FINA2303 Topic 05 Stock Valuation

Topic 5: Stock Valuation
Learning Outcomes
stock
basics
mechanics of stock trades
dividend discount model and its limitations
share repurchases and total payout model
valuation based on comparable firms (extra)
security analysis in finance industry (extra)
Topic 5 Stock Valuation
M K Lai
Page 2
Stock Basics
a
stock in a company represents ownership of

financial claim on the company and the investor
is called a stockholder/shareholder
a stockholder is said to have an ownership
interest in the company, consistent with the
percentage of outstanding shares held
types: common stock and preferred stock
the total return in equity investment
1.
2.
M K Lai
Page 3
Stock Basics
source: HKEx
source: HKEx
M K Lai
Page 4
Preferred Stock Basics

stated
(par) value: value stated in the preferred

stock certificate, e.g. stated value of $10
fixed preferred dividends: expressed in terms of
dollars per share, e.g. $0.5 per share (dividend
yield of $0.5/$10 = 5% of the stated value)
at discretion of board of directors
priority over common stockholders in terms of
1.
2.
M K Lai
Page 5
Preferred Stock Basics

special
features
cumulative
vs. non-cumulative (what is it?)
participating
redeemable
convertible
vs. non-participating (what is it?)

vs. non-redeemable (what is it?)
vs. non-convertible (what is it?)

M K Lai
Page 6
Preferred Stock Certificate
M K Lai
Page 7
Preferred Stock Quote

source: aastocks
M K Lai
Page 8
Preferred Stock Valuation

cash
flows to preferred stockholders

fixed preferred dividends per year (Divpfd)
if the firm does not go broke, the dividend
stream lasts forever (a non-growing perpetuity)
discount
rate = cost of capital of preferred stock

rpfd, reflecting the risk of the preferred stock
Div pfd
preferred stock price =
rpfd
M K Lai
Page 9
Example: Preferred Stock Valuation

A
preferred stock provides an annual dividend of

$10 per share. The cost of capital of preferred
stock is 10%. What is the preferred stock price?
$10
preferred stock price =
= $100
10%
M K Lai
Page 10
Common Stock Basics

right
to share common dividends depending on

operating performance of company on pro rata
basis
at discretion of board of directors
right to vote for resolutions in shareholders
meetings (usually on one-share-one-vote basis)
annual (general) meeting: meeting held once
per year to vote on directors and other
resolutions, and raise questions to
management (there are other shareholders
meetings)
M K Lai
Page 11
A shares and B shares in mainland China

nature of investors, only local in A shares, foreigner in B shares
A shares are traded and settled in Renminbi
B shares are traded and settled in a foreign currency (US dollar in Shanghai and HK dollar in Shenzhen)
Common Stock Basics
straight
voting: vote on each director

separately with as many votes and shares held
cumulative voting: votes equal to number of
directors times shares held and can be cast on
a single director (what is the advantage of it?)
classes of stocks: different types of stocks for
the same company, carrying different voting
rights, e.g. A and B shares in Hong Kong
proxy voting: a grant of authority by a
shareholder allowing another individual to vote
on his behalf
M K Lai
Page 12
Common Stock Basics

proxy
contest: competing groups to collect

proxies to prevail in a matter up for
shareholder votes, usually to take control over
the company by electing a majority of directors
to join the board
what is the percentage of ownership interest
to take control over a company?
residual claim on proceeds from sale of assets
upon liquidation (what is it?)
M K Lai
Page 13
A and B Shares in Hong Kong

source: HKEx
M K Lai
Page 14
Proxy Form
source: Sa Sa
M K Lai
Page 15
Common Stock Certificate
M K Lai
Page 16
Common Stock Valuation

valuation
models to determine fair value (target

price) of stock
dividend discount model: future cash flows are
future dividends
comparable firms method: use price multiples
(e.g. price-earnings ratio) from similar firms
investment recommendation (buy, hold or sell)
if stock price is higher than target price,
recommend to sell .
if stock price is lower than target price,
recommend to buy .
M K Lai
Page 17
Common Stock Quote

source: aastocks
M K Lai
Page 18
Company Research Report

source: ABCI securities
M K Lai
Page 19

source: Reuters
M K Lai
Page 20
Mechanics of Stock Trades

types
of order
market order: the order is executed
immediately at the most favorable market
price available
limit order: the order is executed when the
market price reaches an investors specified
for sell order
limit price or more favorable (
than the prevailing bid price
and
for buy order) higher
lower than the prevailing ask price
floor trader: a person with a trading right who
represents orders on the floor to execute on best
terms for investors
M K Lai
Page 21
floor trader in red

