Stock Valuation

Corporate Finance
Lecture: Stock Valuation

SHEN Tao （沈涛） Tsinghua University
Outline
1 Stock Basics
2 The Dividend-Discount Model
3 Estimating Dividends in the Dividend-Discount Model
4 Limitations of the Dividend-Discount Model
5 Share Repurchases and the Total Payout Model
6 The Discounted Free Cash Flow Model
8 Valuation Based on Comparable Firms
9 Information, Competition, and Stock Prices
Stock Basics
 Common stock is a share of ownership in the corporation, which
gives its owner rights to vote on the election of directors, mergers,
or other major events. Common stock carries the right to share in
the profits of the corporation through dividend payments.
 Classes of Stock
 Dividends are periodic payments, usually in the form of cash that

are made to shareholders as a partial return on their investment in
the corporation. Shareholders are paid dividends in proportion to
the amount of shares they own.
 Preferred Stock
 Cumulative versus Non-Cumulative Preferred Stock
 Preferred Stock: Equity or Debt?
Price and Dividends
 Common Stocks and Dividends
 Earnings are distributed to shareholders through dividends.
 Market price of a stock reflects the value the market has placed
on the right to receive future dividends.
 Payment of dividends is not assured, and dividend policy varies
between firms.
 Dividends - In the U.S. generally paid quarterly
 Cash flow and earnings are not the same thing.
 Stock Price Quote
The Dividend-Discount Model
 A One-Year Investor
 Two Potential Sources of Cash Flows from Stock
 The firm might pay out cash to its shareholders in the form of a
dividend
 The investor might generate cash by selling the shares at some future
date
0 1
-P0 Div1+P1
 Note the Div1 and P1 are based on the investor’s expectation at

time 0.
 Assume the market cost of capital is rE, we must have
Div1 + P1
P0 =
1 + rE
 If the current price is less than P0, investing into the stock has
a positive NPV, so investors will demand more and driving
up the price.
 If the current price is more than P0, (short) selling the stock
has a positive NPV, driving down the stock price.
 rE can also be interpreted as the total expected return of
investing this stock.
 Note rE has two components:
Div1 + P1 Div1 P1 − P0
=rE = −1 +
P0 P0 P0
 
Dividend Yield Capital Gain Rate
 Dividend Yield: expected annual dividend of the stock
divided by its current price.
 Capital Gain: amount the investor will earn on the stock,
difference between the expected sale price and the original
purchase price for the stock .
 Total Return: The expected total return of the stock
should equal the expected return of other investments
available in the market with equivalent risk.
 Example:
 Suppose you expect Longs Drug Stores to pay an annual
dividend of $.56 per share in the coming year and to trade
$45.50 per share at the end of the year. If investments with
equivalent risk to Longs’ stock have an expected return of
6.80%, what is the most you would pay today for Longs’
stock? What dividend yield and capital gain rate would you
expect at this price?
 Solution:
Div1 + P1 0.56 + 45.50

=P0 = = $43.13
1 + rE 1.0680
 Dividend yield is Div1/P0 = 0.56/43.13 = 1.30%.
 The expected capital gain is $45.50 - $43.13 = $2.37 per
share.
 Capital gain rate is 2.37/43.13 = 5.50%.
 A Multiyear Investor
 We first extend the intuition we developed for the one-year
investor’s return to a two-year investor.
Div1 Div2 + P2
=P0 +
1 + rE (1 + rE )
2
 As a two-year investor, we care about the dividends at year 1

