Lecture 5

Valuation Methods: Stocks

 Reminders

 Next Class : Wednesday Sept 18th

 First Case: Chocolat Cordon Rouge

 Bring printout

 Excel practice + solution posted on Canvas (Sept 13th calendar event)

 Learning teams finalized on Canvas (not “Student Groups”).

 Student Talks

 If you are presenting you must email me your slides by midday tomorrow

Lecture 5
Additional videos

Lecture 5
 How to Value a Firm:
The Course Roadmap
 How much are future cash flows worth?
- Lecture 2: Discounting future cash flows to find their value
- Lecture 3: NPV, IRR and other decision rules
- Lecture 4: Application to bonds, how interest rates change over time
- Lecture 5: Application to stocks
- Lecture 6: Application to capital budgeting
 What are the firm’s expected future cash flows?
 What is the appropriate discount rate?
 How should the firm be financed (debt/equity)?

Lecture 5
 Takeaway from last lecture
 The yield on a bond is the IRR on the bond cash flows
 Using U.S. government bond yields, you can compute the risk free
rate :
r = rf + rPremium

When valuing a firm we will use the 10 year US government coupon bond
yield to proxy for the risk free rate

 Extra: We deal with inflation by using nominal cash flows (in $) and
nominal discount rates (from the yield curve)
 Extra: Given that bond markets have competitive prices, the yield
curve tells us about the future

Lecture 4
Plan for today

1 2 3 4
Market Non-
Stocks and Value Operating
Dividends Balance Assets
Sheet

Lecture 5
Plan for today

1 2 3
Market Non-
Stocks and Value Operating
Dividends Balance Assets
Sheet

Lecture 5
The stock market

Session 5 8
 Motivation example:
IBM vs Standard Oil of NJ (1950-2000)

 Annual Growth Rates

Standard Oil of
Growth Measures IBM Advantage
NJ
Revenue per share 12.19% 8.04% IBM
Dividends per share 9.19% 7.11% IBM
Earnings per share 10.94% 7.47% IBM
Sector growth 14.65% -14.22% IBM

Session 5 9
Lecture 6
Stocks and Equities

Lecture 5
What is a Stock?

Lecture 6
 Jargon: Common stocks

 Common Stock (Equity) is a claim on any income remaining

after the payment of all debt obligations, including interest
– In other words, it is a “residual income” security
 Limited Liability – can only lose the original investment
 Common Stockholder receives:
– Any dividend the company chooses to pay
• This might include a final payment in the form of a share repurchase
– Price appreciation (capital gain or possible loss)

Lecture 5
 Valuing stocks

Snapchat went public on March 3rd 2017

• IPO: Issued shares on the NY stock
exchange

https://www.youtube.com/watch?v=_eff8seH3_Q
 What is the value (price) of a
stock?

D1 D2 D3 D4
P0   2  3  4  ...
1  rE 1  rE  1  rE  1  rE 

 What does this mean in words?

The price of a stock is equal to the

present value of its expected future dividends

Lecture 5
 Valuing stocks

 How much would you pay today for a stock that will pay a
dividend of DIV1 and will have a price of P1 next year?
– You should discount the expected cash flows :
DIV1  P1
P0 
1  rE

– DIV1 and P1 here are not certain. They are what investors expect today
– rE is called the equity cost of capital, the opportunity cost of equity
capital, or simply the cost of equity
• It is the expected rate of return that can be earned on other stocks (or
investments) that are equally risky as the stock we are considering
• i.e. Best alternative

Lecture 5
 What is the value (price) of a
stock?
 More periods, dividend every period
 Today’s price is
D1 P
P0   1
1  rE 1  rE

 Same argument applies for price next year

D2 P
P1   2
1  rE 1  rE
 So today’s price is
D1 D2 P2
P0   
1  rE 1  rE 2 1  rE 2

Lecture 5
 What is the value (price) of a
stock?
 If we keep going then…

D1 D2 D3 D4
P0   2  3  4  ...
1  rE 1  rE  1  rE  1  rE 

 What does this mean in words?

