Upload
shivanitarun
View
565
Download
0
Embed Size (px)
Citation preview
Common Stock Valuation
• Stockholders expect to be compensated for their
investment in a firm’s shares through periodic
dividends and capital gains.
• Investors purchase shares when they feel they are
undervalued and sell them when they believe they are
overvalued.
Common Stock Valuation
• Investors base their investment decisions on their
perceptions of an asset’s risk.
• In competitive markets, the interaction of many buyers
and sellers result’s in an equilibrium price – the market
value – for each security.
• This price is reflective of all information available to
market participants in making buy or sell investment
decisions.
Market Efficiency
Common Stock Valuation
• The process of market adjustment to new information
can be viewed in terms of rates of return.
• Whenever investors find that the expected return is
not equal to the required return, price adjustment will
occur.
• If expected return is greater than required return,
investors will buy and bid up price until new
equilibrium price is reached.
• The opposite would occur if required return is greater
than expected return.
Market Adjustment to New Information
Common Stock Valuation
• The efficient market hypothesis, which is the basic
theory describing the behavior of a “perfect” market
specifically states:– Securities are typically in equilibrium, meaning they are
fairly priced and their expected returns equal their required returns.
– At any point in time, security prices full reflect all public information available about a firm and its securities and these prices react quickly to new information.
– Because stocks are fairly priced, investors need not waste time trying to find and capitalize on mis-priced securities.
The Efficient Market Hypothesis
Stock Valuation ModelsThe Basic Stock Valuation Equation
The zero dividend growth model assumes that
the stock will pay the same dividend each year,
year after year.
Stock Valuation ModelsThe Zero Growth Model
Stock Valuation ModelsThe Zero Growth Model
What would an investor pay for a stock if she expected to receive a dividend of $2.50 each year
indefinitely and her RRR is 15%
16.67
• The constant dividend growth model assumes that the
stock will pay dividends that grow at a constant rate
each year -- year after year.
Stock Valuation ModelsThe Constant Growth Model
Constant Growth - Example:
The next Dividend for Rolta India will be Rs.4 per share. Investors require a 16% return on companies such as Rolta India. Rolta’s Dividend increases by 6% every year. Based on the Dividend Growth Model, What is the value of Rolta India stock today?, what is its value in four years?
P0 = D1/r-g = 4 / (0.16 - .06) = Rs.40
D4 = D1 (1+g)3 = Rs.4.764
P4 = D4 (1+g) / (r-g) = Rs.50.50
GROWTH?
Stock Valuation ModelsThe Constant Growth Model
What would an investor be willing to pay for a stock if he just received a dividend of $2.50, his RRR is 15% and he expects dividends to grow at 5% per year?
26.25
• The non-constant dividend or variable growth model assumes that the stock will pay dividends that grow at one rate during one period, and at another rate in another year or thereafter.
Stock Valuation ModelsVariable Growth Model
Step 1: Compute the expected dividends during the first growth period.
g 10.0%
D0 2.50$
D1 2.75$
D2 3.03$
What would an investor be willing to pay for a stock if she just received adividend of $2.50, her required return is 15%, and she expected dividnedsto grow at a rate of 10% per year for the first two years, and then at a rate of5% thereafter.
Stock Valuation ModelsVariable Growth Model
What would an investor be willing to pay for a stock if she just received adividend of $2.50, her required return is 15%, and she expected dividnedsto grow at a rate of 10% per year for the first two years, and then at a rate of5% thereafter.
Step 2: Compute the Estimated Value of the stock at the end of year 2using the Constant Growth Model
D2 3.03$
k 15.00%g 5.00%
V2? 31.76$
Stock Valuation ModelsVariable Growth Model
What would an investor be willing to pay for a stock if she just received adividend of $2.50, her required return is 15%, and she expected dividnedsto grow at a rate of 10% per year for the first two years, and then at a rate of5% thereafter.
Step 3: Compute the Present Value of all expected cash flows to find the price of the stock today.
Cash PV atFlow 15%
1 D1 2.75$ 2.39$
2 D2 3.03$ 2.29$
3 V2? 31.76$ 24.02$
V0 ? 28.69$
Variable Growth Model
Stock Valuation Models
A common stock just paid a dividend of A common stock just paid a dividend of Rs.2. The dividend is expected to grow at Rs.2. The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in 8% for 3 years, then it will grow at 4% in perpetuity. What is the stock worth if the perpetuity. What is the stock worth if the required rate of return is 12%?required rate of return is 12%?
n
n
t
t
r
gr
r
g
gr
DP
)1(
D
)1(
)1(1 2
1
1
1
1
3
3
3
3
)12.1(
04.12.)04.1()08.1(2
)12.1(
)08.1(1
08.12.
)08.1(2
P
3)12.1(
75.328966.154 P
31.2358.5 P 89.28P
Other Approaches to Stock Valuation
• Book value per share is the amount per share that
would be received if all the firm’s assets were sold for
their exact book value and if the proceeds remaining
after paying all liabilities were divided among common
stockholders.
• This method lacks sophistication and its reliance on
historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship to
the firm’s value in the marketplace.
Book Value
Other Approaches to Stock Valuation
• Liquidation value per share is the actual amount per
share of common stock to be received if al of the firm’s
assets were sold for their market values, liabilities
were paid, and any remaining funds were divided
among common stockholders.
• This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
• However, it still fails to consider the earning power of
those assets.
Liquidation Value
Other Approaches to Stock Valuation
• Some stocks pay no dividends. Using P/E ratios are one way to evaluate a stock under these circumstances.
• The model may be written as:
– P = (m)(EPS)
– where m = the estimated P/E multiple.
For example, if the estimated P/E is 15, and a stock’s earnings are $5.00/share, the estimated
value of the stock would be P = 15*5 = $75/share.
Valuation Using P/E Ratios
Determining the appropriate P/E ratio.◦ Possible Solution: use the industry average P/E ratio
Determining the appropriate definition of earnings.◦ Possible Solution: adjust EPS for extraordinary items
Determining estimated future earnings◦ forecasting future earnings is extremely difficult
Other Approaches to Stock ValuationWeaknesses of Using P/E Ratios
Free Cash Flow Model
Stock Valuation Models
• The free cash flow model is based on the same premise as the dividend valuation models except that we value the firm’s free cash flows rather than dividends.
Free Cash Flow Model
Stock Valuation Models
• The free cash flow valuation model estimates the value of the entire company and uses the cost of capital as the discount rate.
• As a result, the value of the firm’s debt and preferred stock must be subtracted from the value of the company to estimate the value of equity.
Free Cash Flow Model
Stock Valuation Models
Dewhurst Inc. wishes to value its stock using the free cash flow model. To apply the model, the firm’s CFO developed the data given in Table.
Free Cash Flow Model
Stock Valuation Models
Step 1: Calculate the present value of the free cash flow occurring from the end of 2009 to infinity, measured at the beginning of 2009.
Free Cash Flow Model
Stock Valuation Models
Total FCF2008 = $600,000 + $10,300,000 = $10,900,000
Step 2: Add the PF of the FCF found in step 1 to the FCF for 2008.
Step 3: Find the sum of the present values of the FCFs for 2004 through 2008 to determine VC. This
is shown in Table 7.4 on the following slide.
Free Cash Flow Model
Stock Valuation Models
Free Cash Flow Model
Stock Valuation Models
VS = $8,628,620 - $3,100,000 = $4,728,620
Step 4: Calculate the value of the common stock using equation 7.8.