and 2, and stock price in year 2.
 Now extend to an N-year investor
Div1 Div2 Div N PN
P0 = + +  + +
1 + rE (1 + r E ) 2 (1 + r E ) N (1 + r E ) N
 If the price of the stock increases at a lower rate than (1+rE), as N
goes to infinity, the last term (the present value of infinite-period
stock price) goes to 0. So we have:
Div Div2 Div3
P0 = 1 + + +
1 + rE (1 + rE ) (1 + rE )
2 3
 In words, the price of a stock is equal to the present value of all of the
expected future dividends it will pay. So stock is a claim to all future
dividends.
Estimating Dividends in DD model
 Constant Dividend Model
 If we assume that expected dividends never change (i.e. no
growth) then the valuation formula is simply a perpetuity.
DIV1
P0 =
r
 But in reality, both dividend and price of stocks increases over
time on average. So we need a better model.
 Constant Dividend-Growth Model
 If we assume the growth rate of dividend growth rate g, then the
valuation formula is a growing perpetuity.
Div1
P0 =
rE − g
 The value of the firm depends on the dividend level of next year,
divided by the equity cost of capital adjusted by the growth rate.
 Note that we can rearrange it as follows:
Div1
= rE +g
P0
 Compare it with previous formula
Div1 + P1 Div1 P − P0
=rE = −1 + 1
P0 P0 P0
 
Dividend Yield Capital Gain Rate
 The expected capital gain rate is equal to g, the expected

growth rate of dividend growth. So stock price and dividend
are expected to grow at the same rate.
 Example
 Suppose Johnson & Johnson just paid $2.85 per share in
dividends this year (year 0). Assume its equity cost of capital
is 9% and dividends are expected to grow by 3% per year in
the future.
1. What is the current stock price of Johnson & Johnson?
2. What is the expected stock price of Johnson & Johnson
three year later?
 Solution
 The dividend flow is a growing perpetuity, so the current
price is
Div1 Div0 × (1 + g ) 2.85 ×1.03
P0 = = = = 48.925
r−g r−g 0.09 − 0.03
 Since the growth rate of stock price is expected to be the
same as the dividend growth rate g, so
P3 = P0 × (1 + g ) 3 = 48.925 ×1.033 = 53.46

 Dividends Versus Investment and Growth
 Usually, dividends are not equal to EPS.
 When there are good projects to invest, firms tend to choose to
payout part of the earnings as dividend, and invest the rest
(retained earnings) to the projects.
 Define a firm’s dividend payout rate as the fraction of its
earnings that the firm pays as dividends each year.
Earningst
Divt × Dividend Payout Ratet
Shares Outstanding t

Epst
 Therefore, a firm can increase dividends (per share) in three

ways:
1. Increase its earnings (net income)
2. Increase its dividend payout rate
3. Decrease its number of shares outstanding
 Excluding dividend payment, the rest of the earnings goes to
new investment.
New Investment = Earnings × (1 - Dividend Payout Rate)

= Earnings × Retention Rate
 If the firm keep its dividend payout rate constant, the growth
rate of dividend is equal to the growth rate of earnings. We
can calculate the growth rate as (see next page):
 Denote the return on new investment as rI
g = Earning Growth Rate

Change in Earnings New Investment × rI
= =
Earnings Earnings
Earnings × (1 - Dividend Payout Rate) × rI
=
Earnings
= (1 - Dividend Payout Rate) × rI
= Retention Rate × rI
 So a low dividend payout rate would increase the growth rate of
dividends.
 Using the expression for g, we can rewrite the constant
dividend-growth model as
Div1 EPS1 × Dividend Payout Rate
P0 = =
rE − g rE − (1 − Dividend Payout Rate) × rI
 Note: keeping other parameters constant,
 Higher EPS, higher stock price.
 Higher return on new investment increases the value of the firm,
hence the stock price.
 Higher dividend payout rate increases both the numerator and
denominator, while its effect on stock price depends the rest of
the parameters.
 Example
 Crane Sporting Goods expects to have earnings per share of $6 in the
coming year. Rather than reinvest these earnings and grow, the firm
plans to pay out all of its earnings as a dividend. With these expectations
of no growth, Crane’s current share price is $60. Suppose Crane could
cut its dividend payout rate to 75% for the foreseeable future and use
the retained earnings to open new stores. The return on investment in
these stores is expected to be 12%. If we assume that the risk of these
new investments is the same as the risk of its existing investments, then
the firm’s equity cost of capital is unchanged. What effect would this
new policy have on Crane’s stock price?
 Solution
 The cost of capital is
Div1
rE= + g= 10% + 0%= 10%
P0
 If Crane reduces its dividend payout rate 75%, then its
dividend this coming year will fall to Div1 = EPS1 x 75% =
$6 x 75% = $4.50.
 Its growth rate will increase to
g = (1 − Dividend Payout Rate) × rI = 25% ×12% = 3%