The price of a stock is equal to the

present value of its expected future dividends

Lecture 5
 Stock Price when Dividends
have Steady Growth
 ConEd is expected to pay a dividend of $2.84 in 2019
(71 cents per share each quarter)
– Paying 69 cents each quarter in 2017
 Analyst growth forecasts for next 5 years: 3.10%
– Actual earnings growth last 5 years: 2.98%

 If we assume constant growth and rE = 7%, what

do you estimate the stock price of ConEd to be?
This model
DIV2019 2.84 is called
P2018 = = = $72.8 Gordon
rE − g 7% − 3.10% growth
model

 ConEd 2018 stock price (9/16/2018): $ 80.29

Lecture 5
 The expected return of a stock
 You buy a stock today for P0 and hold it for one year. What is the return on your
investment if you expect to receive a dividend of D1 at t=1 and then sell the stock
for an expected price of P1?

𝑃1 + 𝐷1 − 𝑃0 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔𝑎𝑖𝑛𝑠 𝑓𝑟𝑜𝑚 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑠𝑡𝑜𝑐𝑘

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = =
𝑃0 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
 (Actually, this is exactly the IRR of the stock, try to see if you can prove it) The
expected return from holding a stock has two components:
𝑃1 −𝑃0 𝐷1
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = +
𝑃0 𝑃0

Return from Price Appreciation Dividend Yield

Lecture 5
 Example: Expected Return

 The price of ConEdison at the end of 2018

DIV2019 2.84
P2018 = = = $72.8
rE − g 7% − 3.10%
 The expected price of ConEdison at the end of 2019
DIV2020 2.84 × (1 + 3.10%)
P2019 = = = $75.1
rE − g 7% − 3.10%
 The expected return
e
DIV2019 + 𝑃2019 − 𝑃2018 2.84 + 75.1 − 72.8
R = =
𝑃2018 72.8
= 7%
Lecture 5
 Expected return and cost of
equity
In competitive markets prices adjust so that the expected return
of investing in a stock is the same as the discount rates of this
stock (also known as the cost of equity).

In a competitive market, stocks of the same risk should have the

same expected returns.

“Efficient market hypothesis”

Lecture 5
 Back to Motivation example:
IBM vs Standard Oil of NJ (1950-2000)

 Annual Growth Rates

Standard Oil of
Growth Measures IBM Advantage
NJ
Revenue per share 12.19% 8.04% IBM
Dividends per share 9.19% 7.11% IBM
Earnings per share 10.94% 7.47% IBM
Sector growth 14.65% -14.22% IBM

IBM’s stock performs better but is more expensive!

IBM’s average return 1950-2003: 13.83%

Standard Oil’s average return 1950-2003: 14.42%

Source: Siegel “The Future for Investors”

Session 5 23
 Realized return of a stock
 The realized return from holding a stock is defined in the
same way with the exception being that it is measured using
the actual realized dividend D1Real and price P1Real:

𝑃1𝑟𝑒𝑎𝑙 +𝐷1𝑟𝑒𝑎𝑙 −𝑃0𝑟𝑒𝑎𝑙

Realized return =
𝑃0

Lecture 5
 Example: Realized Return

 The price of ConEdison at the end of 2018

P2018 = $72.8
 The realized price at the end of 2019
P2019 = $75.1
 The realized dividend at the end of 2019
D2019 = $4 > $2.84 (𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
 The realized return
realized
DIV2019 + 𝑃2019 − 𝑃2018 4 + 75.1 − 72.8
R = = = 8.65%
𝑃2018 72.8

Lecture 5
 What about stocks with no
dividends?

 IPOed in 1986
 Paid first dividend in 2003
 2003-2017: 100B in total dividends
Year 2003 2004 2005 2006 2007 2008
Total Dividends ($B) $ 1.32 $ 26.70 $ 2.64 $ 2.88 $ 3.30 $ 3.63
$30
2009 2010 2011 2012 2013 2014 2015 2016 2017
$25 $ 4.28 $4.28 $ 5.27 $ 6.59 $ 7.58 $ 9.23 $ 10.22 $ 11.87 $ 12.85
$20

$15

$10

$5

$-
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Total Dividends ($B)

What about stocks with no
dividends?

Lecture 6
 What is the Value of a Stock?

