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Basics of stock valuation
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Analysis of Common Stocks
Investments and Portfolio Management
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 asset—a 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 Firm’s 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 dividends—may 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)