FINA2303 Topic 05 Stock Valuation (1)

8/18/2019 FINA2303 Topic 05 Stock Valuation (1)

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Topic 5: Stock Valuation


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Topic 5 Stock Valuation M K Lai Page 2

Learning Outcomes

stock basics

mechanics of stock trades dividend discount model and its limitations

share repurchases and total payout model

valuation based on comparable firms (extra)

security analysis in finance industry (extra)


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Stock Basics

a stock in a company represents ownership of

financial claim on the company and the investoris called a stockholder/shareholder

a stockholder is said to have an ownership

interest in the company, consistent with thepercentage of outstanding shares held

types: common stock and preferred stock

the total return in equity investment

1.

2.


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source: HKEx

Stock Basics

source: HKEx



Preferred Stock Basics

stated (par) value: value stated in the preferred

stock certificate, e.g. stated value of $10

fixed preferred dividends: expressed in terms of

dollars per share, e.g. $0.5 per share (dividend

yield of $0.5/$10 = 5% of the stated value) at discretion of board of directors

priority over common stockholders in terms of

1.

2.



Preferred Stock Basics

special features

cumulative vs. non-cumulative (what is it?)

participating vs. non-participating (what is it?)

redeemable vs. non-redeemable (what is it?)

convertible vs. non-convertible (what is it?)



Preferred Stock Certificate



Preferred Stock Quote

source: aastocks



Preferred Stock Valuation

cash flows to preferred stockholders

fixed preferred dividends per year (Divpfd) if the firm does not go broke, the dividend

stream lasts forever (a non-growing perpetuity)

discount rate = cost of capital of preferred stock

rpfd, reflecting the risk of the preferred stock

pfd

pfd

r

Divpricestockpreferred =


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Example: Preferred Stock Valuation

A preferred stock provides an annual dividend of

$10 per share. The cost of capital of preferred

stock is 10%. What is the preferred stock price?

100$%10

10$pricestockpreferred ==


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Common Stock Basics

right to share common dividends depending onoperating performance of company on pro rata

basis

at discretion of board of directors

right to vote for resolutions in shareholders’meetings (usually on one-share-one-vote basis)

annual (general) meeting: meeting held once

per year to vote on directors and otherresolutions, and raise questions tomanagement (there are other shareholders’

meetings)

A shares and B shares in mainland China


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Common Stock Basics

straight voting: vote on each directorseparately with as many votes and shares held

cumulative voting: votes equal to number ofdirectors times shares held and can be cast ona single director (what is the advantage of it?)

classes of stocks: different types of stocks forthe same company, carrying different votingrights, e.g. A and B shares in Hong Kong

proxy voting: a grant of authority by ashareholder allowing another individual to vote

on his behalf

A shares and B shares in mainland Chinanature of investors, only local in A shares, foreigner in B sharesA shares are traded and settled in Renminbi

B shares are traded and settled in a foreign currency (US dollar in Shanghai and HK dollar in Shenzhen)


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Common Stock Basics

proxy contest: competing groups to collect

proxies to prevail in a matter up for

shareholder votes, usually to take control over

the company by electing a majority of directors

to join the boardwhat is the percentage of ownership interest

to take control over a company?

residual claim on proceeds from sale of assetsupon liquidation (what is it?)


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A and B Shares in Hong Kong

source: HKEx


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Proxy Form

source: Sa Sa


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Common Stock Certificate


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Common Stock Valuation

valuation models to determine fair value (targetprice) of stock

dividend discount model: future cash flows arefuture dividends

comparable firms method: use price multiples(e.g. price-earnings ratio) from similar firms

investment recommendation (buy, hold or sell)

if stock price is higher than target price,recommend to .

if stock price is lower than target price,

recommend to .

sell

buy


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Common Stock Quote

source: aastocks


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Company Research Report

source: ABCI securities


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source: Reuters


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Mechanics of Stock Trades

types of order

market order: the order is executedimmediately at the most favorable marketprice available

limit order: the order is executed when themarket price reaches an investor’s specifiedlimit price or more favorable ( for sell orderand for buy order)

floor trader: a person with a trading right whorepresents orders on the floor to execute on bestterms for investors

higher than the prevailing bid price

lower than the prevailing ask price


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source: HKEx

floor trader in red

waistcoat


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round/board lot: shares are usually traded in a

board lot or a multiple of it, e.g. 400 shares for

HSBC

odd lot: number of shares less than one board lot

usually an odd lot is traded at less favorableprice than a board lot

block trade: a large quantity of shares of the

same stock is traded in one transaction

lot size


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Teletext Screenorder-driven (HK)

spread: difference between bid and ask


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Dividend Discount Model

dividend discount model: a model that valuesshares of a company according to the present

value of future dividends the company will pay cash flows to common stockholders

dividends per year until the end of investmenthorizon (Divt)

selling price of stock at the end of investment

horizon (Pt) discount rate = equity cost of capital or required

rate of return on common stock (rE), reflecting the

risk of the common stock


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One-Year Model

estimate dividends (Div1), expected stock price

(P1

) in year 1 (investment horizon = 1 year) and

equity cost of capital = rE

E

110

r1

PDivP

+

+=

82.91$%101

100$1$P0 =

+

+

=

example: Suppose that expected dividends = $1

and expected stock price = $100 in year 1. If

the required rate of return is 10%, what is thecurrent stock price?


