Finance (FNCE 101)

Valuing Stocks Chapters 8,17 Professor WANG Rong

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Todays Agenda

Common Stock/Preferred Stock Dividend Policy Stock Valuation Dividend Discount Models Multiples Valuation Free Cash Flow Model Does dividend policy matter?
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Common Stock

Common Stock - Ownership shares in a public firm. Stockholder has voting rights Classes of Stock with different voting rights

Dividend - cash distribution from the firm to the shareholders. Dividends are not a liability of the firm until a dividend has been declared by the Board. Consequently, a firm cannot go bankrupt for not declaring dividends Dividend payments are not considered a business expense, therefore, they are not tax deductible
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Dividend Policy

Dividend Policy: The time pattern of dividend payout.

Managers need to decide: high/low dividends, stable/irregular dividends, the frequency of dividends.

Dividend policy in practice

Constant dividend policy Constant growth dividend policy dividends increased at a constant rate each year Constant payout ratio pay a constant percent of earnings each year Residual dividend policy pay out all the excess earnings (residual).

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Stock Repurchase

Company buys back its own shares of stock Similar to a cash dividend in that it returns cash from the firm to the stockholders Potential advantages of stock repurchase: Tax benefit for stock repurchase: only capital gain is taxed at the time of sale Information content of stock repurchase Stock repurchases send a positive signal that management believes that the current price is low The stock price often increases when repurchases are announced
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Preferred Stock

Preferred Stock - Stock that takes priority over common stock in regards to dividends. Dividends Fixed dividends that must be paid before dividends can be paid to common stockholders; Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely; Preferred stock generally does not carry voting rights.
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Stock Valuation Dividend Discount Model

Cash Flows to Stockholders If you buy a share of stock, you can receive cash in two ways The company pays dividends You sell your shares, either to another investor in the market or back to the company As with bonds, the price of the stock is the present value of these expected cash flows
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Stock Valuation Four-Period Example

Question: Suppose you are thinking of purchasing a stock , and want to hold the stock for four years. You will receive $3 dividend in year 1, $3.24 in year 2, $3.50 in year 3, and $3.78 in year 4. The stock can be sold for $102.04 in year 4. If the required return is 12%, what is the price you would be willing to pay?

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Stock Valuation Multiple Period Model

Div1 Div 2 Div H PH P0 ... 1 2 H (1 r ) (1 r ) (1 r ) (1 r ) H

H - Time horizon for your investment. Todays stock price equals to PV of all dividends from year 1 to year H and PV of forecast stock price at year H.

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Stock Valuation

As H infinity (remember: stock has no maturity),

DIV t P P0 t (1 r ) t 1 (1 r )

DIV t t ( 1 r ) t 1

The price of the stock is really just the present value of all expected future dividends How can we forecast an infinite number of dividends?

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Stock Valuation Some Special Cases

Constant dividend (zero growth) model

The firm will pay a constant dividend forever The price is computed using the perpetuity formula The firm will increase the dividend by a constant percent every period

Constant dividend growth model

Nonconstant growth model

Dividend growth is not consistent initially, but settles down to constant growth eventually
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Stock Valuation Constant Dividend Model

Zero Growth (constant dividend): If we forecast no growth, and plan to hold out stock infinitely, we will then value the stock as a PERPETUITY.

Div1 EPS1 Perpetuity P0 or r r

Assumes all earnings are paid to shareholders.
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Stock Valuation Constant Dividend Model

Example Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

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Stock Valuation Constant Growth Model

Constant Growth DDM - dividends grow at a constant rate (Gordon Growth Model). 2 2 P0 = Div0(1+g)/(1+r) + Div0(1+g) /(1+r) + Div0(1+g)3/(1+r)3 + With a little algebra, this reduces to:

Div 0 (1 g) Div 1 P0 r -g r -g

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Stock Valuation Constant Growth Model

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, how much should the stock be selling for?

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Exercise Constant Growth Model

Example: Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%. What is the price expected to be in year 4?

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Stock Valuation Nonconstant Growth Model

Nonconstant Growth: Dividend growth is not consistent initially, but settles down to constant growth eventually. Example: ABC common stock is expected to have a dividend of $2.50 at year 1 and $3.00 at year 2. After year 2, the dividend will grow at a constant rate of 6%. If the discount rate is 15%, what

should be the current stock price?

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Stock Valuation Nonconstant Growth Model

Example: Suppose a firm is expected to increase dividends by 20% in one year and by 15% in year two. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock?
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Growth Stocks - How to estimate the growth?

