Transcript CHAPTER 8 Stocks and Their Valuation

CHAPTER 9
Stocks and Their Valuation

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
Features of common stock
Determining common stock values
Preferred stock
9-1
Facts about common stock
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Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
9-2
Corporate Organization
1-3
9-3
Intrinsic Value and Stock Price
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corporate insiders, and analysts use a variety
of approaches to estimate a stock’s intrinsic
value (P0).
In equilibrium we assume that a stock’s price
equals its intrinsic value.
 Investors estimate intrinsic value to help
determine which stocks are attractive to
buy and/or sell.
 Stocks with a price below (above) its
intrinsic value are undervalued
(overvalued).
9-4
Different approaches for estimating the
intrinsic value of a common stock
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Dividend growth model
Corporate value model
9-5
Dividend growth model
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^
P0 
Value of a stock is the present value of the
future dividends expected to be generated by
the stock.
D1
(1  rs )
1

D2
(1  rs )
2

D3
(1  rs )
3
 ... 
D
(1  rs )

9-6
Common Stock Valuation
Div 1
Div 2
Div ∞
Div 3
k%
k%
k%
k%
9-7
Bond Valuation: (a comparison)
Pmt 1
Pmt 2
Pmt 3
Pmt 20
+
k%
k%
k%
k%
9-8
Constant growth stock
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A stock whose dividends are expected to
grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D1 (1+g)1
D3 = D2 (1+g)1
9-9
If D0 = $2 and g is a constant 6%, find the
expected dividend stream for the next 3
years, and their PVs (assume rs = 13%
.
0
D0 = 2.00
1.8761
1
2
3
∞
2.12A
2.247B
2.382C
Div ∞
g = 6%
1.7599
rs = 13%
rs %
1.6509
A, D1= D0(1+g)1
= 2.00 (1+0.06)
= 2.12
B, D2= D1(1+g)1
= 2.12(1+0.06)
= 2.247
C, D3= D2(1+g)1
= 2.247 (1+0.06)1
= 2.382
9-10
Constant growth stock
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A stock whose dividends are expected to
grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D1 (1+g)1
D3 = D2 (1+g)1
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If g is constant, the dividend growth formula
converges to:
^
P0 
D 0 (1  g)
rs - g

D1
rs - g
9-11
What is the stock’s intrinsic value?

Using the constant growth model:
Pˆ 0 

A
D1
rs - g

$2.12
0.13 - 0.06
$2.12
0.07
 $30.29
A , D0 (1+g)
= 2.0 (1+0.06)
= 2.12
9-12
What would the expected price
today be, if g = 0?
The dividend stream would be a
perpetuity.