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One-Year Model

total return = rE = expected dividend yield +

capital gain rate

dividend yield: annual dividend of a stock

divided by current stock price (interim income)

capital gain rate: capital gain as percentageof current stock price where capital gain is

selling price minus purchase price (capital

gain/loss)


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One-Year Model

0

01

0

1

E P

PP

P

Div

r

−+=

totalreturn

expecteddividend

yield

capitalgain rate


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Multiple-Year Model

assume hold the stock for N years and sell it at

PN (terminal value)

N

E

NN

1tt

E

t0

)r1(

P

)r1(

DivP

+

+

+

=∑=

example: A company is expected to pay a dividendof $2 and $2.5 in the coming two years. It is

expected that the stock can be sold at $50 at the

end of year 2. If the required rate of return for thestock is 15%, what is the current stock price?

44.41$%)151(

50$5.2$

%151

2$

P 20 =+

+

++

=


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Infinite Year Model

assume hold the stock forever or the company

has to pay annual dividend to some investors

and need to estimate future dividends only

not applicable and further assumption has to bemade to make it tractable

∑∞

= +

=

1tt

E

t0

)r(1DivP


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Constant Growth Model

assume dividends grow at a constant rate (g) (a

growing perpetuity) (equal to capital gain rate)

rE must be greater than g

better to value large, mature companies with

well-established dividend policies

notice: if g = 0, P0 = Div1 /rE (zero-growth model)

gr

)g1*(Div

gr

DivP

E

0

E

10

−

+=

−

=


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Example: Constant Growth Model

A common stock will announce an annual

dividend of $2.5 in year 1. The dividends are

expected to have a sustainable growth rate of 3%.

The cost of common stock is 15%. What is the

current stock price?

83.20$

%3%15

5.2$P0 =

−

=


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Required Rate of Return

use the constant growth model to find the

required rate of return re

g

P

Divr

0

1E +=

expecteddividend yield

capital gain rate


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Dividends and Growth

dividend payout rate/ratio: fraction of a firm’s

earnings that the firm pays out as dividends each

year

retention rate/ratio: fraction of a firm’s earnings

that the firm retains, in principle, forreinvestment and growth (retention rate = 1 –

dividend payout rate)

ttt

t

t

tt

ratepayoutdividend*EPSDiv

ratepayoutdividend*goutstandinshares

earningsDiv

=

=


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a firm can increase its dividends by

increasing its earnings

change in earnings = new

investment*return on new investment

new investment = earnings * retention rate

earnings growth rate (g) = change in

earnings/earnings = retention rate * return

on new investment

increasing its dividend payout rate

decreasing the number of shares outstanding

t r

a d e of f b

e t w e en

t h em


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earnings = dividends + retained profits

if return on new investment is higher than cost of

equity (rE,), share price increases by dividends

and retained profits

if return on new investment is lower than cost of

equity (rE,), share price increases by dividends

and retained profits


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Example: Dividends and Growth

The current stock price of a company is $60. It is

expected that the assets-in-place can generate an

expected earnings per share of $6 next year. The

company can choose to have 100% dividend

payout rate or 50% retention rate for new

investment given that the risk level of the

company does not change. Calculate the new

stock price if the return on new investment is (a)12%; and (b) 8%.


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(a) return on new investment = 12%

(i) 100% dividend payout rate

g = 0%*12% = 0%

rE = $6/$60 + 0% = 10%

P0 = $6/(10%-0%) = $60

(ii) 50% retention rate

g = 50%*12% = 6%rE = 10% (assumed no change in risk level)

P0

= $3/(10%-6%) = $75 (higher stock price)


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(b) return on new investment = 8%

(i) 100% dividend payout rate

g = 0%*8% = 0%

rE = $6/$60 + 0% = 10%

P0 = $6/(10%-0%) = $60

(ii) 50% retention rate

g = 50%*8% = 4%rE = 10% (assumed no change in risk level)

P0

= $3/(10%-4%) = $50 (lower stock price)