How to estimate g? Use a companys return on equity (ROE) and payout ratio or plowback ratio

Definitions

Assuming that ROE, payout ratio, and plowback ratio all stay constant,
g = (1-payout ratio) ROE = plowback ratio ROE

The plowback ratio affects two things:

Growth rate g Dividend D1

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Growth Stocks An Example

Example Our company 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 firms current return on equity of 20%. What is the value of the stock before and after the plowback decision?

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Growth Stocks
Question: Is plowing back more earnings (or higher dividend growth) always better? Why?

Verify that if ROE < r, stock price with growth < stock price without growth. (You can assume ROE = 0.10) Plowing earnings back into new investments adds to the current stock price only if the reinvested earnings will earn a higher rate of return, which means ROE should be greater than r (required return).
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Components of the Expected (required) Return

The Expected (required) Return - The percentage yield that an investor expects to receive from a specific investment over a period of time. Sometimes called the holding period return (HPR).

The one-year expected (required) return is computed as

Div1 P1 P0 Expected Return r P0

Dividend Yield = Div1/P0 Capital gains yield = (P1 - P0 ) /P0

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Components of the Expected (required) Return

From Gordon growth model, we have Div1 r g P0

Div1/P0 is dividend yield. g is growth rate and capital gains yield

A fundamental rule: All securities of the same risk are priced to offer the same expected rate of return.
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Finding the Expected (Required) Return - Example

Example: Suppose a firms stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year.
What is the required return? What is the dividend yield? What is the capital gains yield (capital appreciation)?

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Multiples Valuation

A multiple is a ratio of stock price or market value to another firm characteristic/measure.

Multiples valuation is used to value companies and assess the relative value of stocks. The most commonly used multiples are

Price Earnings Ratio (PE ratio) = Stock Price / Earnings per Share Market to Book Ratio (MB ratio) = Stock Price / Book value per Share
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Multiples Valuation
The procedure of Valuation with Multiples

1. Choose comparable firms. 2. Choose bases for multiples.

For example, we can choose PE ratio.

3. Average across all comparable firms. 4. Project bases for the valued firms.

For example, we need to project the earnings of the firm being valued.
For example, estimated stock price=average PE ratio x projected earnings per share
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Value the firm.

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The many Faces of PE Ratios

What stock price to use? Price = current market price Price = average stock price for the past year What earnings per share (EPS) to use? Last years Earnings (Trailing PE) Current years Earnings (Current PE) Next years forecasted Earnings (Forward/Leading PE) Relative PE Ratio (benchmark: markets PE ratio) PE / PE of Market PEG (Price Earnings Growth Ratio) PE / expected growth in earnings
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Concept of Free Cash Flow

Free cash flow (or cash flow from assets) equals the cash flow from normal business activities of the firm. Free cash flow is the cash flow available for distribution to all investors (e.g., equity holders, bondholders, convertible bond holders) after funding the firms investment; Free cash flow does not relate to: How the firm finances its operations Examples: borrowing, issuing stock, repaying debt, interest expense or income. Investments that are not related to normal business activity.
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How are FCFs used?

Free cash flows are used to pay security holders. Debt holders Examples of Stockholders Security holders
Cash flows paid to the security holders are the financial cash flows Examples of Interest and Principal payment Financial Cash Flows Dividends/Share repurchases

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FCF vs. Net Income

Does Net Income = Free Cash Flow? No! How do the two differ? Net Income includes non-cash expenses and revenues (Example: Depreciation) Net Income includes non-operating expenses and income (Example: Interest)
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How Do We Calculate FCF?

Indirect Method (-> this class) Starts with Net Income and adjusts for non-cash charges included in Net Income. This is the method most people know/use. Direct Method Begins with Cash Sales and restates the Income Statement to include only cash charges and operating cash flows. Both methods yield the same free cash flow.
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General Areas of Adjustments

Operating Adjustment Net Income + Non-cash charges Depreciation Operating Adjustment Amortization Change NWC EXCLUDING Cash, Marketable Securities N/P, or Short-Term borrowing Account Receivable Inventories Other current assets/liabilities Operating Adjustment Account Payable Proceeds for sale of or payment for Fixed Assets + After-tax portion of interest expense Financial Adjustment After-tax portion of interest income = Free Cash Flow
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Typical Items of Adjustments

Depreciation: If a firm takes a charge for depreciation, this non-cash charge is added back in full. Change in Net Working Capital: Increase (Decrease) in working capital=negative (positive) cash flow Interest Expense and Interest Income If a firm has interest expense, this non-operating item is added back after-tax.(= INT EXP*(1-tax)) If a firm has interest income, this non-operating item is subtracted after-tax.(= INT INC*(1-tax))
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In-Class Exercise: FCF of XYZ, Inc.