 In these cases many of the expected dividends may

be zero…

0 0 0 DT DT+1
P0 = + + +... + + .+..
1+ rE (1+ rE ) (1+ rE )
2 3
(1+ rE ) (1+ rE )
T T+1

Lecture 5
Plan for today

1 2 3 4
Market Non-
Stocks and Value Operating
Dividends Balance Assets
Sheet

Lecture 5
 Link to valuation

 Key lesson: to value a stock we need to estimate

future cash flows

 These cash flows depend on the cash flows that we

expect the firm’s operations will produce in the
future: Entreprise Value

 Which brings us back (recall lecture 1) to the market

value balance sheet..

Lecture 5
 Market Value Balance Sheet
Assets Liabilities

Value of Operations MV of Equity

(aka Enterprise Value)

Present Value of the

cash flows that the
operations will generate
in the future
Debt Caveat: Need to talk about non-operating
assets (next section of lecture)

Entreprise Value= MV Equity + Debt

PV of future CF = PV of future “dividends”+ PV of future payments to creditors
Lecture 5
 MV Balance Sheet:
CloudStore Example

 CloudStore currently has 200M shares and $900M of debt

outstanding.

 Question: What is the market value of Cloudstore’s equity?

What is the share price?

 Cash flow projections and discount rate are as per Problem

Set 1, Question 2…..(see next slide)
 Problem Set 1: Q2,a-c

 Expected cash flows for CloudStore:

Year 1 2 3 4 5
Cash Flow 470 640 4,350 2,750 1,600

 Expected growth of 5% for each year after year 5.

 Discount rate: 18%
 Market Value Balance Sheet
Assets Liabilities

Value of Operations MV of Equity

We will estimate the
(aka Enterprise Value) ???
market value of equity at
???
Cloudstore by

1) estimating the
Present Value of the
enterprise value by
cash flows that the
taking the present
operations will generate
Debt value of the cash flows
in the future
900M
2) using the market value
balance sheet.

MV Equity = Enterprise Value - Debt

Lecture 5
 Step 1
Problem Set 1: Q2,a-c
 A growing perpetuity: starts at some number and grows at a
constant rate from then on
Discount Individually Value as Growing Perpetuity

Year 1 2 3 4 5 6 7
Cash Flow 470 640 4,350 2,750 1,600 1,680 1,764

-41.8% 5.0% 5.0%

 From what year onwards can value these cash flows as a

growing perpetuity?
 Problem Set 1: Q2,a-c

 The value of the first 4 cash flows can be captured by

discounting each individually. For example:
1
PV(CF4 )  2,750   1,418
1  18% 4

Year 1 2 3 4
Cash Flow 470 640 4,350 2,750
× Discount Factor 0.85 0.72 0.61 0.52
= PV of Cash Flow 398 460 2,648 1,418

Total PV(CF1 to 4 )  398  460  2,648  1,418  4,924

 Problem Set 1: Q2,a-c

 The cash flows starting in year 5 are a growing perpetuity

CF5 1,600
PVat t 4 (CF5 and onwards )    12,308
r  g 18%  5%

 Remember, the growing perpetuity formula tells you what a

set of cash flows is worth one year before it begins. So this
gives their value at t=4.
 To discount it back to the present:

PVat t 4 12,308
PVat t 0 (CF5 and onwards )    6,348
1  r  1  18% 
4 4
 Problem Set 1: Q2,a-c

 Cloudstore’s enterprise value is equal to the sum of the

present value of all its future cash flows:

EV  PV(CF1 to 4 )  PV(CF5 and onwards )

 4,924  6,348
 11,272 M
 Step 2
MV Balance Sheet
Assets Liabilities

Value of Operations MV of Equity

(aka Enterprise Value) 10,372M MV Equity = Entreprise Value
11,272M - Debt

MV Equity = 11,272 – 900

Present Value of the = $10,372M
cash flows that the
operations will generate
Debt
in the future
900M
This is the approach we
will always follow when
we do valuation

Lecture 5
 Find the Share Price

Market Value of Equity 10,372

Share Price    51.86
No. of Shares Outsatnding 200

Lecture 5
 Why does approach work?
 Can we always subtract Debt from Entreprise Value to get market value of
Equity?
– Independently of face value, maturity, coupon rates, interest rates?

