Valuing Common Stocks

Fundamentals of Corporate Finance

Chapter 7 BMM
Finansiell ekonomi LiU
2012
 Keep in mind
Present value concepts can be
applied to the valuation of common
stocks
the relationship between stock price,
earnings per share EPS and growth
rate g
learn the process of estimating the
cost of equity
 Learning objectives
1. Market Values, Book Values, and
Liquidation Values
2. How to value Common Stocks
3. Simplifying the Dividend Discount
Model (the discounted cash flow
model)
4. Growth Stocks and Income Stocks
5. There Are No Free Lunches on Wall
Street
 Concepts and definitions
Primary Market - Market for the sale of new
securities by corporations.

Secondary Market - Market in which

previously issued securities are traded
among investors.

Common Stock - Ownership shares in a

publicly held corporation.
 Some concepts
Book Value: Net worth of the firm according to the
balance sheet.
Dividend: Periodic cash distribution from the firm to
the shareholders.
P/E Ratio: Price per share divided by earnings per
share.
Earnings per share: EPS = Earnings/ number of
shares
ROE:
return on equity= Earnings /Book value of equity
Note, earnings =net income= rsresultat= vinst
 Going concern value
The difference between a firms
actual market value and its
liquidation value is the so called
going concern value.
Market value-Liquidation Value =
Going concern value
Liquidation Value
Net proceeds that could be realized by
selling the firms assets and paying
off its creditors.
 Valuation of common stocks
Single period investment case
The (present) value of a common
stock equals the present value of
dividends expected during the period
plus the present value of the
expected end-of-period price.
Div1 P1
Price P0
1 r
The present value of future cash flows from a stock
is also called the Intrinsic value of the stock.
The DCF model: discounted cash flow
method (Dividend Discount Model)

The value of any stock is the

present value of its future cash
flows.
Dividends represent the future cash
flows of the firm.
PV(stock) PV(expecte d future dividends)
How Common Stocks Are
Valued
Expected Return r
The percentage yield that an investor
forecasts from a specific investment over a
set period of time.

Div1 P1 P0
Expected Return r
P0
 Valuing Common Stocks
For a stock with no growth, and assuming
the stock will exist indefinitely, we can
value the stock as a PERPETUITY.

Div1 EPS1
Perpetuity P0
r r

No growth means all earnings are paid to

shareholders.
How Common Stocks Are
Valued
Example: If Blue Sky is selling for $100 per
share today and is expected to sell for
$110 one year from now, what is the
expected return if the dividend one year
from now is forecasted to be $5.00?

5 110 100
Expected Return 0.15
100
How Common Stocks Are
Valued
The price of any share of stock can
be thought of as the present
value of the futures cash flows.
For a stock the future cash flows
are dividends and the
ultimate sales price of the
stock. Div1 P1
Price P
0
1 r
Present value of one period return
How Common Stocks Are
Valued
Example - continued: Blue Sky price can
be thought of as follows.

5 110
Price P0 100
1.15
 Valuing Common Stocks
Constant Growth DDM - A version of
the dividend growth model in
which dividends grow at a constant
rate (Gordon Growth Model).
Div1
P0
rg
Given any combination of variables in
the equation, you can solve for the
unknown variable.
 Example: valuing stocks
What is the value of the stock that expects
to pay a $3.00 dividend next year, and
then increase the dividend at a rate of 8%
per year, indefinitely? Assume a 12%
expected return. (note: suppose that Blue
Sky invested 40% back to the company,
the dividend becomes 5*60%=3.)
Div1 $3.00
P0 $75.00
r g 0.12 0.08
Estimating the Cost of Equity
Capital

Dividend Growth Rate can also be

derived from applying the return on
equity to the percentage of earnings
plowed back into operations.

g = return on equity X plowback ratio

Valuing Common Stocks
Dividend Discount Model - Computation of
todays stock price which states that share
value equals the present value of all
expected future dividends.
Div1 Div2 Div H PH
P0 ...
(1 r ) (1 r )
1 2
(1 r ) H

H - Time horizon for your investment.

How Common Stocks Are
Valued
Formula

Div1 Div2 Div H PH

P0 ...
(1 r ) (1 r )
1 2
(1 r ) H

H
Div t PH
P0
t 1 (1 r ) t
(1 r ) H
How Common Stocks Are
Valued
Example
Blue Sky is forecasted to pay a $5.00 dividend at the end
of year one and a $5.50 dividend at the end of year two. At
the end of the second year the stock will be sold for $121. If
the discount rate is 15%, what is the price of the stock?

5.00 5.50 121

PV
(1 0.15) (1 0.15)
1 2

PV $100.00
How Common Stocks Are
Valued
Example
Current forecasts are for Blue Sky to pay
dividends of $3, $3.24, and $3.50 over the
next three years, respectively. At the end
of three years you anticipate selling your
stock at a market price of $94.48. What is
the price of the stock given a 12%
expected return?
How Common Stocks Are
Valued
Example
Current forecasts are for Blue Sky to pay dividends of $3,
$3.24, and $3.50 over the next three years, respectively. At
the end of three years you anticipate selling your stock at a
market price of $94.48. What is the price of the stock given
a 12% expected return?

3.00 3.24 3.50 94.48

PV
(1 0.12) (1 0.12)
1 2
(1 0.12) 3

PV $75.00
How Common Stocks Are
Valued
Estimating the Cost of Equity
Capital
Example A stock was selling for
$42.45 per share at the start of
2012. Dividend payments for the
next year were expected to be $1.68
a share. What is the dividend yield?
1.68
Dividend Yield
42.45
0.04
Estimating the Cost of Equity
Capital
Example - continued - Northwest Natural Gas stock
was selling for $42.45 per share at the start of
2009. Dividend payments for the next year were
expected to be $1.68 a share. What is the
expected return, assuming a growth rate of 6.1%?

