Stock Valuation

Valuation
E[CFt ]
N
Market Value  PV  
t 1 (1  r )
t

Cash Flows Discount Rate

Bonds Coupons
YTM
Face Value

Stocks Perpetual
REquity
Dividends

Firms Free Cash Flow

RFirm
WACC
Projects Incremental Free
RProject
Cash Flow
Characteristics of Equity
 Dividends are set by the Board of Directors
 Minimal Par Value
 Last Priority – Residual Claimant
 No Maturity
 Voting Rights
 Dividend Payments are not tax deductible
General Stock Valuation
 Present Value of Expected Future Cash
Flows

◦ Dividend payments

◦ Share price upon sale

N
Divt PriceN
Price   
t 1 (1  r ) (1  r )
t N
General Stock Valuation
Example
 You are considering the purchase of a share of
stock.

 You expect dividends to be $2 per year for the next

3 years.

 You expect to sell the stock for $34 at the end of 3

years.

 Investments of similar risk earn an expected return

of 12%

 How much are you willing to pay for the stock?

General Stock Valuation
Example
3
$2 $34
Price   
t 1 (1  12%) t
(1  12%) 3

Price  $4.80  $24.20  $29.00

 The most you would be willing to pay, given these
expectations, is $29.00.

 If the stock is priced higher than this, you would

expect to earn a higher rate of return on other
stocks with similar risk.
Terminal Value
 The purchaser of the stock will be:
◦ Another investor who will receive the proceeding
dividends
◦ The firm repurchasing stock

 Repurchases are priced such that

shareholders are indifferent to receiving the
repurchase price and continuing to hold the
stock
General Stock Valuation
 The value of a firm’s equity reduces to the
present value of future dividends

x
Divt
Price  lim 
t 1 (1  r )
x  t
Gordon Growth Model
 Assumptions:
◦ Firm pays dividends every period forever
◦ Dividends grow at a constant rate g every period
◦ The growth rate is less than the discount rate

Div1 Div1 *(1  g ) Div1 *(1  g ) 2

Price0     ...
(1  r ) (1  r ) 2
(1  r ) 3

Div1
Price0 
rg
Gordon Growth Model
Example
 Suppose a stock has the following
characteristics:
◦ Next year’s annual dividend will be $3 per share
◦ Thereafter, dividends are expected to grow at 4%
per year
◦ Stocks of similar risk have an expected return of
12%
 How much would you pay for this stock?
Gordon Growth Model
Example
 The stock has the following dividend
structure:
◦ $3 next year - $3.12 in 2 years
◦ $3.24 in 3 years - $3.37 in 4 years
Gordon Growth Model
Example
 The stock has the following dividend
structure:
◦ $3 next year - $3.12 in 2 years
◦ $3.24 in 3 years - $3.37 in 4 years

$3 $3.12 $3.24
Price0     ...
(1  12%) (1  12%) (1  12%)
2 3
Gordon Growth Model
Example
 The stock has the following dividend
structure:
◦ $3 next year - $3.12 in 2 years
◦ $3.24 in 3 years - $3.37 in 4 years

$3 $3.12 $3.24
Price0     ...
(1  12%) (1  12%) (1  12%)
2 3

$3
Price0   $37.50
12%  4%
Growth Rates
 This is an infinite growth rate

 Sustainable long-term growth rates are

bound by the growth of the industry and
the economy

 If growth will be high for a finite period and

then drop to a sustainable long-term
growth rate, these different periods must be
separately calculated
Different Growth Rates
Example
 A firm will pay a $.50 annual dividend next year.

 The dividend is expected to grow for the next 6

years at 18% per year (The dividend in year 7 is
expected to be 18% higher than in year 6).

 Thereafter, dividends are expected to grow at 5%

(The dividend in year 8 is expected to be 5% higher
than in year 7).

 The expected return on stocks of similar risk is

15%.

 What price are you willing to pay for the stock?

Different Growth Rates
Example
 Dividends are expected to be:
◦ $0.50 in 1 year - $0.59 in 2 years
◦ $0.70 in 3 years - $0.82 in 4 years
◦ $0.97 in 5 years - $1.14 in 6 years
◦ $1.35 in 7 years - $1.42 in 8 years
Different Growth Rates
Example
 Dividends are expected to be:
◦ $0.50 in 1 year - $0.59 in 2 years
◦ $0.70 in 3 years - $0.82 in 4 years
◦ $0.97 in 5 years - $1.14 in 6 years
◦ $1.35 in 7 years - $1.42 in 8 years

$1.35
Price6   $13.50
15%  5%
 Different Growth Rates
Example
 Dividends are expected to be:
◦ $0.50 in 1 year - $0.59 in 2 years
◦ $0.70 in 3 years - $0.82 in 4 years
◦ $0.97 in 5 years - $1.14 in 6 years
◦ $1.35 in 7 years - $1.42 in 8 years