waistcoat
source: HKEx
M K Lai
Page 22

round/board
lot: shares are usually traded in a

board lot or a multiple of it, e.g. 400 shares for
HSBC lot size
odd lot: number of shares less than one board lot
usually an odd lot is traded at less favorable
price than a board lot
block trade: a large quantity of shares of the
same stock is traded in one transaction
M K Lai
Page 23
spread: difference between bid and ask
order-driven (HK)
Teletext Screen
M K Lai
Page 24
Dividend Discount Model

dividend
discount model: a model that values

shares of a company according to the present
value of future dividends the company will pay
cash flows to common stockholders
dividends per year until the end of investment
horizon (Divt)
selling price of stock at the end of investment
horizon (Pt)
discount rate = equity cost of capital or required
rate of return on common stock (rE), reflecting the
risk of the common stock
M K Lai
Page 25
One-Year Model
estimate
dividends (Div1), expected stock price

(P1) in year 1 (investment horizon = 1 year) and
equity cost of capital = rE
Div 1 + P1
P0 =
1 + rE
example:
Suppose that expected dividends = $1

and expected stock price = $100 in year 1. If
the required rate of return is 10%, what is the
current stock price?
$1 + $100
P0 =
= $91.82
1 + 10%
M K Lai
Page 26
One-Year Model
total
return = rE = expected dividend yield +

capital gain rate
dividend
yield: annual dividend of a stock

divided by current stock price (interim income)
capital
gain rate: capital gain as percentage

of current stock price where capital gain is
selling price minus purchase price (capital
gain/loss)
M K Lai
Page 27
One-Year Model
Div 1 P1 P0
rE =
+
P0
P0
total
return
expected
dividend
yield
M K Lai
capital
gain rate
Page 28
Multiple-Year Model
assume
hold the stock for N years and sell it at

PN (terminal value)
N
Div t
PN
P0 =
+
t
N
(1 + rE )
t =1 (1 + rE )
example:
A company is expected to pay a dividend

of $2 and $2.5 in the coming two years. It is
expected that the stock can be sold at $50 at the
end of year 2. If the required rate of return for the
stock is 15%, what is the current stock price?
$2
$2.5 + $50
P0 =
+
= $41.44
2
1 + 15% (1 + 15%)
M K Lai
Page 29
Infinite Year Model

assume
hold the stock forever or the company

has to pay annual dividend to some investors
and need to estimate future dividends only
not
applicable and further assumption has to be

made to make it tractable
Div t
P0 =
t
t =1 (1 + rE )
M K Lai
Page 30
Constant Growth Model

assume
dividends grow at a constant rate (g) (a

growing perpetuity) (equal to capital gain rate)
rE must be greater than g

better
to value large, mature companies with

well-established dividend policies
notice: if g = 0, P0 = Div1/rE (zero-growth model)
Div 1 Div 0 *(1 + g )

P0 =
=
rE g
rE g
M K Lai
Page 31
Example: Constant Growth Model

A
common stock will announce an annual

dividend of $2.5 in year 1. The dividends are
expected to have a sustainable growth rate of 3%.
The cost of common stock is 15%. What is the
current stock price?
$2.5
P0 =
= $20.83
15% 3%
M K Lai
Page 32
Required Rate of Return

use
the constant growth model to find the

required rate of return re
Div 1
rE =
+g
P0
expected
dividend yield
M K Lai
capital gain rate
Page 33
Dividends and Growth

dividend
payout rate/ratio: fraction of a firms

earnings that the firm pays out as dividends each
year
retention rate/ratio: fraction of a firms earnings
that the firm retains, in principle, for
reinvestment and growth (retention rate = 1
dividend payout rate)
earnings t
Div t =
* dividend payout rate t
shares outstanding t
Div t = EPS t * dividend payout rate t
M K Lai
Page 34

a
M K Lai
Page 35
tradeoff between them
firm can increase its dividends by

increasing its earnings
change in earnings = new
investment*return on new investment
new investment = earnings * retention rate
earnings growth rate (g) = change in
earnings/earnings = retention rate * return
on new investment
increasing its dividend payout rate
decreasing the number of shares outstanding

earnings
= dividends + retained profits
if
return on new investment is higher than cost of

equity (rE,), share price increases by
dividends
and
retained profits
if
return on new investment is lower than cost of

equity (rE,), share price increases by
dividends
and
retained profits
M K Lai
Page 36
Example: Dividends and Growth