 Yes!

 You showed it in PS1 Q3:

– Borrowing in a competitive markets is never a good or a bad deal

PV(future payments to creditors) = Money borrowed today

 So instead of subtracting cash flows to creditors each year, we can

subtract instead the market value of debt today only

 Both give the same answer when calculating PV of cash flow going to
equity holders

Lecture 5
 Lessons: Two ways to compute
the value of equity
1. Indirect (“Firm valuation model”)
– First discount operating cash flows (result is called Enterprise Value),
– and then subtract the value of debt
2. Direct (“Equity valuation model”)
– First subtract payments to debt (result is free cash flows to equity)
– and then discount

Both work because PV(future payments to creditors) = Money borrowed today

WARNING: When using method 1, do not subtract payments to debts in the

first step as you would be double counting

We will use Method 1 in this class.

Lecture 5
 Market vs Book Value of Debt

 The book value of debt is the amount written in a firm’s

balance sheet. This is the amount of the principal outstanding.

 This is not necessarily equal to the market value of debt.

Why?

 In general we will use the book value of debt as a very close

approximation to it’s market value.
 This should include the short and long term component of all debt
and any other interest bearing liabilities
 What about when additional
debt is anticipated in the future?
Assets Liabilities

Suppose we knew that to

Value of Operations fund rapid expansion
MV of Equity CloudStore was going to
(aka Enterprise Value)
11,272M borrow an additional $800M
over the next 2 years?

Present Value of the What is the value of equity?

cash flows that the
operations will generate
Debt
in the future
900M MV Equity = 11,272M – 900?

OR

MV Equity = 11,272M – 1,700?

Lecture 5
Lecture 6
 Lesson

When using the market value balance sheet to value a

firm’s equity, subtract the actual total value of debt
that it has on its balance sheet at the time of valuation
– Do NOT subtract the value of debt you expect it will have
in the future!

– When we cover optimal capital structure we will estimate

how a firms level of debt may differ in the future from
what it is right now!

Lecture 5
 Ignore future debt
Assets Liabilities

Suppose we knew that to

Value of Operations fund rapid expansion
MV of Equity Cloudstore was going to
(aka Enterprise Value)
11,272M borrow an additional $800M
over the next 2 years?

Present Value of the What is the value of equity?

cash flows that the
operations will generate
Debt
in the future
900M MV Equity = 11,272M – 900?

OR

MV Equity = 11,272M – 1,700?

Lecture 5
Plan for today

1 2 3
Market Non-
Stocks and Value Operating
Dividends Balance Assets
Sheet

Lecture 5
What is the largest hedge fund
in the world?

Lecture 6
 Market Value Balance Sheet
Assets Liabilities
Value of Operations
(aka Enterprise Value)
MV of Equity
Present Value of the Non operating assets
cash flows that the
Examples: Cash,
operations will generate marketable securities (e.g.
in the future bonds and stocks),
unutilized assets (e.g. land)

Debt
V(Non–Op. Assets)
E.g. Cash

Lecture 5
 Market value of Equity

MV(Equity) = Enterprise Value + V(Non-op assets) - Debt

This is can also be written as

MV(Equity) = Enterprise Value - Net Debt

where:
Net Debt = Debt - V(Non-op assets)

Net Debt: The value of debt holders claim on the cash flows of the
operations of the firm net of any cash and other non-operating assets.
Lecture 5
 Valuation with Non-Op Assets

 Example: You have been asked to estimate the market value

of equity of a company that is about to IPO. You have the
following information
– The firm’s Enterprise Value is $120M
• You estimated this as the present value of the cash flows that the
firm is expected to produce in the future
– The firm has $25M in cash on the balance sheet
• This is the only non-operating asset that the firm has
– The firm has $55M of total debt on its balance sheet
• This combines the current and long-term component of debt
• This includes all interest bearing liabilities

 Question: What is the value of the firm’s equity?