Ch i G h R


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Changing Growth Rates

a company may undergo different life stages

with different growth rates

assume it will stabilize at a constant growth rate

g after N years

)gr(

Div

)r1(

DivP

E

1NN

1tt

E

t0

−

+

+

= +

=

∑

= PN = terminal

value in year N

Ch i G th R t


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Changing Growth Rates

…0 1 2 N-1 N

Div1 Div2 DivN-1

DivN

year

cash

flows

…

DivN+1 DivN+2

cut-off point where growth rate

is stabilized at the normal rate

…

use constant growth modelto find present value of all

dividends at year N (PN)

from year N+1 onwards

PN

dividends based on

different growth rates

E l Ch gi g G th R t


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Example: Changing Growth Rates

Suppose that there is a high-tech company with

dividends growing at a supernormal rate of 50%

for 2 years. After that, other competitors will

enter the market and the company will grow at a

stabilized rate of 5%. If Div0

= $1 and rE

= 10%,

what is the current stock price?

E l Ch gi g G th R t


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Example: Changing Growth Rates

27.42$%)101(

25.47$

%)101(

25.2$

%101

5.1$P

25.47$

%5%10

%)51(*25.2$P

25.2$%)501(*1$D

5.1$%)501(*1$D

220

2

2

2

1

=

+

+

+

+

+

=

=

−

+=

=+=

=+=

Li it ti f Di id d Di t M d l


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Limitations of Dividend Discount Model

uncertain dividend forecasts (result is highly

sensitive to inputs)

not applicable to non-dividend paying stocks

Share Repurchases and Total Payout


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p y

Model

share repurchase: a transaction in which a firmuses excess cash to buy back its own stock (in US,

it is optional for the company to cancel theshares; in HK, the company must cancel theshares)

net assets . number of shares outstanding .

effect is similar to dividend payout

the effect on stock price is uncertaindepending on the difference between therepurchase price and the fair value of the stock

Share Repurchases and Total Payout


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y

Model

in US, there is an increasing number of firms

using stock repurchases to replace dividend

payout, but not in Hong Kong (why?)

total payout model: a method that values sharesof a firm by discounting firm’s total payouts to

equity holders (cash dividends + net stock

repurchases), and then dividing by the number ofshares outstanding

Example: Total Payout Model


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A company has 200 million shares outstanding

and expects earnings of $750 million at the end

of the year. It plans to pay out 30% of itsearnings as dividends and 20% for stock

repurchases. The growth rate of earnings is

expected to be 6.67% per year given that the

total payouts remain constant. If the equity cost

of capital is 12%, calculate the current stockprice.



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18.35$million200

million65.035,7$P

million65.035,7$%67.6%12

%50*million750$PV

0 ==

=

−

=

Summary of DCF Models


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Summary of DCF Models

divide by sharesoutstanding

equityvalue

dividendsand share

repurchases

total payoutmodel

no adjustmentstock pricedividends

dividend

discountmodel

to get stock

price byestimating

determine

present value

ofDCF model

Valuation Based on Comparable Firms


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valuation/price multiple: a ratio of a firm’s value

to some measure of the firm’s scale or cash flow

price-earnings (P/E) ratio = stock

price/earnings per share

price-to-book value or market-to-book valueratio = stock price/book value of equity share

price-to-sales ratio = stock price/sales per

share

price-to-cash flow ratio = stock price/cash flow

from operating activities per share



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method of comparables: an estimate of the valueof a firm based on the value of other comparable

firms or other investments that are expected togenerate very similar cash flows in the future;also known as relative valuation method

similar firms should have similar pricemultiple

estimate average price multiple from similar

firms e.g. stock value of subject firm = average

price-earnings ratio * earnings per share of

subject firm

Price-Earnings Ratio


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Price Earnings Ratio

trailing (historical) earnings: a firm’s earnings

over the prior 12 months

forward (prospective) earnings: a firm’s expected

earnings over the coming 12 months

trailing P/E ratio: a firm’s price-earnings ratiocalculated using trailing earnings

forward P/E ratio: a firm’s price-earnings ratio

calculated using forward earnings

which is more important to an investor?

Price-Earnings Ratio


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Price Earnings Ratio

P/E ratio has same limitations as dividend

discount model because it relates exclusively to

equity

Example 1: Price-Earnings Ratio


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source: quamnet

Example 1: Price Earnings Ratio

price

multiples



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source: etnet

trailing EPS

forward EPS (market consensus – what is it?)



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Sa Sa stock price = $2.81

trailing P/E ratio = $2.81/0.295 = 9.53

forward P/E ratio = $2.81/0.27 = 10.41



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A company has earnings per share of $2.17. The

average P/E ratio of comparable firms is 18.63.

