS = 4 * 15% = 0.60 (a permanent increase) NPV1 = -4 + 0.60/0.10 = +2 (in year 1) PV(NPV1) = 2/1.10 = 1.82
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NPVGO: details
P0 PV g = 0 NPVGO 150.00 100.00 50.00 Y1 to Y25 Y26 to 50 Y51 to 75 Y76 to 100 EPSt 10.00 10.60 11.24 11.91 12.62 13.38 14.19 15.04 15.94 16.89 17.91 18.98 20.12 21.33 22.61 23.97 25.40 26.93 28.54 30.26 Net Inv. 4.00 4.24 4.49 4.76 5.05 5.35 5.67 6.01 6.38 6.76 7.16 7.59 8.05 8.53 9.04 9.59 10.16 10.77 11.42 12.10 30.19 11.96 4.74 1.88 EPS 0.60 0.64 0.67 0.71 0.76 0.80 0.85 0.90 0.96 1.01 1.07 1.14 1.21 1.28 1.36 1.44 1.52 1.62 1.71 1.82 NPV 2.00 2.12 2.25 2.38 2.52 2.68 2.84 3.01 3.19 3.38 3.58 3.80 4.02 4.27 4.52 4.79 5.08 5.39 5.71 6.05 PV(NPV) 1.82 1.75 1.69 1.63 1.57 1.51 1.46 1.40 1.35 1.30 1.26 1.21 1.17 1.12 1.08 1.04 1.01 0.97 0.93 0.90
Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
EPS1 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00
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