Stock Valuation models

o  Dividend discount model

o  NPVGO model

o  Comparables

o  DCF model

9-1
Cash Flows to Stockholders
o  If you buy a share of stock, you can receive
cash in two ways
n  The company pays dividends
n  You sell your shares, either to another investor in
the market or back to the company

o  Like bonds, the price of the stock is the

present value of these expected cash flows
9-2
One Period Example
Suppose you are thinking of purchasing the stock of ABC Oil,
and you expect it to pay Rs 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?

– Compute the PV of the expected cash flows

– Price = (14 + 2) / (1.2) = 13.33

9-3
Two Period Example
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?

– PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

9-4
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

9-5
The PV of Common Stocks
o  The value of any asset is the present value of its
expected future cash flows.

o  Stock ownership produces cash flows from:

n  Dividends
n  Capital Gains

9-6
Developing The Model
o  You could continue to push back when you
would sell the stock
o  You would find that the price of the stock is
really just the present value of all expected
future dividends
o  So, how can we estimate all future dividend
payments?
9-7
Dividend discount model

Div1 Div2 DivH + PH

P0 = + + ... +
(1 + R)1 (1 + R)2 (1 + R) H

H
Divt PH
P0 = ∑ t
+
t =1 (1 + R ) (1 + R) H

9-8
Dividend discount model

Example
Fledgling Electronics is forecasted to pay a Rs.5.00 dividend
at the end of year one and a Rs.5.50 dividend at the end of
year two. At the end of the second year the stock will be sold
for Rs.121. If the discount rate is 15%, what is the price of
the stock?

9-9
Dividend discount model

Example
Fledgling Electronics is forecasted to pay a Rs.5.00 dividend
at the end of year one and a Rs.5.50 dividend at the end of
year two. At the end of the second year the stock will be sold
for Rs.121. If the discount rate is 15%, what is the price of
the stock?
5.00 5.50 + 121
PV = 1
+
(1 + .15) (1 + .15) 2
PV = Rs.100.00

9-10
Dividend discount model

Current forecasts are for XYZ Company to pay

dividends of Rs.3, Rs.3.24, and Rs.3.50 over the
next three years, respectively. At the end of three
years you anticipate selling your stock at a market
price of Rs.94.48. What is the price of the stock
given a 12% expected return?

9-11
Dividend discount model

Current forecasts are for XYZ Company to pay dividends of

Rs.3, Rs.3.24, and Rs.3.50 over the next three years,
respectively. At the end of three years you anticipate selling
your stock at a market price of Rs.94.48. What is the price of
the stock given a 12% expected return?

3.00 3.24 3.50 + 94.48

PV = 1
+ 2
+
(1 + .12) (1 + .12) (1 + .12) 3
PV = Rs.75.00

9-12
How Common Stocks Are Valued

9-13
 Stock perpetuity, R=15%, g=5%
Expected Future Values Present Values
Price Cumulative
Horizon Period (H) Dividend (DIVt ) Future Price Total
(Pt ) Dividends

0 100.00 100.00 100.00

1 10.00 105.00 8.70 91.30 100.00

2 10.50 110.25 16.64 83.36 100.00

3 11.03 115.76 23.88 76.12 100.00

4 11.58 121.55 30.50 69.50 100.00

10 15.51 162.89 59.74 40.26 100.00

20 25.27 265.33 83.79 16.21 100.00

50 109.21 1,146.74 98.94 1.06 100.00

100 1,252.39 13,150.13 99.99 0.01 100.00

9-14
Valuation of different types of stocks
n  Zero Growth

n  Constant Growth

n  Differential Growth

9-15
Case 1: Zero Growth
o  Assume that dividends will remain at the same level
forever
Div 1 = Div 2 = Div 3 = !
•  Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div 1 Div 2 Div 3

P0 = 1
+ 2
+ 3
+!
(1 + R ) (1 + R ) (1 + R )
Div
P0 =
R
9-16
Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
Div 1 = Div 0 (1 + g )
Div 2 = Div 1 (1 + g ) = Div 0 (1 + g ) 2
Div 3 = Div 2 (1 + g ) = Div 0 (1 + g ) 3
..
.
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:
Div 1
P0 =
R−g 9-17
Constant Growth Example
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 level, how much should the
stock be selling for?

