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7/28/2019 Ppt About Stocks and Their Valuation
1/35
9-1
CHAPTER 9Stocks and Their Valuation
Features of common stock Determining common stock values Preferred stock
7/28/2019 Ppt About Stocks and Their Valuation
2/35
9-2
Facts about common stock Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Managements goal: Maximize thestock price
7/28/2019 Ppt About Stocks and Their Valuation
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9-3
Intrinsic Value and Stock Price Outside investors, corporate insiders, and
analysts use a variety of approaches toestimate a stocks intrinsic value (P
0).
In equilibrium we assume that a stocks priceequals its intrinsic value. Outsiders estimate intrinsic value to help
determine which stocks are attractive tobuy and/or sell.
Stocks with a price below (above) itsintrinsic value are undervalued(overvalued).
7/28/2019 Ppt About Stocks and Their Valuation
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9-4
Determinants of Intrinsic Value
and Stock Prices (Figure 1-1)
7/28/2019 Ppt About Stocks and Their Valuation
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9-5
Different approaches for estimating the
intrinsic value of a common stock
Dividend growth model
Corporate value model
Using the multiples of comparablefirms
7/28/2019 Ppt About Stocks and Their Valuation
6/35
9-6
Dividend growth model Value of a stock is the present value of the
future dividends expected to be generated by
the stock.
)r(1
D...
)r(1
D
)r(1
D
)r(1
DP
s
3
s
32
s
21
s
10
^
7/28/2019 Ppt About Stocks and Their Valuation
7/35
9-7
Constant growth stock A stock whose dividends are expected to
grow forever at a constant rate, g.
D1 = D0 (1+g)1D2 = D0 (1+g)
2
Dt = D0 (1+g)t
If g is constant, the dividend growth formulaconverges to:
g-r
D
g-r
g)(1DP
s
1
s
00
^
7/28/2019 Ppt About Stocks and Their Valuation
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9-8
Future dividends and their
present valuest
0t )g1(DD
tt
t)r1(
DPVD
t0PVDP
$
0.25
Years (t)0
7/28/2019 Ppt About Stocks and Their Valuation
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9-9
What happens if g > rs? If g > rs, the constant growth formula
leads to a negative stock price, which
does not make sense. The constant growth model can only be
used if:
rs > g
g is expected to be constant forever
7/28/2019 Ppt About Stocks and Their Valuation
10/35
9-10
If rRF = 7%, rM = 12%, and b = 1.2,what is the required rate of return on
the firms stock?
Use the SML to calculate the requiredrate of return (rs):
rs = rRF + (rM rRF)b
= 7% + (12% - 7%)1.2
= 13%
7/28/2019 Ppt About Stocks and Their Valuation
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9-11
If D0 = $2 and g is a constant 6%,find the expected dividend stream for
the next 3 years, and their PVs.
1.8761
1.7599
D0 = 2.00
1.6509
rs = 13%
g = 6%
0 1
2.247
2
2.382
3
2.12
7/28/2019 Ppt About Stocks and Their Valuation
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9-12
What is the stocks intrinsic value? Using the constant growth model:
$30.29
0.07
$2.12
0.06-0.13$2.12g-rDP s0
1
7/28/2019 Ppt About Stocks and Their Valuation
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9-13
What is the expected market price
of the stock, one year from now? D1 will have been paid out already. So,
P1 is the present value (as of year 1) of
D2, D3, D4, etc.
Could also find expected P1 as:$32.10
0.06-0.13
$2.247
g-r
DP
s
2^
1
$32.10(1.06)PP 0^
1
7/28/2019 Ppt About Stocks and Their Valuation
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9-14
What are the expected dividend yield,capital gains yield, and total return
during the first year? Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
Capital gains yield= (P1 P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
Total return (rs)= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
7/28/2019 Ppt About Stocks and Their Valuation
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9-15
What would the expected price
today be, if g = 0? The dividend stream would be a
perpetuity.
2.00 2.002.00
0 1 2 3rs = 13% ...
$15.380.13
$2.00
r
PMTP
^
0
7/28/2019 Ppt About Stocks and Their Valuation
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9-16
Supernormal growth:What if g = 30% for 3 years before
achieving long-run growth of 6%?
Can no longer use just the constant growthmodel to find stock value.
However, the growth does becomeconstant after 3 years.
7/28/2019 Ppt About Stocks and Their Valuation
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9-17
Valuing common stock withnonconstant growth
rs = 13%
g = 30% g = 30% g = 30% g = 6%
$P 0.06
$66.5434.658
0.13 -
2.301
2.647
3.045
46.114
54.107 = P0^
0 1 2 3 4
D0 = 2.00 2.600 3.380 4.394
...
4.658
7/28/2019 Ppt About Stocks and Their Valuation
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9-18
Find expected dividend and capital gainsyields during the first and fourth years.
Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
Capital gains yield (first year)= 13.00% - 4.81% = 8.19%
During nonconstant growth, dividend yieldand capital gains yield are not constant,
and capital gains yield g. After t = 3, the stock has constant growth
and dividend yield = 7%, while capitalgains yield = 6%.
7/28/2019 Ppt About Stocks and Their Valuation
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9-19
Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?
rs = 13%
g = 0% g = 0% g = 0% g = 6%
0.06
$ $30.29P32.12
0.13
-
1.77
1.57
1.39
20.99
25.72 = P0^
0 1 2 3 4
D0 = 2.00 2.00 2.00 2.00
...