The
current stock price of a company is $60. It is

expected that the assets-in-place can generate an
expected earnings per share of $6 next year. The
company can choose to have 100% dividend
payout rate or 50% retention rate for new
investment given that the risk level of the
company does not change. Calculate the new
stock price if the return on new investment is (a)
12%; and (b) 8%.
M K Lai
Page 37

(a)
return on new investment = 12%

(i) 100% dividend payout rate
g = 0%*12% = 0%
rE = $6/$60 + 0% = 10%
P0 = $6/(10%-0%) = $60
(ii) 50% retention rate
g = 50%*12% = 6%
rE = 10% (assumed no change in risk level)
P0 = $3/(10%-6%) = $75 (higher stock price)
M K Lai
Page 38

(b)
return on new investment = 8%

(i) 100% dividend payout rate
g = 0%*8% = 0%
rE = $6/$60 + 0% = 10%
P0 = $6/(10%-0%) = $60
(ii) 50% retention rate
g = 50%*8% = 4%
rE = 10% (assumed no change in risk level)
P0 = $3/(10%-4%) = $50 (lower stock price)
M K Lai
Page 39
Changing Growth Rates

a
company may undergo different life stages

with different growth rates
assume it will stabilize at a constant growth rate
g after N years
N
Div t
Div N+1
P0 =
+
t
(rE g )
t =1 (1 + rE )
= PN = terminal
value in year N
M K Lai
Page 40
Changing Growth Rates

cut-off point where growth rate
is stabilized at the normal rate
year 0
cash
flows
Div1
Div2
N-1
DivN-1 DivN DivN+1 DivN+2
dividends based on
different growth rates
PN
use constant growth model

to find present value of all
dividends at year N (PN)
from year N+1 onwards
M K Lai
Page 41
Example: Changing Growth Rates

Suppose that there is a high-tech company with

dividends growing at a supernormal rate of 50%
for 2 years. After that, other competitors will
enter the market and the company will grow at a
stabilized rate of 5%. If Div0 = $1 and rE = 10%,
what is the current stock price?
M K Lai
Page 42
Example: Changing Growth Rates

D1 = $1 * (1 + 50%) = $1.5
D2 = $1 * (1 + 50%)2 = $2.25
$2.25* (1 + 5%)
P2 =
= $47.25
10% 5%
$1.5
$2.25
$47.25
P0 =
+
+
= $42.27
2
2
1 + 10% (1 + 10%) (1 + 10%)
M K Lai
Page 43
Limitations of Dividend Discount Model

uncertain
dividend forecasts (result is highly

sensitive to inputs)
not
applicable to non-dividend paying stocks
M K Lai
Page 44
Share Repurchases and Total Payout

Model
share
repurchase: a transaction in which a firm

uses excess cash to buy back its own stock (in US,
it is optional for the company to cancel the
shares; in HK, the company must cancel the
shares)
net assets
.
number of shares outstanding
.
effect is similar to dividend payout
the effect on stock price is uncertain
depending on the difference between the
repurchase price and the fair value of the stock
M K Lai
Page 45
Share Repurchases and Total Payout

Model
in
US, there is an increasing number of firms

using stock repurchases to replace dividend
payout, but not in Hong Kong (why?)
total
payout model: a method that values shares

of a firm by discounting firms total payouts to
equity holders (cash dividends + net stock
repurchases), and then dividing by the number of
shares outstanding
M K Lai
Page 46
Example: Total Payout Model

A
company has 200 million shares outstanding

and expects earnings of $750 million at the end
of the year. It plans to pay out 30% of its
earnings as dividends and 20% for stock
repurchases. The growth rate of earnings is
expected to be 6.67% per year given that the
total payouts remain constant. If the equity cost
of capital is 12%, calculate the current stock
price.
M K Lai
Page 47
Example: Total Payout Model

