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
How to determine the growth rate?
Length of growth period
How to determine the required rate of return

Models for Stock Valuation

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 period
this 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

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

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

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 Length of High
Rate
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)