Transcript Tulane University

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Stock Valuation
RWJ-Chapter 8
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Valuation of Bonds and Stocks
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First Principles:
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Value of financial securities = PV of expected future cash flows
To value bonds and stocks we need to:
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Estimate future cash flows:
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Size (how much) and
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Timing (when)
Discount future cash flows at an appropriate rate:
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The rate should be appropriate to the risk presented by the
security.
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Discounted Cash Flow Techniques
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Advantages:
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Since DCF valuation is based on an asset’s fundamentals, it should be less
exposed to market moods and perceptions.
If you are buying business, rather than stocks, DCF is the right way to think
about you are getting when you buy an asset. (Warren Buffet)
DCF forces you to think about the underlying characteristics of the firm, and
understand its business.
Disadvantages:
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It requires far more explicit inputs and information than other valuation
approaches
These inputs and information are not only noisy, but also can be
manipulated by the analyst to provide the conclusion he/she wants
There is no guarantee that anything will emerge as under or over valued.
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Discounted Cash Flow Techniques:
Dividend Discount Model (DDM)
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Under the dividend discount model, the future cash flows for
stocks are:
D0
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D2
D3
D4
D5
Dn+ Selling Price
Under the DDM, the future cash flows for stocks are
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D1
Dividends and Selling Price
These cash flows are highly uncertain. To find the value of
common stocks, we make assumptions about high dividends
evolve in the future
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Two set assumptions:
 Dividend grow at constant rate (constant dividend growth model)
 Non-constant dividend growth
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DDM- Constant Dividends Growth
Model
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Assume that dividends grow at a constant rate (g), per period
forever. Given this assumption the price of common stock
equals:
Do=Dividend that the
firm just paid
D1=Dividend next
period
𝐷0 (1 + 𝑔)
𝐷1
𝑃𝑒 =
=
𝑟𝑒 − 𝑔
𝑟𝑒 − 𝑔
Required rate of
return on equity
(CAPM)
Dividend Growth
Rate
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Example-Zero Growth
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Hampshire Products will pay a dividend of $4 per share a year
from now. Analysts expect the dividends to stay the same forever.
The required rate of return on the stock is 15%.What is the value
of the stock?
Since future cash flows are constant, the value of a zero growth
stock is the present value of a perpetuity:
Div3
Div1
Div2
P0 



1
2
3
(1  r ) (1  r )
(1  r )
Div
P0 
 4 / 0.15  $26.67
r
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Constant Growth

Assume that dividends will grow at a constant rate, g, forever.
i.e.
Div1  Div0 (1  g )
2
Div2  Div1 (1  g )  Div0 (1  g )
3
Div3  Div2 (1  g )  Div0 (1  g )
.
.
.

Since future cash flows grow at a constant rate forever, the
value of a constant growth stock is the present value of a
growing perpetuity:
Div1
P0 
rg
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Example- Constant Growth
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Assume that Hampshire Products’ dividends are expected to
grow at 10% per year forever. What is the value of the stock?
Since future cash flows grow at a constant rate forever, the
value of a constant growth stock is the present value of a
growing perpetuity:
Div1
P0 
 4 /(0.15  0.10)  $80
rg
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Differential Growth
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Assume that dividends will grow at different rates in the
foreseeable future and then will grow at a constant rate
thereafter.
To value a Differential Growth Stock, we need to:
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Estimate future dividends in the foreseeable future.
Estimate the future stock price when the stock becomes a Constant
Growth Stock (case 2).
Compute the total present value of the estimated future dividends
and future stock price at the appropriate discount rate.
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Example- A Differential Growth
A common stock just paid a dividend of $2. The dividend is
expected to grow at 8% for 3 years, then it will grow at 4% in
perpetuity.
What is the stock worth? The discount rate is 12%.
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Example-Continued
$2(1.08)
0
1
$2.16
0
$2(1.08)
1
2
3
$2(1.08) $2(1.08) (1.04)
…
2
3
4
$2.62
$2.52 
.08
$2.33
2
3
3
The constant growth phase
beginning in year 4 can be
valued as a growing
perpetuity at time 3.
$2.62
P3 
 $32.75
.08
$2.16 $2.33 $2.52  $32.75
P0 