$750 million * 50%
= $7,035.65 million
PV =
12% 6.67%
$7,035.65 million
= $35.18
P0 =
200 million
M K Lai
Page 48
Summary of DCF Models
DCF model
present value
determine
of
dividend
discount
model
dividends
total payout
model
dividends
and share
repurchases
to get stock
price by
estimating
stock price no adjustment

equity
value
M K Lai
divide by shares
outstanding
Page 49
Valuation Based on Comparable Firms

valuation/price
multiple: a ratio of a firms value

to some measure of the firms scale or cash flow
price-earnings (P/E) ratio = stock
price/earnings per share
price-to-book value or market-to-book value
ratio = stock price/book value of equity share
price-to-sales ratio = stock price/sales per
share
price-to-cash flow ratio = stock price/cash flow
from operating activities per share
M K Lai
Page 50
Valuation Based on Comparable Firms

method
of comparables: an estimate of the value

of a firm based on the value of other comparable
firms or other investments that are expected to
generate very similar cash flows in the future;
also known as relative valuation method
similar firms should have similar price
multiple
estimate average price multiple from similar
firms
e.g. stock value of subject firm = average
price-earnings ratio * earnings per share of
subject firm
M K Lai
Page 51
Price-Earnings Ratio
trailing
(historical) earnings: a firms earnings

over the prior 12 months
forward (prospective) earnings: a firms expected
earnings over the coming 12 months
trailing P/E ratio: a firms price-earnings ratio
calculated using trailing earnings
forward P/E ratio: a firms price-earnings ratio
calculated using forward earnings
which is more important to an investor?
M K Lai
Page 52
Price-Earnings Ratio
P/E
ratio has same limitations as dividend

discount model because it relates exclusively to
equity
M K Lai
Page 53
Example 1: Price-Earnings Ratio
source: quamnet
price
multiples
M K Lai
Page 54

trailing EPS
forward EPS (market consensus what is it?)
source: etnet
M K Lai
Page 55

Sa
Sa stock price = $2.81
trailing
P/E ratio = $2.81/0.295 = 9.53
forward
P/E ratio = $2.81/0.27 = 10.41
M K Lai
Page 56

A
company has earnings per share of $2.17. The

average P/E ratio of comparable firms is 18.63.
Determine the stock value of the company.
stock
value = $2.17*18.63 = $40.43
M K Lai
Page 57
Security Analysis in Finance Industry:

Fundamental Analysis
fundamental
analysis: identify fundamental

factors to derive securitys fair value (target price)
and compare it with current security price to
make investment recommendation (give some
examples of fundamental factors)
macroeconomic factors: changes in GDP,
inflation rate, interest rate
industry-specific factors: change in demand for
products and services in industry, government
industrial policy
M K Lai
Page 58

Fundamental Analysis
company-specific
factors: quality of
management, labor-employer relations, debt
ratio
analytical method includes financial
statement analysis
M K Lai
Page 59

Economic Report
M K Lai
Page 60

Industry Report
M K Lai
Page 61

investment
recommendation
fair value estimated

through valuation models
M K Lai
Page 62

Technical Analysis
technical
analysis: use market information

(historical stock prices and trading volume data
to reflect market sentiment and psychological
factors) to identify security price patterns and
predict future price trend (trading signals to buy
or sell)
technical
indicators: moving average
charting:
bull-bear line
M K Lai
Page 63

Bull-Bear Line
source: aastocks
death
cross
golden
cross
250-day moving
average line =
bull-bear line
M K Lai
Page 64

Investment Psychology
behavioral
finance/investment psychology:
identify behavioral (psychological) biases
(cognitive biases, emotional biases and heuristics)
affecting behaviors of individual investors (not
necessary to be rational at all times) and the
financial markets (not necessary to reflect fair
value at all times) as a whole
e.g.
mental accounting, disposition effect, herd

instinct
M K Lai
Page 65

Mental Accounting
windfall
hard-earned
more impulsive in
consumption; more
aggressive in investment
give second thought in

consumption; more
conservative in investment
M K Lai
Page 66

Disposition Effect
the
tendency to hold on to stocks that have lost

value and sell stocks that have risen in value
since the time of purchase
sell winners too soon and hold on losers too
long
when stock price rises a little bit, sell it to
realize profit (risk averse)
when stock price falls, hold on it to avoid
realizing loss and even carry out a dilution
strategy to buy more shares to lower the
average price (risk seeking)
M K Lai
Page 67

Herd Instinct
information
cascading
effect (seeing many
people make same
choice provides evidence
that outweighs own
judgment)
social pressure
(compliance bias)
obedience to authority
(opinion leader) (expert
bias)
see video
M K Lai
Page 68
Putting it All Together

an
investor should value the stock using his own

expectations and buy or sell it accordingly when
the stock value is higher or lower than current
stock price
stock
price changes in response to the arrival of

new information into the market
the
only way to raise the stock price is to make

value-adding decisions
M K Lai
Page 69
Difference Between Bond and Common

Stock
bond
common stock
status of security holder

obligations of issuer
interim income
profit sharing
return of capital
priority of claim upon liquidation
right on default
M K Lai
Page 70
Difference Between Bond and Common