P0 = .50(1+.02) / (.15 - .02) = $3.92

9-18
Case 3: Differential Growth
o  Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
o  To value a Differential Growth Stock, we need
to:
n  Estimate future dividends in the foreseeable future.
n  Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
n  Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate. 9-19
PV of a stock

o  Valuing differential Growth

Div1 Div2 DivH PH
PV = 1
+ 2
+ ... + H
+
(1 + R) (1 + R) (1 + R) (1 + R) H

DivH +1
PH =
R−g
9-20
 PV of a stock

Example – Phoenix produces dividends in three

consecutive years of 0, .31, and .65, respectively.
The dividend in year four is estimated to be .67 and
should grow in perpetuity at 4%. Given a discount
rate of 10%, what is the price of the stock??

9-21
 PV of a stock

Example – Phoenix produces dividends in three

consecutive years of 0, .31, and .65, respectively.
The dividend in year four is estimated to be .67 and
should grow in perpetuity at 4%. Given a discount
rate of 10%, what is the price of the stock??

0 .31 .65 ⎡ 1 .67 ⎤

PV = + + +⎢ ×
(1 + .1) (1 + .1) (1 + .1) ⎣ (1 + .1) (.10 − .04) ⎥⎦
1 2 3 3

= 9.13

9-22
Can be treated as growing annuity too…..
•  Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.
Div 1 = Div 0 (1 + g1 )
Div 2 = Div 1 (1 + g 1 ) = Div 0 (1 + g 1 ) 2
..
.
Div N = Div N −1 (1 + g 1 ) = Div 0 (1 + g 1 ) N

Div N +1 = Div N (1 + g 2 ) = Div 0 (1 + g 1 ) N (1 + g 2 )

.
..
9-23
Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter

Div 0 (1 + g 1 ) Div 0 (1 + g 1 ) 2
…
0 1 2
Div N (1 + g 2 )
Div 0 (1 + g 1 ) N = Div 0 (1 + g1 ) N (1 + g 2 )
… …
N N+1 9-24
Case 3: Differential Growth
We can value this as the sum of:
§  a T-year annuity growing at rate g1
T
C ⎡ (1 + g1 ) ⎤
PA = ⎢1 − T ⎥
R − g1 ⎣ (1 + R ) ⎦
§  plus the discounted value of a perpetuity growing at
rate g2 that starts in year T+1
⎛ Div T +1 ⎞
⎜⎜ ⎟⎟
⎝ R − g2 ⎠
PB = T
(1 + R ) 9-25
Case 3: Differential Growth
Consolidating gives:

⎛ Div T +1 ⎞
⎜ ⎟
C ⎡ (1 + g1 )T ⎤ ⎜⎝ R − g 2 ⎟⎠
P= ⎢1 − T ⎥
+ T
R − g1 ⎣ (1 + R ) ⎦ (1 + R )

Or, we can “cash flow” it out.

9-26
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%.

9-27
With the Formula
⎛ $2(1.08) 3 (1.04) ⎞
⎜ ⎟
$2 × (1.08) ⎡ (1.08) 3 ⎤ ⎜⎝ .12 − .04 ⎟
⎠
P= ⎢1 − 3⎥
+ 3
.12 − .08 ⎣ (1.12) ⎦ (1.12)

P = $54 × [1 − .8966 ] +
($32.75 )
3
(1.12)