$1.35
Price6   $13.50
15%  5%

$0.50 $0.59 $0.70 $0.82 $0.97 $1.14  $13.50

Price0      
(1  15%) (1  15%) 2 (1  15%)3 (1  15%) 4 (1  15%)5 (1  15%) 6

Price0  $8.62
Stocks Terminology
 Book Value versus Market Value

 ROE versus Equity Cost of Capital

 Earnings Per Share (EPS)

 Payout Ratio (POR)

 Dividend Yield
Stocks Terminology
Equations
Earningst
EPSt   ROE * BEt 1
Number of Shares

Divt
Payout Ratio 
EPSt

BEt  BEt 1  Retained Earnings  (1  POR )* EPSt

Div1
Dividend Yield 
P0
Estimating Growth Rates
 Let’s assume the payout ratio remains constant
◦ This implies that dividends and earnings have the same
growth rate

 Growth rate is the percentage change in earnings

EPSt 1  EPSt ROE * BEt  ROE * BEt 1 BEt  BEt 1

g  
EPSt ROE * BEt 1 BEt 1
(1  POR )* EPSt
g  (1  POR )* ROEt
BEt 1
Estimating Growth Rates
Example
 You have the following estimates for a
stock:
◦ ROE is expected to remain constant at 15%
◦ Payout Ratio is also expected to remain constant
at 70%
◦ The current dividend is $2 per share
◦ The discount rate for stocks of similar risk is 12%

 How much are you willing to pay for this

stock?
Estimating Growth Rates
Example
 The first dividend is $2
 The discount rate is 12%
 We need to estimate the growth rate

Div1
Price0 
rg

g  (1  POR ) * ROE 
Estimating Growth Rates
Example
 The first dividend is $2
 The discount rate is 12%
 We need to estimate the growth rate

Div1
Price0 
rg

g  (1  POR ) * ROE  (1  70%) *15%  4.5%

$2
Price0   $26.67
12%  4.5%
Stock Multiples
Multiples
 Price-earnings ratio (P/E ratio)
◦ Current stock price divided by annual earnings
per share (EPS).

 Earnings yield
◦ Inverse of the P/E ratio: earnings divided by price
(E/P).

 High-P/E stocks are often referred to as

growth stocks, while low-P/E stocks are
often referred to as value stocks.
Multiples
 What is the economic interpretation of the
P/E ratio?
Div1
Price0 
rg

EPS1 * POR
Price0 
r  ROE *(1  POR )

Price0 POR

EPS1 r  ROE *(1  POR )
Multiples
Price0 POR

EPS1 r  ROE *(1  POR )
 Firms with higher equity costs of capital will have lower P/E
Ratios

 Firms that are more profitable (higher ROE) will have higher
P/E Ratios

 Payout Ratios:
◦ If ROE>r, higher POR yields a lower P/E Ratio
◦ If ROE<r, higher POR yields a higher P/E Ratio

 Comparing P/E Ratios requires similar accounting treatment

in calculating earnings
Multiples
 Price-cash flow ratio (P/CF ratio)
◦ Current stock price divided by current cash flow per share.
◦ Cash flow is usually taken to be net income plus
depreciation.

 As we will discuss when we get to capital

budgeting, cash flow can be more informative than
net income.

 Earnings and cash flows that are far from each

other may be a signal of poor quality earnings.
Multiples
 Price-sales ratio (P/S ratio)
◦ Current stock price divided by annual sales per
share.
◦ A high P/S ratio suggests high sales growth,
while a low P/S ratio suggests sluggish sales
growth.

 Price-book ratio (P/B ratio)

◦ Market value of a company’s common stock
divided by its book (accounting) value of equity.
◦ A ratio bigger than 1.0 indicates that the firm is
creating value for its stockholders.
Multiples
Example
 The following is historical data for Google:

2007 2008 2009 2010 2011 Average

Closing Stock Price* $691.48 $307.65 $619.98 $593.97 $645.90
EPS $13.43 $13.41 $20.52 $26.47 $29.97
P/E 51.49 22.94 30.21 22.44 21.55 29.73
CFPS $18.46 $24.92 $29.32 $34.49 $44.83
P/CFPS 37.46 12.35 21.15 17.22 14.41 20.52
SPS $53.03 $69.17 $74.43 $91.26 $116.67
P/SPS 13.04 4.45 8.33 6.51 5.54 7.57
*End of Fiscal Year

 Suppose the analyst consensus forecast for 2012 is

EPS of $43.21, CFPS of $45.48 and SPS of $131.06
Multiples
Example
 Using this data, what stock price do you
estimate for Google?
Earnings (P/E) Cash Flow (P/CF) Sales (P/S)
Current Estimate Per Share $43.21 $45.48 $131.06
Average Price Ratio 29.73 20.52 7.57
Estimated Stock Price $1,284.63 $933.25 $992.12

 Currently, Google’s stock is trading at

$568.10.