 So the new stock price is
Div1 $4.50
=P0 = = $64.29
rE − g 0.10 − 0.03
 By decreasing the dividend payout rate, Crane takes

advantage of the “good” investment (high rI ), hence increase
its value. As a result, its stock price increases from $60 to
$64.29.
 Example (continued)
 Suppose Crane Supporting Goods decides to cut its dividend
payout rate to 75% to invest in new stores, as before. But
now suppose that the return on these new investments is 8%,
rather than 12%. Give its expected earnings per share this
year of $6 and its equity cost of capital of 10% (we again
assume that the risk of the new investments is the same as its
existing investments), what will happen to Crane’s current
share price in this case?
 Solution
 Crane’s dividend will fall to $6 x 75% = $4.50.
 Its growth rate under the new policy will now be g = 25% x
8% = 2%.
 The new share price is therefore
Div1 $4.50
= P0 = = $56.25
rE − g .10 − .02
 Investing into the “bad” project (low rI ) actually decrease the
firm value and the stock price.
 In summary, the previous examples show that: Cutting
dividend to increase investment will raise the stock price if,
and only if, the new investment have a higher expected
return(rI) than the equity’s cost of equity(rE).
 Another way to say the statement after “if and only if ” above
is: the new investment have a positive NPV, hence add value
to the company.
 Link to Growth and Value stocks
 Growth firms have good projects to invest, so they retain most or all
of the earnings, and focus primarily on capital gains. (e.g. Technology
Stocks).
 Value firms have few good projects, so they pay most of the earnings
as dividends (e.g. Utility Stocks)
 Question: If the future value of the stock is a function of dividends,

how do we explain a the valuations of “Growth” stocks that pay small
or no dividends?
 Changing Growth Rates
 Since few firms grow at constant rates, the dividend discount
model can easily be adapted to reflect various rates of growth in
early periods with the Constant Growth Perpetuity formula
used to calculate a “terminal value” when constant growth is
present.
DIV1 DIV2 DIV3 DIVt Pt

P0 = + + +...+ +
1 + r (1 + r ) (1 + r )
2 3
(1 + r ) (1 + r )t
t
DIVt +1
where Pt =
r−g
 Example
 Small Fry, Inc., has just invented a potato chip that looks and tastes like a
french fry. Given the phenomenal market response to this product,
Small Fry is reinvesting all of its earnings to expand its operations.
Earnings were $2 per share this past year and are expected to grow at a
rate of 20% per year until the end of year 4. At that point, other
companies are likely to bring out competing products. Analysts project
that at the end of year 4, Small Fry will cut its investment and begin
paying 60% of its earnings and dividends. Its growth will also slow to a
long-run rate of 4%. If Small Fry’s equity cost of capital is 8%, what is
the value of a share today?
 Solution
Div4 $2.49
=P3 = = $62.25
rE − g 0.08 − 0.04
Div1 Div2 Div3 P3 $62.25
P0 = + + + = =
$49.42
1 + rE (1 + rE ) 2
(1 + rE ) (1 + rE ) (1.08)
3 3 3
 Limitations of Dividend-Discount Model
 Forecasting actual dividends is difficult.
 Dividend payout policies change over time.
 Earnings depend on interest which varies with debt.
 Shares are issued and repurchased over time.
 These decisions are subject to management’s discretion so
valuation methods that are focused more on the fundamental
aspects of a firm’s cash flows are useful.
Total Payout Model
 Share Repurchases are equivalent to Dividends.
 Rather than focusing on Dividends per Share to calculate the
price of an individual shares, this approach looks at aggregate
payments to shareholders.
 When a firm uses share repurchases this method is more
reliable and easy to apply
PV (Total Dividends + Share Repurchases)