Stock
bond
common stock
voting right
tax implication to issuer
protection
M K Lai
Page 71
Challenging Questions
1. A stocks bid and ask prices quoted by investors
are $10 and $10.1 respectively under an orderdriven system. If an investor inputs a market
buy order, what is the transaction price? If an
investor inputs a limited buy order at $9.8, what
is the range of stock price that will result in the
execution of the limit order?
2. When there is a block sale, the stock price is
likely to
. The underlying reasons are
information and liquidity. Explain.
M K Lai
Page 72
3. Two investors agree on the expected dividend
next year, the growth rate and the risk of a stock.
However, one investor has an expected
investment horizon of 1 year while the other 10
years. Based on the constant growth model,
they should both be willing to pay the same
price for the stock. Do you agree? Why or why
not?
4. Evaluate this statement You say stock price
equals the present value of future dividends?
Thats nonsense! All the investors I know are
looking for capital gains.
M K Lai
Page 73
5. Some practitioners claim that the dividend yield
can be used to measure the return on stock
investment. Do you agree? Why or why not?
6. Under the constant growth model, is it true that
the growth rate in dividends and the growth rate
in the stock price are identical? Why or why not?
7. The constant growth model shows that there is
a positive relationship between the dividends
and the stock price. Hence, the stock price can
increase if a company increases its dividend
payout. Do you agree? Why or why not?
M K Lai
Page 74
8. Some practitioners claim that the P/E ratio of a
stock can be interpreted as the payback period
for the stock. Do you agree? Why or why not?
9. Based on the constant growth model, P/E ratio =
retention rate/(discount rate growth rate). The
P/E ratio is higher when
A. the risk of the company is
;
B. the company has
growth opportunities;
and
M K Lai
Page 75
C. retention ratio
when return on new investment >
discount rate,
retention ratio results in
higher price-earnings ratio
when return on new investment <
discount rate,
retention ratio results in
higher price-earnings ratio
when return on new investment =
discount rate, retention ratio does not
affect the price-earnings ratio
M K Lai
Page 76
10.Other things being equal, the lower the priceearnings ratio, the better the stock investment
is. Do you agree? Why or why not?
11.In case of bankruptcy, a liquidator sells the
assets of the company and distributes the
proceeds from the sale to different stakeholders
according to the rule of absolute priority, usually
stated in the Companies Act or Ordinance. What
is the order of priority of preferred stockholders,
common stockholders, secured creditors and
unsecured creditors in a companys bankruptcy?
M K Lai
Page 77

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Topic 5: Stock Valuation

Topic 5 Stock Valuation

stock in a company represents ownership of

Topic 5 Stock Valuation

Preferred Stock Basics

(par) value: value stated in the preferred

Preferred Stock Basics

vs. non-cumulative (what is it?)

vs. non-participating (what is it?)

vs. non-convertible (what is it?)

Preferred Stock Certificate

Topic 5 Stock Valuation

Preferred Stock Quote

Topic 5 Stock Valuation

Preferred Stock Valuation

flows to preferred stockholders

rate = cost of capital of preferred stock

Example: Preferred Stock Valuation

preferred stock provides an annual dividend of

Topic 5 Stock Valuation

Common Stock Basics

to share common dividends depending on

A shares and B shares in mainland China

Common Stock Basics

voting: vote on each director

Common Stock Basics

contest: competing groups to collect

Topic 5 Stock Valuation

A and B Shares in Hong Kong

Topic 5 Stock Valuation

Topic 5 Stock Valuation

Common Stock Certificate

Topic 5 Stock Valuation

Common Stock Valuation

models to determine fair value (target

Common Stock Quote

Topic 5 Stock Valuation

Company Research Report

Topic 5 Stock Valuation

Company Research Report

Topic 5 Stock Valuation

Mechanics of Stock Trades

Mechanics of Stock Trades

floor trader in red

Mechanics of Stock Trades

lot: shares are usually traded in a

Topic 5 Stock Valuation

spread: difference between bid and ask

Topic 5 Stock Valuation

Dividend Discount Model

discount model: a model that values

dividends (Div1), expected stock price

Suppose that expected dividends = $1

Topic 5 Stock Valuation

return = rE = expected dividend yield +

yield: annual dividend of a stock

gain rate: capital gain as percentage

Topic 5 Stock Valuation

Topic 5 Stock Valuation

hold the stock for N years and sell it at

A company is expected to pay a dividend

Infinite Year Model

hold the stock forever or the company