1.68
r 0.061
42.45
r 0.101
Estimating the Cost of Equity
Capital
Required Return Measurements

Div 1
Dividend Yield
P0

Div1
Restated P0
rg
Div1
r g
P0
 Estimating the Cost of Equity
Capital
Valuing Non-Constant Growth

Div1 Div 2 Div H PH

PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H

The H period
Div H 1
has a share PH
value PH rg
it is evaluated
as a growing
perpetuity
 Estimating the Cost of Equity
Capital
Example Phoenix produces dividends in three
consecutive years of 0, 0.31, and 0.65,
respectively. The dividend in year four is
estimated to be .67 and should grow in perpetuity
at 4%. Given a discount rate of 10%, what is the
price of the stock?
0 0.31 0.65 1 0.67
PV
(1 0.1) (1 0.1) (1 0.1) (1 0.1) (0.10 0.04)
1 2 3 3

9.13
Note here the
discount factor is
1/(1+0,1)3
 Stock Price and Earnings Per
Share
If a firm chooses to pay a lower dividend,
and reinvest the funds, the stock price
may increase because future dividends
may be higher.

Payout Ratio: Fraction of earnings paid out

as dividends
Plowback Ratio: Fraction of earnings
retained by the firm
The payout ratio= 1-Plowback ratio
Stock Price and Earnings Per
Share
Example
Our company forecasts to pay a $8.33
dividend next year, which represents
100% of its earnings. This will provide
investors with a 15% expected return.
Instead, we decide to retain 40% of
the earnings at the firms current
return on equity of 25%. What is the
value of the stock before and after the
earnings distribution decision?
 Example
Pay a $8.33 dividend next year, which represents
100% of its earnings. a 15% expected return.
plowback 40% of the earnings at the firms
current return on equity of 25%.
the value of the stock with and without growth:

No Growth With Growth

8.33
P0 $55.56 g 0.25 0.40 0.10
0.15 5.00
P0 $100.00
0.15 0.10
With growth of the equity, the price of
the share worth more than before! 100-
55,56=44,44
Stock Price and Earnings Per Share

Example - continued
If the company did not plowback some earnings, the
stock price would remain at $55.56. With the
plowback, the price rose to $100.00.

The difference between these two numbers is called

the Present Value of Growth Opportunities
(PVGO).

PVGO 100.00 55.56 $44.44

Remain critical! The growth rate of dividend 10%
would amount to huge payment after 10 year!
Especially when it is close to the discount rate. (r-g
should be larger than 0). The stock price will
explode!
Stock Price and Earnings Per
Share
Present Value of Growth Opportunities
(PVGO): Net present value of a firms
future investments.
div1 div1
PVGO
rg r

Sustainable Growth Rate is the

steady rate at which a firm can grow:
g = plowback ratio X return on equity.
Valuing a Business
Valuing a Business or Project
The value of a business or Project is
usually computed as the discounted value
of FCF out to a valuation horizon (H).
The valuation horizon is sometimes
called the terminal value.

FCF1 FCF2 FCFH PVH

PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H
Valuing a Business
Valuing a Business or Project

FCF1 FCF2 FCFH PVH

PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H

PV (free cash flows) PV (horizon value)

 Sustainable growth
Long-term growth rate in dividends is a
function of Plowback ratio and return on
equity.
Growth rate of equity=g
ROE= Earning/equity= (1+g)Earnings/
(1+g)equity
The second year will have (1+g) Earnings to
distribute to shareholders. Keep the payout
ratio constant, we will have an dividend
growth (1+g).
 No Free Lunches
Technical Analysts
Investors who attempt to identify
undervalued stocks by searching for
patterns in past stock prices.
Forecast stock prices based on the
watching the fluctuations in historical
prices (thus wiggle watchers)
 No Free Lunches
Scatter Plot of NYSE Composite Index over two successive weeks.
Wheres the pattern?
 Random Walk Theory
Security prices change randomly,
with no predictable trends or
patterns.
Statistically speaking, the movement
of stock prices is random (skewed
positive over the long term).
 Random Walk Theory
Coin Toss Game Heads
$106.09
Heads
$103.00

$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails
Random Walk Theory
Random Walk Theory
 Random Walk Theory
Market
Index
1,300

1,200

1,100

Cycles
disappear
once Last This Next
identified Month Month Month
 Another Tool
Fundamental Analysts
Investors who attempt to find mispriced
securities by analyzing fundamental
information, such as accounting data
and business prospects.
Research the value of stocks using NPV
and other measurements of cash flow
 Efficient Market Theory
Efficient Market - Market in which prices reflect
all available information.

Weak Form Efficiency

Market prices reflect all historical information
Semi-Strong Form Efficiency
Market prices reflect all publicly available
information
Strong Form Efficiency
Market prices reflect all information, both public and
private
Efficient Market Theory
Announcement Date
 Market Anomalies
Existing Anomalies
The Earnings Announcement Puzzle
The New-Issue Puzzle

Old Anomalies
The Small Firm Effect
The January Effect
The PE Effect
The Neglected Firm Effect
The Value Line Effect
 Behavioral Finance
Attitudes towards risk
Beliefs about probabilities
 Thank you!
Problems?
yinghong.chen@li
u.se