P = $ 5 . 58 + $ 23 . 31 P = $ 28 .89
9-28
 With Cash Flows
$ 2(1 .08) $ 2(1 .08) 2 $ 2(1 .08) 3 $ 2(1 .08) 3 (1 .04 )
…
0 1 2 3 4
$2.62 The constant
$ 2 .16 $ 2 .33 $2.52 + growth phase
.12 − .04 beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$2 .16 $ 2.33 $ 2.52 + $ 32 .75
P0 = + 2
+ 3
= $28 .89
1.12 (1 .12 ) (1 .12 ) $2 .62
P3 = = $32 .75
.08 9-29
To summarize

9-30
Estimates of Parameters
o  The value of a firm depends upon its growth
rate, g, and its discount rate, R.
n  Wheredoes g come from?
g = Retention ratio × Return on retained earnings

9-31
‘g’
o  Stable growth rate – This is a growth rate that a

firm can sustain forever in earnings, dividends

and cashflows.

o  This is a function of the company/industry/

economy’s growth rate or the world economy’s

growth rate 9-32

Stock Price Sensitivity to Dividend Growth, g

D1 = $2; R= 20%

9-33
Stock Price Sensitivity to Required Return, R
250
D1 = $2; g = 5%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
r

9-34
Where does R come from
D 0 (1 + g) D1
P0 = =
R -g R -g
Rearrange and solve for R:
D 0 (1 + g) D1
R= +g= +g
P0 P0

9-35
Hence……
o  The discount rate can be broken into two parts.

n  The dividend yield

n  The growth rate (in dividends)

o  Inpractice, there is a great deal of estimation

error involved in estimating R.
9-36
What happens if g > R?
D
Pˆ0 = 1
requires R > g.
R−g
o  If R< g, get negative stock price, which is
nonsense.

o  We can’t use model unless (1) g < R and (2) g is

expected to be constant forever. Because g must
be a long-term growth rate, it cannot be > R.
9-37
NPVGO model
o  Suppose a firm pays all its earnings each year
to the shareholders EPS=Div

o  Value of the stock is EPS/R

o  Distributingentire earnings as dividends may

not be an optimal one

9-38
NPVGO model contd…
o  Suppose the firm invest in positive NPV projects.

o  The net present value per share of the project as of

date 0 is NPVGO, which stands for the net present
value(per share) of the growth opportunity

o  If the firm decides to take on the growth project the

current price of the stock is
EPS
P= + NPVGO
R 9-39
NPVGO Model: Example
Consider a firm that has forecasted EPS of $5,
a discount rate of 16%, and is currently priced
at $75 per share.
o  We can calculate the value of the firm as a cash cow.
EPS $ 5
P0 = = = $ 31 .25
R .16
o  So, NPVGO must be: $75 - $31.25 = $43.75

9-40
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a Rs.8.33
dividend next year, which represents 100%
of its earnings. This will provide investors
with a 15% expected return. Instead, we
decide to plowback 40% of the earnings at
the firm’s current return on equity of 25%.
What is the value of the stock before and
after the plowback decision?
9-41
 Stock Price and Earnings Per Share
Example
Our company forecasts to pay a Rs.8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plowback 40% of the
earnings at the firm’s current return on equity of 25%. What is the
value of the stock before and after the plowback decision?

No Growth With Growth

g = .25 × .40 = .10

8.33
P0 = = Rs.55.56 5.00
.15 P0 =
.15 − .10
= Rs.100.00

9-42
Stock Price and Earnings Per Share
Example - continued
If the company did not plowback some earnings, the stock
price would remain at Rs.55.56. With the plowback, the
price rose to Rs.100.00.

The difference between these two numbers is called the

Present Value of Growth Opportunities (PVGO).

PVGO = 100.00 − 55.56 = Rs.44.44

9-43
 Intrinsic Value and Market Price

o  Intrinsic Value
n  Self assigned Value
n  Variety of models are used for estimation
o  Market Price
n  Consensus value of all potential traders
o  Trading Signal
n  IV > MP Buy
n  IV < MP Sell or Short Sell
n  IV = MP Hold or Fairly Priced

9-44
 Comparing the Valuation Models

o  In practice
n  Values from various models may differ
n  Analysts are always forced to make
simplifying assumptions

9-45
Comparables
o  Comparables are used to value companies based
primarily on multiples.
o  Common multiples include:
§  Price-to-Earnings
§  Price to Book Value

9-46
Price-Earnings Ratio
o  The price-earnings ratio is calculated as the current
stock price divided by annual EPS.