2.12
7/28/2019 Ppt About Stocks and Their Valuation
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9-20
Find expected dividend and capital gainsyields during the first and fourth years.
Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
Capital gains yield (first year)= 13.00% - 7.78% = 5.22%
After t = 3, the stock has constant
growth and dividend yield = 7%,while capital gains yield = 6%.
7/28/2019 Ppt About Stocks and Their Valuation
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9-21
If the stock was expected to havenegative growth (g = -6%), would anyonebuy the stock, and what is its value?
The firm still has earnings and paysdividends, even though they may be
declining, they still have value.
$9.890.19
$1.88
(-0.06)-0.13
(0.94)$2.00
g-r
)g1(D
g-r
DP
s
0
s
1^
0
7/28/2019 Ppt About Stocks and Their Valuation
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9-22
Find expected annual dividend andcapital gains yields.
Capital gains yield= g = -6.00%
Dividend yield= 13.00% - (-6.00%) = 19.00%
Since the stock is experiencing constant
growth, dividend yield and capital gainsyield are constant. Dividend yield issufficiently large (19%) to offset a negativecapital gains.
7/28/2019 Ppt About Stocks and Their Valuation
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9-23
Summary: Dividend Growth Model
D0 = $2.00Assumption about g? Price
1. g = 6% constant $30.29
2. g = 0% constant $15.383. g = -6% constant $9.89
4. gs = a. 30% supernormal, 3 yrsgn = b. 6% constant $54.11
5. g = a. 0% for 3 years
b. 6% constant $25.72
7/28/2019 Ppt About Stocks and Their Valuation
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9-24
Corporate value model
Also called the free cash flow method.Suggests the value of the entire firm
equals the present value of the firmsfree cash flows.
Remember, free cash flow is the firms
after-tax operating income less the netcapital investment
FCF = NOPAT Net capital investment
7/28/2019 Ppt About Stocks and Their Valuation
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9-25
Applying the corporate value model
Find the market value (MV) of the firm,by finding the PV of the firms future
FCFs. Subtract MV of firms debt and preferred
stock to get MV of common stock.
Divide MV of common stock by thenumber of shares outstanding to getintrinsic stock price (value).
7/28/2019 Ppt About Stocks and Their Valuation
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9-26
Issues regarding thecorporate value model
Often preferred to the dividend growthmodel, especially when considering number
of firms that dont pay dividends or whendividends are hard to forecast.
Similar to dividend growth model, assumes atsome point free cash flow will grow at a
constant rate.
Terminal value (TVN) represents value of firmat the point that growth becomes constant.
7/28/2019 Ppt About Stocks and Their Valuation
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9-27
Given the long-run gFCF = 6%, andWACC of 10%, use the corporate value
model to find the firms intrinsic value.
g = 6%
r = 10%
21.20
0 1 2 3 4
-5 10 20
...
416.942
-4.545
8.26415.026
398.19721.20
530 = = TV30.10 0.06-
7/28/2019 Ppt About Stocks and Their Valuation
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9-28
If the firm has $40 million in debt andhas 10 million shares of stock, what is
the firms intrinsic value per share? 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
7/28/2019 Ppt About Stocks and Their Valuation
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9-29
Firm multiples method
Analysts often use the following multiplesto value stocks.
P / E P / CF
P / Sales
EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply thisby expected earnings to back out anestimate of the stock price.
7/28/2019 Ppt About Stocks and Their Valuation
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9-30
What is market equilibrium?
In equilibrium, stock prices are stable andthere is no general tendency for people to
buy versus to sell. In equilibrium, two conditions hold:
The current market stock price equals its
intrinsic value (P0 = P0).
Expected returns must equal required returns.
)br(rrrgP
Dr RFMRFs
0
1^
s -
^
7/28/2019 Ppt About Stocks and Their Valuation
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9-31
Market equilibrium
Expected returns are determined byestimating dividends and expected
capital gains. Required returns are determined by
estimating risk and applying the CAPM.
7/28/2019 Ppt About Stocks and Their Valuation
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9-32
How is market equilibriumestablished?
If price is below intrinsic value
The current price (P0) is too low and
offers a bargain.
Buy orders will be greater than sellorders.
P0 will be bid up until expected returnequals required return.
7/28/2019 Ppt About Stocks and Their Valuation
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9-33
How are the equilibriumvalues determined?
Are the equilibrium intrinsic value andexpected return estimated by
managers or are they determined bysomething else? Equilibrium levels are based on the
markets estimate of intrinsic value and
the markets required rate of return, whichare both dependent upon the attitudes ofthe marginal investor.
7/28/2019 Ppt About Stocks and Their Valuation
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9-34
Preferred stock
Hybrid security.
Like bonds, preferred stockholders
receive a fixed dividend that must bepaid before dividends are paid tocommon stockholders.
However, companies can omitpreferred dividend payments withoutfear of pushing the firm intobankruptcy.
7/28/2019 Ppt About Stocks and Their Valuation
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9 35
If preferred stock with an annualdividend of $5 sells for $50, what is the
preferred stocks expected return?
Vp = D / rp
$50 = $5 / rp
rp = $5 / $50
= 0.10 = 10%
^