0
rs = 13%
1
2
...
2.00
^
* PMT
P0 
r

3
$2.00
0.13
2.00
2.00
 $15.38
* P0 = D
rs-g
If g = 0
9-13
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
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Can no longer use just the constant growth
model to find stock value.
However, the growth does become
constant after 3 years.
9-14
Common Stock Valuation
g= 30%
g= 6%
D2
D1
rs%
D3
D4
∞
D∞
rs%
rs%
rs%
P3= D4
rs-g
= D3 (1+6%)
rs-g
P3; Present value of
all future cash
flows to be
received beyond Yr 3
9-15
Valuing common stock with
nonconstant growthp: (example 1)
0 r = 13% 1
s
g = 30%
D0 = 2.00
2.301
g = 30%
rs=13%,2.600
n=1
3
g = 30%
3.380
4
...
g = 6%
4.394
rs=13%, n=2
2.647
rs=13%, n=3
46.114B
^
= P0
4.658
A= D3 (1+g)
= 4.394(1+6%)
= 4658
rs=13%, n=3
3.045
54.107
2
P$ 3 
4.658A
0.13 - 0.06
B: FV=66.54, n=3, I/yr=13%, PV=?
 $66.54
9-16
Nonconstant growth: (example 2)
What if g = 0% for 3 years before longrun growth of 6%?
0 r = 13% 1
s
g = 0%
D0 = 2.00
1.77
g = 0%
rs=13%,2.00
n=1
3
g = 0%
2.00
4
...
g = 6%
2.00
2.12
rs=13%, n=2
1.57
rs=13%, n=3
1.39
rs=13%, n=3
20.99
25.72
2
^
= P0
P$ 3 
2.12
0.13 - 0.06
 $30.29
9-17
Super normal growth (example 3):
G= 40% for 5 years before achieving L-r
growth of 7%
G= 40%
D1
D2
D3
G= 7%
D4
D5
D6
P5= D6
rs-g
= D5 (1+7%)
rs-g
D∞
P5; Present value of
all future cash
flows to be
received beyond Yr 5
9-18
What are the expected dividend yield, capital
gains yield, and total return during the first
year(assume D1 = 2.12, P1 = 32.10 & P0 =
30.29)?
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Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
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Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
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Total return (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
9-19
Preferred stock
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Hybrid security.
Like bonds, preferred stockholders
receive a fixed dividend that must be
paid before dividends are paid to
common stockholders.
However, companies can omit
preferred dividend payments without
fear of pushing the firm into
bankruptcy.
9-20
Preferred stock Valuation
If a preferred stock pays an annual
dividend of RM5 a share and market
interest rate is 10%, what is the preferred
stock’s current price?
Vp = D/rp
D= 5
rp=10%
,
Vp= RM5/ 10%
Vp = RM50
9-21
If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?
Vp = D / rp
$50 = $5 / rp
^r = $5 / $50
p
= 0.10 = 10%
9-22
What would be the intrinsic price for this
stock, one year from now (assume longrun growth of x% until ∞ )?
D0
Today
D1
D2
One year from nowto determine the
intrinsic value(p1)
D∞
If today: P0 = D1
rs - g
If one year: P1 = D2
from now
rs - g
9-23
What is the expected market price of
the stock, one year from now(p1)?
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Assume D0 = 2, g= 6%, rs = 13%
P1 is the present value (as of year 1) of
D2, D3, D4, etc.
^
P1 
*D
2
rs - g

$2.247
0.13 - 0.06 *D = D (1+g)
2
1
 $32.10
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Could also find
expected P1 as:
^
P1  P0 (1.06)  $32.10
= 2.12 (1+0.06)
= 2.247
*D1= D0 (1+g)
= 2.00 (1+0.06)
= 2.12
9-24
Corporate value model
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Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s
free cash flows.
Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
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FCF = NOPAT – Net capital investment
9-25
FCF= NOPAT – Net capital invest
FCF = [EBIT(1-T) + Depreciation exp]
- [ capital exp + working capital]
9-26
Applying the corporate value model
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Find the market value (MV) of the firm,
by finding the PV of the firm’s future
FCFs.
Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
Divide MV of common stock by the
number of shares outstanding to get
intrinsic stock price (value).
9-27
Given the long-run beyond yr 3 is gFCF = 6%,
and WACC of 10%, use the corporate value
model to find the firm’s intrinsic value.
* FCF Y1= -5
Y2= 10
Y3= 20
0 r = 10%
1
-5
-4.545
8.264
15.026
398.197
416.942
2
10
3
4
20
...
g = 6%
21.20
21.20
530 =
0.10 - 0.06
= TV3
9-28
If the firm has $40 million in debt and
has 10 million shares of stock, what is
the firm’s intrinsic value per share?
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MV of equity = MV of firm – MV of debt
= $416.94 - $40
= $376.94 million
Value per share = MV of equity / # of shares
= $376.94 / 10
= $37.69
9-29
How is market equilibrium
established?
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If price is below intrinsic value …
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The current price (P0) is “too low.
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If price is above intrinsic value…
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The current price (P0) is “too high”
9-30