Price per share

P/E ratio =
EPS

9-47
PE and NPVGO
EPS
o  Recall, P= + NPVGO
R
o  Dividing every term by EPS provides the following description
of the PE ratio:

1 NPVGO
PE = +
R EPS
o  So, a firm’s PE ratio is positively related to growth
opportunities and negatively related to risk (R)

9-48
 Price Earnings Ratios

o  P/E Ratios are a function of two factors

n  Required Rates of Return (k)
n  Expected growth in Earnings/Dividends
o  Uses
n  Relative valuation
n  Extensive Use in industry

9-49
P/E Ratio: Constant Growth

D1 E 1 (1− b )
P0 = =
k − g k − (b × ROE )
P0 1− b
=
E 1 k − (b × ROE )

b = retention ratio
ROE = Return on Equity

9-50
Compute P/E Ratio
o  Retention ratio(b)=60%
o  ROE = 15%
o  K=12.5%
o  Previous years Earnings = Rs 2.5

9-51
 Numerical Example: Growth

PE = (1 - .60) / (.125 - .09) = 11.4

9-52
Effect of ROE and Ploughback on Growth and
the P/E Ratio

9-53
 P/E Ratios and Stock Risk

o  Holding all else equal

n  Riskier stocks will have lower P/E
multiples
n  Higher values of k; therefore, the P/E
multiple will be lower
P 1− b
=
E k−g

9-54
Why would investors pay high price earning
multiple for a company?
o  There are two key drivers of higher Price/
Earnings ratios, namely:
n  Future growth prospects of company (& industry)
The future earnings of the company are expected to
be high due to the future growth potential.
n  Perceived risk of company (or industry)
Shares that are considered lower risk usually offer a
higher Price/Earnings ratio. This is due to the
security they provide.
n  Forward P/E vs. trailing P/E

9-55
PE Ratios from India(as on 30th August,
2019)
Companies PE Ratio
Ashok Leyland 12.07
HPCL 6.57
Asian Paints 72.57
ICICI Bank 78.67
Motilal Oswal Financial Services 26.08
Infosys 24.14
Larsen & Toubro 27.90
Pidilite 71.48
Nestle 77.10
Page Industries 52.90

9-56
Earning and Earnings Multiples

Earnings are created by business and earnings multiples are

created by markets

9-57
Problem1
o  ABC is a young start up company. No
dividends are paid on the stock over the next
nine years, because the firm needs to plow
back its earnings to fuel growth. The company
will pay its first dividend of Rs 15 per share
dividend in the 10th year and will increase the
dividend by 5.5% per year thereafter. If the
required rate of return on this stock is 13%,
what is the current share price?
9-58
Problem2
A company is growing quickly. Dividends are
expected to grow at a rate of 20% for the next
three years, with the growth rate falling off to
a constant 5% thereafter. If the required rate
of return is 12% and the company just paid a
Rs 2.80 dividend, what is the current share
price?

9-59
Problem3
A company is experiencing rapid growth.
Dividends are expected to grow at 30% during
the next three years, 18% over the following
year, and then 8% per year indefinitely. The
required return on the stock is 11%, and the
stock currently sells for Rs 65 per share. What
is the projected dividend for the coming year?

9-60
Problem 4
ABC co. earned 18 million for the fiscal year ending
yesterday. The payout ratio of the firm is 30%. The firm
will continue to pay 30% of its earnings as annual, end-
of-year dividends. The remaining 70% of earnings is
retained by the company for use in projects. The
company has 2 million shares of common stock
outstanding. The current stock price is Rs 93. The
historical return ROE of 13% is expected to continue in
the future. What is the required rate of return on the
stock?
9-61