MC11-253

Muhammad NAWAZ

HAILEY COLLEGE OF COMMERCE PUNJAB UNIVERSITY LAHORE PAKISTAN

Common Stock Valuation

Common Stock

A security that represents ownership in a company. Holders of common stock exercise control by electing a board of directors. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders have been paid in full.

What is Value

In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller.

Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset.

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 flowsThree step process:1. Estimate the expected cash flows.2. Determine the appropriate interest rate to

discount the cash flows.3. Compute the present value of the

expected cash flows by discounted them with interest rate determine in step 2.

Intrinsic Value

Maximum price which an investor is ready to pay for purchase of a security.

Intrinsic value is present value and is also called estimated value or economic value.

Intrinsic Value

Intrinsic value is compared with market value of security and is based on these factors:

Future cash inflows Timing of return Required rate of return i.e. ’’k’’ k=risk free rate of return + risk

premium.

Discounted Cash Flow Model

This technique estimates the value of a security by discounting its expected future cash flows back to the present value and adding them together.The estimated value of a security = present value of future cash flows

t=n expected cash flowValue = V0 = -----------------------------

t=1 (1+k)t

Discounted Cash Flow Model

To use this model, an investor must:Estimate the amount of future cash

flowsEstimate the timing of future cash flowsEstimate an appropriate discount rateUsing above components value of a

security is calculated which is then compared to the current market price of the security

This calculated value is denoted by V0 and is called intrinsic value

Discounted Cash Flow Model

Dividend Discount Model(DDM)Value of a common stock is the present value of all future dividends.

D1 D2 Dn

Value of stock= ------- + ------- + --- + --------

(1+k)1 (1+k)2 (1+k)n

n Dn

Value of stock = ---------- t=1 (1+k)n

Dividend Discount Model(DDM)

Types of dividend discount model:

1.Zero dividend growth2.Constant growth3.Variable growth

Zero Growth Model

Dividend every year will be the sameInvestor anticipates to receive the same amount dividend per year forever

D1

Vcs = ------------- where D1 =D0 (1+g)

Kcs

Dividend Discount Model(DDM)

Dividend Discount Model(DDM)

Constant Growth Model

Assume that firm grows at a stable growth rate of g per year forever

D1

Vcs = ---------

Kcs - g

Variable growth rate

Assume that firm’s growth rate is variable

D0(1+g1 )t Dn +1 1

Vcs = ------------ + ---------- ---------

( 1+Kcs )t Kcs – g2 (1+Kcs )n

g1 = growth in 1st phase

g2 = growth in 2nd phase

Dividend Discount Model(DDM)

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Intrinsic Value & Market Value

When market value is less than or equal to intrinsic value then common stock must be retained or purchased.

When market value is greater than intrinsic value then common stock must be sold or avoid.

Other Valuation Methods

Some companies do not pay dividends, or the dividends are unpredictable.In these cases we have several other possible valuation models:

Free Cash Flow ModelP/E approachPrice to Sales (P/S)

The Free Cash Flow Model

Free cash flow is the cash flow that’s left over after making all required investments in operating assets:

Where NOPAT is net operating profit after taxNote that the total value of the firm equals the value of its debt plus preferred plus common:

CapOpNOPATFCF

CSPD VVVV

The Free Cash Flow Model

We can find the total value of the firm’s operations (not including non-operating assets), by calculating the present value of its future free cash flows:

Now, add in the value of its non-operating assets to get the total value of the firm:

gk

gFCFVOps

10

NonOpsNonOpsOps V

gk

gFCFVVV

10

The Free Cash Flow Model

Now, to calculate the value of its equity, we subtract the value of the firm’s debt and the value of its preferred stock:

Since this is the total value of its equity, we divide by the number of shares outstanding to get the per share value of the stock.

PDNonOpsCS VVV

gk

gFCFV

10

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Price/Earnings Ratio

Alternative approach often used by security analystsP/E ratio is the strength with which investors value earnings as expressed in stock price

Divide the current market price of the stock by the latest 12-month earnings

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To estimate share value

P/E ratio can be derived from

Indicates the factors that affect the estimated P/E ratio

11 /E P Eo P/E rati justified

earnings estimated P

o

o

k - g/ED

/E or Pk - gD

P oo11

11

P/E Ratio Approach

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P/E Ratio Approach

The higher the payout ratio, the higher the justified P/E

Payout ratio is the proportion of earnings that are paid out as dividends

The higher the expected growth rate, g, the higher the justified P/EThe higher the required rate of return, k, the lower the justified P/E

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P/E Ratios and Interest Rates

A P/E ratio reflects investor optimism and pessimism

Related to the required rate of return

As interest rates increase, required rates of return on all securities generally increaseP/E ratios and interest rates are indirectly related

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Other Valuation Methods

Price-to-book value ratioRatio of share price to stockholder equity as measured on the balance sheet

Price-to-sales ratioRatio of a company’s total market value (price times number of shares) divided by salesMarket valuation of a firm’s revenues

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Which Approach Is Best?

Best estimate is probably the present value of the (estimated) dividends

P/E multiplier remains popular for its ease in use and the objections to the dividend discount model