Lecture 5
 Market Value Balance Sheet
Assets Liabilities
Value of Operations
(aka Enterprise Value) What is the market
$120M MV of Equity value of the firm’s
??? equity?
Present Value of the
cash flows that the
operations will generate
MV(Equity) + 55 = 120 + 25
in the future
MV(Equity) = 120 + 25 - 55
Debt
$55M MV(Equity) = $90M
V(Non–Op. Assets)
$25M

V(Firm) = 120M + 25M V(Firm) = MV(Equity) + 55M

Lecture 5
 Same calculation but using
Net Debt
Assets Liabilities
Value of Operations
(aka Enterprise Value) What is the market
$120M MV of Equity value of the firm’s
??? equity?
Present Value of the
cash flows that the
operations will generate Net Debt = Debt – V(Non Ops)
in the future Net Debt Net Debt = 55 – 25 = 30
$30M
MV(Equity) = EV - ND
V(Non–Op. Assets) Debt Claim on Non-Op MV(Equity) = 120 - 30
$25M $25M
MV(Equity) = $90M

Lecture 5
 EV at Alphabet Inc??
Assets Liabilities
Value of Operations As of 09/09/2019:
(aka Enterprise Value)
??? Total Debt: 14B
Total Cash: 121B
Present Value of the Market Cap: 824B
MV of Equity
cash flows that the 824B
operations will generate
What is market’s assessment
in the future
of the value of Alphabet’s
Enterprise Value (i.e. value of
operations)?
V(Non–Op. Assets)
$121B Debt
$14B EV = 824+ 14 – 121
= 717B
We could write this as:
Lecture 5 Net Debt + Equity = -107 + 824
 Lesson for non-operating
income
 Do not include income from any non-operating
assets in cash flows
– Would double counting the value of the asset
 We are already including the present value of non-operating
income when we add the VALUE of non-operating assets
 The same applies to all other non-operating income.

Lecture 5
 Taking stock

 Value of a stock = PV of cash flows it will receive (dividends)

 Estimate Entreprise Value (value of a firm’s operations) and
use the market value balance sheet to calculate what the
value of equity’s claim is (PV of cash flows not going to debt)
– Use the value of debt at time of valuation on the balance sheet
 The market value balance sheet tells us what not to include in
the “free cash flows”
– Do not include interest expense (or principal repayments)
– Do not include non-operating income (e.g. interest income on cash)

Lecture 5
 Don’t forget

 Next Class:

 First Case: Chocolat Cordon Rouge

 Student Talks

Lecture 5
 Extra slides: Alternate Approach:
Value the cash flows to equity
Estimate the cash flows that will go to the equity
holders each period and value them.
– Suppose the firm will retire $300M of principal at the
end of each year and pay any interest until the debt is
fully repaid
– The interest rate on Cloudstore’s debt is 18%
– All remaining cash flows will be paid out as a dividend
(AKA cash flows to equity)

After first year interest expense will be:

18% × 900 = $162M

Lecture 5
 Find CFs to Equity

1. The cash flows paid to debt each year are the sum
of principal and interest payments:
Year 0 1 2 3 4 5
Debt Outsatnding 900 600 300 - - -
Interest (18%) 162 108 54 - -
+ Principal Repayment 300 300 300 - -
= Cash Flows to Debt 462 408 354 - -

2. The dividend each year is the residual claim on all

of the firm’s cash flows:
Year 0 1 2 3 4 5
Cash Flow - 470 640 4,350 2,750 1,600
- Cash Flows to Debt 462 408 354 - -
= Dividend 8
Lecture 5 232 3,996 2,750 1,600
 Value the CFs to Equity

3. Discount the dividends for years 1 to 4 at 18%:

Year 0 1 2 3 4
Dividend 8 232 3,996 2,750
× Discount Factor 0.85 0.72 0.61 0.52
= PV of Divdends 7 167 2,432 1,418
Value of Divdends (1 to 4) 4,024
 Add PV of dividends from 5 onwards: 6,348M
 Value of equity = PV of all dividends:
4,024 + 6,348 = 10,372M
 Same answer as before! Why?
Lecture 5
 Is this a trick?

 We made the simplify assumption that the discount

rate for debt, equity and the firm’s cash flows were
all the same
– Usually rD < r < rE

 However this does NOT drive any of the conclusions

– For the moment, trust me on this since when computing the
appropriate discount rates is something we have not seen yet

Lecture 5