Net Income + Depreciation - change in A/R - change in Inventory + change in A/P + change in other. Currr. Liab. + After-tax Interest Expense - Purchase of Fixed Assets FCF 6,424

*Use the change in NFA and depreciation to calculate the purchase of fixed assets.
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Key Concept of Valuation

Why do we need to compute FCF? We need to use this to compute the intrinsic value of a project or firm!
Intrinsic firm value (PV of FCF) - Value of the debt (PV of debt) = Value of the equity
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Statement of Cash Flows

Definition Statement of the sources & uses of cash

How is the statement of cash flows linked with balance sheet?

Cash Flows Operating Activities Investing Activities Financing Activities

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Free Cash Flow vs. Statement of Cash Flows

Does cash flow from operating activities on Statement of Cash Flows = Free Cash Flow? How do the two differ? CHECK THIS Non-operating activities; e.g., gain or loss from the sale of investment assets Cash flow from investment

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Free Cash Flow Model

Firm Value = sum of the PV(all future free cash flow)
Forecast free cash flows in two stages: present value of free cash flow estimates over the first stage (Non-Constant Growth Period) plus present value of the horizon/terminal value of free cash flows in second stage (Constant Growth Period) the excess cash balance N FCFt PV N FirmValue Cash t (1 r ) N t 1 (1 r )

Discount rate r is the Weighted Average Cost of Capital

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Sequential Method

But firms issue multiple, priority-/seniority-based corporate contingent claims (securities). Therefore, we use Sequential Method to obtain equity value. Value each class of securities sequentially Get value of most senior securities e.g. Debt Move to less senior securities (if present) Finally, value residual claim; i.e. Equity For example, if a firm only issues one debt and common stock, we should first find out the value of the debt, and then
Stock Price Firm Value Debt Number of Shares

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In-Class Exercise

Last year, a firm had free cash flow of $1,000. The free cash flow is expected to grow at a rate of 14% for 2 years and then the growth will stabilize at a rate of 6%. Assume that the firm has $1,000 excess cash. The cost of capital is 12%. What is the total value of this firm? If the firm has a debt that is currently worth of $7,000 and 500 shares outstanding, what is stock price per share?
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Valuation Road Map

E[CFt ] Market Value PV t (1 r ) t 1
Cash Flows Discount Rate r REquity RFirm WACC
N

Bonds Stocks Firms

Coupons Face Value Perpetual Dividends

Free Cash Flow

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Does Dividend Policy Matter?

F. Modigliani and M. Miller prove that in their perfect world w/o frictions, dividend policy is irrelevant (that is, firm value is invariant to payout policy). M&Ms Perfect World Assumptions: No tax frictions or transaction costs. No default costs, nor default risk. No agency conflicts/problems. No asymmetric information. The investment policy of the firm is fixed and is not altered by changes in the dividend policy. (Separation of Investment and Dividend Policy) See the example in chapter 17.2
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Does Dividend Policy Matter?

In the real world, investors can prefer high/low payout. Advantage of Low Dividend Payout Avoid taxation on dividend income in US Firms can avoid flotation cost from selling stocks to raise funds for investment. By paying low dividend, firms plow back earnings for reinvestment. Advantage of High Dividend Payout Many investors favour current income. Investors who receive a tax break or are exempt from taxation on dividends.
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Does Dividend Policy Matter?

Information content of dividends Increases in dividends signal that management believes that earnings increases are permanent: good signal. Decreases in dividends signal that management believes that earnings decreases are permanent: bad signal.

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The Dividend Decision in the Real World

Lintners Stylized Facts (How Dividends are Determined) 1. Firms have longer term target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. (dividend smooth) 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed. 5. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt.
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Homework Assignments

Problems are posted at eLearn.

Next Class in week 9: Risk and Return (chapters 12, 13) Math Review
Reminder Submit the selected company for the group project before the end of next week
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Midterm Exam

21 Feb 2013, Friday 6pm -7:30pm G4 LKCSB SR 3-5 G5 LKCSB SR 3-6 G6 LKCSB SR 3-7 G7 LKCSB SR 3-8 Topics: week 1 to week 6 Closed book and closed notes, formula sheet is available. Calculators are allowed.
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Appendix: why g=ROE*plowback ratio?

Assume ROE, payout and plowback are constant. By definition, Div(t)=NI(t)*payout ratio=ROE*Equity(t)*payout ratio. Div(t-1)=NI(t-1)*payout ratio=ROE*Equity(t-1)*payout ratio. Since Equity(t)=Equity(t-1)+NI(t-1)*plowback ratio and NI(t-1)=ROE*Equity(t-1), We have Equity(t)=Equity(t-1)*(1+ROE*plowback ratio). Therefore, Div(t)=Div(t-1)*(1+ROE*plowback ratio).
Note that NI*plowback ratio is the residual earning which is added to the book equity.
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