Analysis of Common Stocks

Investments and Portfolio Management (MB 72)

Outline
Process of Valuation of a Financial Asset Process of Valuation of Common Stocks Determining parameters of models

Models for Stock Valuation

How to determine the growth rate? Length of growth period How to determine the required rate of return Dividend Discount Models Price-Earnings Models Free Cash Flow to Equity Valuation Models

Valuation of Financial Assets

Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows Three step process:
Estimate the expected cash flows Determine the appropriate interest rate or interest rates to discount the cash flows Compute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2

Estimating Cash Flows

Holding aside the risk of bankruptcy, the cash flows of a common stock are:
Payment of dividend so long as we hold the stock Sale price of common stock when we sell the stock

Is it difficult to estimate the cash flows of a common stock?

Value of a Common Stock

Fair Market Value of a common stock depends on
PV of cash flows from a stock PV of an infinite dividend stream OR PV of a finite dividend stream plus PV of the sale price of the stock

Discounted Cash Flow Valuation

Value of any asseta function of 3 variables
How it generates its cash flows? When these cash flows are expected to occur? Uncertainty of these cash flows

t=n CFt Value = ---------t=1 (1+r)t

Dividend Discount Model (DDM)

Value of a share of common stock is the present value of all future dividends n DPSt Value per share of stock= ---------t=1 (1+r)t
What if the stock is not held for an infinite period?
One year holding period Multiple year holding periods

Dividend Discount Model

Two types of cash flows
Dividends during the holding period Expected price at the end of holding periodthis itself is dependent on future dividends

How to determine the value of a share of common stock?

Infinite Holding Period

What will be the value of a share of common stock?
Present value of an infinite stream of anticipated dividends

Simplified assumptions to simply valuation model

Zero Growth Model Constant Growth Model Two-stage growth model Three-stage growth model

Zero Growth Model

Dividend every year will be the same Investor anticipates to receive the same amount dividend per year forever
DPS V = ------------rcs

Constant Growth Model

Assume that firm grows at a stable growth rate of g per year forever DPS1 V = --------r-g

Two-Stage DDM
In general version of the model, two stages of growth
An initial period of extraordinary growth After initial period, a period of stable growth n DPSt Pn

t=1 (1+r)t (1 + r)n DPSn+1 Where Pn = ----------------(r gn)

P0 = ---------- + ---------

Three-stage growth model

Four Basic Inputs

Length of high growth period Dividends per share each period Required rate of return by stockholders each period Terminal price at the end of high growth period

High Growth Rate and Stable Growth Rate

Stable Growth Rate?
Growth rate expected to last forever Firms other measures of performance including can be expected to grow at the same rate

What growth rate is reasonable as a stable growth rate?

A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy

Length of High Growth Period?

How much is the current growth rate? Source of high growth?

High Growth Period

The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth period The larger the current size of the firm, the shorter the high-growth period.

Guide to Length of High-Growth Period

Current Growth Rate Length of High Growth Period

1% higher than stable No high growth 1 10% higher than stable 5 years > 10% higher than stable 10 years

How do we Estimate Growth Rate?

g = b[ROA+D/E(ROA-I (1-t))]
Where b refers to the retention ratio ROA is the return on assets D/E is the debt to equity ratio in book value terms i = interest expense/book value of debt

FCFE Valuation Model

The cash flow that the firm can afford as dividends and contrasted with actual dividendsmay not payout as dividends The residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and create new assets for future growth.

FCFE = Net Income + Depreciation Capital Spending - Working Capital Principal Repayments + New Debt Issues If there is a target debt ratio, FCFE = Net Income - (1 - )(Capital Expenditure Depreciation) - ( 1- ) Working Capital

FCFE Model
n FCFEt

Pn

P0 = ---------- + --------t=1 (1+r)t (1 + r)n

FCFEn+1 Where Pn = ----------------(r gn)