Private and Confidential

Bond and Stock Valuation

Analyst Training Program

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 Discussion topics

 Stock Valuation
 Stock terminologies
 Introduction to stock valuation
Bond and Stock Valuation

 Intrinsic Value Method

 Dividend Discount Model (DDM)
 Non-constant growth: Two stage DDM
 Non-constant growth: Three stage DDM

 Sum Up..

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Bond and Stock Valuation

Stock Valuation

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 Stock terminologies

 Common stock
 Security that represents ownership in a corporation
 Holders of common stock exercise control by electing a board of directors and voting on corporate policy
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 Common stockholders are on the bottom of the priority ladder for ownership structure
 In the event of liquidation, common shareholders have rights to a company's assets only after
bondholders, preferred shareholders and other debt-holders have been paid in full

 Dividend Payments
 Dividends are payments made by a corporation to its shareholder members
 When a corporation earns a profit or surplus, that money can be put to two uses:
• It can either be re-invested in the business (called retained earnings)

• It can be paid to the shareholders of the company as a dividend.

 Dividend payout ratio

 The percentage of earnings paid to shareholders in dividends
Dividend
 Dividend _ payout _ ratio 
Net _ Income

 Preferred stock
 Class of ownership in a corporation that has a higher claim on assets and earnings than common stock
 Preferred stock generally has a dividend that must be paid out before dividends to common stockholders
and the shares usually do not have voting rights

 Capital gains
 Capital gain is profit that results from the sale or exchange of a stocks with proceeds of sale exceeding
purchase price

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 Stock Valuation – Fundamental Approach

 Intrinsic Value Method

 Capitalization of expected income
 Intrinsic value based on the discounted value of the expected stream of cash flows
Bond and Stock Valuation

 Dividend Discount Model (DDM)

 Constant Growth: Gordon Growth Method
 Non-constant growth: Two stage DDM
 Non-constant growth: Three stage DDM

 Relative Valuation
 Valuation relative to a financial performance measure
 P/E
 EV/EBITDA
 P/S
 P/BV

Note: Relative Valuation will be discussed later, when we take the full valuation module!

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 Stock valuation: Intrinsic Value Method

 The first step in valuing common stocks is to determine the expected future cash flows
 Find the present values of these cash flows and adding them together :

CFt
Instrinsic _ valuestock  
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 t 1 1  k t
 For a stock, there are two cash flows:
 Future dividend payments
 The future selling price

 Illustration
Example: Dividend discount model
Assume that you are considering the purchase of a stock which will pay dividends of $20 (Div 1) next year, and $21.6 (Div 2)
the following year. After receiving the second dividend, you plan on selling the stock for $333.3
What is the intrinsic value of this stock if your required return is 15%?
Stock Price: $333.3
Present Value? Dividend 1: $20.0 Dividend 2: $21.6 20.0 21.6  333.3
Instrinsic _ valuestock  
(1  0.15)1 (1  0.15) 2
2 . 00

 Unrealistic Assumptions
 Do we know the exact dividends that will be paid in the future?
 Do we know how much will we be able to sell the stock for in the future?

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 Dividend Discount Model (DDM)

 Lets make the following assumptions, to derive a simple model for common stock valuation
 Stock holding period is infinite (i.e., never sell the stock so we don’t have to worry about forecasting a
future selling price)
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 The dividends will grow at a constant rate forever

 Constant Growth DDM (Gordon Growth Method)

 Computes the value of a share of stock as the PV of its expected future cash dividends

D0 (1  g ) D1
 Value _ stock 
(Ke  g )

(Ke  g )
Can you derive this formula?

 Constant growth DDM gives us the present value of an infinite stream of dividends that are
growing at a constant rate
 Illustration
Example : Gordon Growth Model (Constant Growth Model)

In the previous example, the same stock is selling at $315. What might the market assuming the growth rate of dividends
for this stock

20.0
315  Implied growth = 8.7%
(0.15  g )

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 Dividend Discount Model (DDM)

DDM requires estimation of two inputs

 Required rate of return (Using CAPM formula)
 Will focus on this when we talk about valuations!
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 As of now assume that we are provided with the required rate of return

 Estimation of growth rate

 Use the historical growth rate and assume it will continue
 Generate your own forecast with whatever method seems appropriate for calculation of growth
 Use Payout ratio formula

 Payout ratio formula

 If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because
future dividends may be higher
 Growth can be derived from applying the return on equity to the percentage of earnings plowed back into
operations
• Payout Ratio: Fraction of earnings paid out as dividends

• Plowback Ratio: Fraction of earnings retained by the firm

Growth Rate = Return on Equity X Plowback Ratio

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 Dividend Discount Model (DDM)

Example : Calculation of Growth Rate

Denco Inc forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide
investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s
current return on equity of 20%. What is the value of the stock before and after the plowback decision?
Bond and Stock Valuation

5 5 * 0.6
Value _ stock   42 Value _ stock   75
(0.12) (0.12  0.08)
Growth Rate = 8%
Growth Rate = 0%
(20% * 40%)

Note: If the company did not plowback, the stock would have remained at $42. With plowback, the stock price rose to $75

 Extended DDM model

 We can use the DDM at any point in time. for example we can calculate the price that a stock should sell
for in two years

DN (1  g ) DN 1
 Value _ stock N 
(Ke  g )

(Ke  g )
 To value a stock at year 2, we simply use the dividend for year 3 (D3).
 In our earlier example, dividends were growing by 8% and required rate of return was 15%

21.6(1  .08) 23.3

Value _ stock 2    333.3
(0.15  0.08) (0.15  0.08)

 Note: Value at period 2 is simply the present value of D3, D4, D5, …, D∞

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 Non-constant growth – Two stage DDM

 Two stage DDM

 The DDM assumes that dividends will grow at a constant rate forever, but what if they don’t?
 If we assume that growth will eventually be constant, then we can modify DDM
Bond and Stock Valuation

 Intrinsic value of the stock is the present value of its future cash flows
 Further, we can use the DDM to determine the value of the stock at some future period when growth is
constant
 If we calculate the present value of that price and the present value of the dividends up to that point, we
will have the present value of all of the future cash flows.

D 1  g1  D0 1  g1  1  g 2 
T t T

 V0   0 
t 1 ( 1  k)t ( 1  k)T k  g 2 

 Illustration
Example : Calculation of Growth Rate

Check Mate forecasts that its dividend will grow at 15% per year for the next three years before settling down at
a constant 8% forever. Dividend (current year) = $20; Expected return = 12%. What is the value of the stock now?
 First, note that we can calculate the value of the stock at the end of period 3 (using D4)
 Now, find the present values of the future selling price and D1, D2, and D3
20*1.15 20*1.15^2 20*1.15^3 20*1.15^3*1.08 32.85
… V3   821.27
.12  .08
0 1 2 3 4

g = 15% g = 8% 23.00 26.45 30.42  821.27

V0     647.84
1.12 1.12 2 1.123

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 Non-constant growth – Three stage DDM

 One improvement that we can make to the two-stage DDM is to allow the growth rate to
change slowly rather than instantaneously
 The three-stage DDM is given by:
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 First phase: there is a constant dividend growth (g1) or with no dividend

 Second phase: there is a gradual dividend decline to the final level
 Third phase: there is a constant dividend growth again (g3), i.e. the growth company opportunities are
over

D0 1  g1 
T t N
Dt DN 1
 V0     
t 1 ( 1  k)t
t T 1 ( 1  k)
t
k  g 3 ( 1  k)N

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Bond and Stock Valuation

Sum Up..

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