Determine the stock value of the company.

stock value = $2.17*18.63 = $40.43

Security Analysis in Finance Industry:

F d t l A l i


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Fundamental Analysis

fundamental analysis: identify fundamental

factors to derive security’s fair value (target price)

and compare it with current security price tomake investment recommendation (give some

examples of fundamental factors)

macroeconomic factors: changes in GDP,

inflation rate, interest rate

industry-specific factors: change in demand forproducts and services in industry, government

industrial policy


F d t l A l i


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Fundamental Analysis

company-specific factors: quality of

management, labor-employer relations, debt

ratio

analytical method includes financial

statement analysis


Economic Report


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Economic Report



Industry Report


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Industry Report





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fair value estimated

through valuation models

investment

recommendation


Technical Analysis


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Technical Analysis

technical analysis: use market information

(historical stock prices and trading volume data

to reflect market sentiment and psychologicalfactors) to identify security price patterns and

predict future price trend (trading signals to buy

or sell)

technical indicators: moving average

charting: bull-bear line


Bull Bear Line


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Bull-Bear Line

source: aastocks

golden

cross

death

cross

250-day moving

average line =

“bull-bear line”


Investment Psychology


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Investment Psychology

behavioral finance/investment psychology:

identify behavioral (psychological) biases

(cognitive biases, emotional biases and heuristics)affecting behaviors of individual investors (not

necessary to be rational at all times) and the

financial markets (not necessary to reflect fair

value at all times) as a whole

e.g. mental accounting, disposition effect, herd

instinct


Mental Accounting


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Mental Accounting

hard-earned windfall

give second thought in

consumption; more

conservative in investment

more impulsive in

consumption; more

aggressive in investment


Disposition Effect


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Disposition Effect

the tendency to hold on to stocks that have lostvalue and sell stocks that have risen in value

since the time of purchase sell winners too soon and hold on losers too

long

when stock price rises a little bit, sell it torealize profit (risk averse)

when stock price falls, hold on it to avoid

realizing loss and even carry out a “dilution”strategy to buy more shares to lower theaverage price (risk seeking)


Herd Instinct


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Herd Instinct

information cascadingeffect (seeing many

people make samechoice provides evidencethat outweighs own

judgment) social pressure

(compliance bias)

obedience to authority(opinion leader) (expertbias)

see video

Putting it All Together


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an investor should value the stock using his own

expectations and buy or sell it accordingly when

the stock value is higher or lower than currentstock price

stock price changes in response to the arrival of

new information into the market

the only way to raise the stock price is to make

value-adding decisions

Difference Between Bond and Common

Stock


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Stock

right on default

priority of claim upon liquidation

return of capital

profit sharing

interim income

obligations of issuer

status of security holder

common stockbond

Difference Between Bond and Common

Stock


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Stock

voting right

protection

tax implication to issuer

common stockbond

Challenging Questions


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1. A stock’s bid and ask prices quoted by investors

are $10 and $10.1 respectively under an order-

driven system. If an investor inputs a marketbuy order, what is the transaction price? If an

investor inputs a limited buy order at $9.8, what

is the range of stock price that will result in theexecution of the limit order?

2. When there is a block sale, the stock price islikely to . The underlying reasons are

information and liquidity. Explain.



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3. Two investors agree on the expected dividendnext year, the growth rate and the risk of a stock.

However, one investor has an expectedinvestment horizon of 1 year while the other 10years. Based on the constant growth model,

they should both be willing to pay the sameprice for the stock. Do you agree? Why or whynot?

4. Evaluate this statement” “You say stock priceequals the present value of future dividends?That’s nonsense! All the investors I know are

looking for capital gains.”



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5. Some practitioners claim that the dividend yield

can be used to measure the return on stock

investment. Do you agree? Why or why not?

6. Under the constant growth model, is it true that

the growth rate in dividends and the growth rate

in the stock price are identical? Why or why not?

7. The constant growth model shows that there is

a positive relationship between the dividendsand the stock price. Hence, the stock price can

increase if a company increases its dividend

payout. Do you agree? Why or why not?



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8. Some practitioners claim that the P/E ratio of a

stock can be interpreted as the “payback period”

for the stock. Do you agree? Why or why not?9. Based on the constant growth model, P/E ratio =

retention rate/(discount rate – growth rate). The

P/E ratio is higher when

A. the risk of the company is ;

B. the company has growth opportunities;and


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10.Other things being equal, the lower the price-

earnings ratio, the better the stock investment

is. Do you agree? Why or why not?11.In case of bankruptcy, a liquidator sells the

assets of the company and distributes the

proceeds from the sale to different stakeholders

according to the rule of absolute priority, usually

stated in the Companies Act or Ordinance. Whatis the order of priority of preferred stockholders,

common stockholders, secured creditors and

unsecured creditors in a company’s bankruptcy?

Documents

FINA2303 Topic 05 Stock Valuation (1)