 $28.89
2
3
1.12 (1.12)
(1.12)
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Question:
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What is the problem in dividend discount model?
If the dividend discount model is correct, why aren’t no dividend
stocks selling at zero?
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Component of Return
𝐸𝑛𝑑𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑆ℎ𝑎𝑟𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 + 𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
OR
𝐸𝑛𝑑𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑆ℎ𝑎𝑟𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑅𝑒𝑡𝑢𝑟𝑛 =
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𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
Capital Gain
Dividend Yield
+ Let’s link what we learn from financial
statement analysis and stock valuation
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Remember from the financial statement analysis:
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We have two ways to find cash flows
𝑂𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 1 − 𝑇𝑎𝑥 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − ∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠
Current Assets –Current Liabilities
OR;
𝐹𝐶𝐹 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
+𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝐷𝑒𝑏𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − ∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠
Current Assets –Current Liabilities
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Example
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The Best Manufacturing Company is considering a new investment.
Financial projections for the investment tabulated at the bottom. The
corporate tax rate is 34%. Assume all sales revenue is received in cash,
all operating costs and income taxes are paid in cash, and all cash flows
occur at the end of the year. All net working capital is recovered at the end
of the project.
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Find Incremental Cash Flows
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Suppose discount rate is 12%. What is the Value of this project?
Year 0
Year 1
Year 2
Year 3
Year 4
Sales Revenue
8,500
9,000
9,500
7000
Operating Costs
1,900
2,000
2,200
1,700
Depreciation
4,000
4,000
4,000
4,000
250
300
200
Investments
Working Capital
Spending
16,000
200
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Example-Valuation of Nike
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What is FCF in 2013?
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How to apply the DCF approach on Nike, Inc.?
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Relative Valuation Techniques:
Multiples
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In contrast to various discounted cash flows techniques that
attempt to estimate a specific value based on its estimated
growth rates and its discount rate, the relative valuation
techniques implicitly contend that it is possible to determine the
value of an economic entity by comparing its stock price to
relevant variable that affect a stock’s value, such as earnings,
cash flow, book value and sales
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Relative Valuation TechniquesEarnings Multiplier Model
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Price to earnings ratio measure how many dollars investors are
willing to pay for a dollar of expected earnings:
𝐸𝑀 =
𝑃𝑡
𝐸𝑃𝑆𝑡+1
Assume the firm is mature and maintains a constant dividend growth,
then we can use the dividend discounted model (DDM) to find the
stock price
𝑃
𝐷1 (𝑘 − 𝑔) 𝐷1 𝐸𝑃𝑆1 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜
=
=
=
𝐸𝑃𝑆
𝐸𝑃𝑆1
(𝑘 − 𝑔)
(𝑘 − 𝑔)
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Example
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If stock has an expected dividend payout ratio of 50%, a
required rate of return of 12%, and expected growth rate for
dividends of 8%, what is the stock’s P/E ratio?
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Relative Valuation Techniques:
The Price to Cash Flow Ratio
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Price to cash flow ratio is introduced due to the concern that
some firms may manipulate and generate misleading P/E ratio.
Comparing to earnings, cash flow values are generally less
prone to manipulation.
𝑃𝑡
𝑃𝐶𝐹 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝐹𝑡+1
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Relative Valuation Techniques:
Price to Book Value Ratio
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Fama and French (1992) find a significant inverse relation
between price to book ratios and excess returns of stocks.
Based on their findings, the price to book ratio gained
popularity and credibility as a relative valuation technique for all
types of firms
𝑃𝐵 𝑟𝑎𝑡𝑖𝑜 =
𝑃𝑡
𝐵𝑉𝑡+1
(1)
=Total Assets/ # Shares
(2)
=Share holders’ Equity/ # Shares
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Relative Valuation Techniques:
Price to Sales Ratio
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The advocates of the price/sales ratio believe the ratio is useful
for two reasons:
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(1)strong and consistent sales growth is a requirement for a growth
company
(2) Sales information is subject to less manipulation than any other
data item.
𝑃𝑆 𝑅𝑎𝑡𝑖𝑜 =
𝑃𝑡
𝑆𝑡+1
Be careful: Profitability ratios vary
dramatically across industries
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Applying the relative valuation
techniques: Example
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Let’s suppose Wal-Mart’s current stock price is $47.50/share.
Expected Earnings for Wal-Mart is $2.62/share. What is the
earnings multiplier for Wal-Mart?
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How could we know if earnings multiplier is too high or too low?
+ Applying Earnings Multipliers
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(1) Historical Multipliers:
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(2) Industry Comparison:
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If historically, the price for Wal-Mart 7x to 12x earnings, an analyst
would have to justify the price being so high relative to Wal-Mart’s
current or expected earnings.
It may be that the price cannot justified and therefore the stock is
overvalued
In addition to average P/E ratio for the stock’s industry can be used as a
comparison. If the “discount merchandise” industry as a whole has a
current P/E of 10x earnings, again, there would be concern as to
whether Wal-Mart’s P/E of 18 is justified
It might be that industry leader is more valuable than its peers, and may
be that it is priced higher
(3) Market Comparison:
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Finally, the historical relationship between P/E and Wall-Mart’s P/E can
be analyzed
If Wal-Mart has always had a higher P/E than the overall market, and if
this is the currently the case, then the analyst needs to decide whether
this is still the case and will continue into foreseeable future