Share Price =
Shares Outstanding
Total Payout Model
 Example
 Google, Inc. has 286 million share outstanding and expects
earnings at the end of this year of $5 billion. Google plans to
pay out 60% of its earnings in total, paying 30% as a dividend
and using 30% to repurchase shares. If Google’s earnings are
expected to grow by 8.1% per year and these payout rates
remain constant, determine Google’s share price assuming an
equity cost of capital of 10%.
Total Payout Model
 Solution
 Total payout is the sum of dividend and repurchase
 Total payouts is 60% x $5 billion = $3 billion at the end of
this year.
 So the market value of its equity (market capitalization) is:
$3 billion
PV(Total Payout) = = $157.89 billion
0.10 - 0.081
 Its stock price is
$157.89 billion
P0 = = $552
286 million
Free Cash Flow Valuation Model
 This model starts estimating the enterprise value – the value of
the firm’s business .
 Like the capital budgeting process, we estimate the firm’s
enterprise value as the present value of the free cash flows.
 
Unlevered Net Income 
Free Cash=Flow (Revenues − Costs − Depreciation) × (1 − tax rate)
+ Depreciation
Note V is the enterprise value. − CapEx − Change in NWC
0
V0 = PV (Future Free Cash Flow of Firm)

Free Cash Flow Valuation Model
 So the price of the stock can be estimated as
=
Enterprise Value Market Value of Equity + Debt − Cash
V0 + Cash 0 − Debt 0
P0 =
Shares Outstasnding 0
Note: when we calculate PV(Free CFs), the discount rate here is not rE,
because the existence of both equity and debt will affect the risk of the
business. Here we use weighted average cost of capital (WACC) rWACC ,
which we will come back to on Chapter 12.
Valuing Nike, Inc., Stock Using Free
Cash Flow
Problem:
 Nike had sales of $25.3billion in 2009. Suppose you expect its
sales to grow at a rate of 10% in 2013, but then slow by 1% per
year to the long-run growth rate that is characteristic of the
apparel industry—5%—by 2018. Based on Nike’s past
profitability an investment needs, you expect EBIT to be 10% of
sales, increases in net working capital requirements to be 10% of
any increase in sales, and capital expenditures to equal
depreciation expenses. If Nike has $3.3 billion in cash, $1.2 billion
in debt, 893.6 million shares outstanding, a tax rate of 24%, and a
weighted average cost of capital of 10%, what is your estimate of
the value of Nike’s stock in early 2013?
Cash Flow
Solution:
Plan:
 We can estimate Nike’s future free cash flow by
constructing a pro forma statement. The only difference
is that the pro forma statement is for the whole
company, rather than just one project. Further, we need
to calculate a terminal (or continuation) value for Nike
at the end of our explicit projections.
Cash Flow
Plan (cont’d):
 Because we expect Nike’s free cash flow to grow at a
constant rate after 2015, we can compute a terminal
enterprise value. The present value of the free cash flows
during the years 2013–2018 and the terminal value will
be the total enterprise value for Nike. Using that value,
we can subtract the debt, add the cash, and divide by the
number of shares outstanding to compute the price per
share.
Cash Flow
Execute:
 The spreadsheet below presents a simplified pro forma for Nike based on the
information we have:
Year 2012 2013 2014 2015 2016 2017 2018

FCF Forecast ($ million)
Sales 25,300.0 27,830.0 30,334.7 32,761.5 35,054.8 37,158.1 39,016.0

Growth Versus Prior Year 10% 9% 8% 7% 6% 5%
EBIT (10% of sales) 2,783.0 3,033.5 3,276.1 3,505.5 3,715.8 3,901.6
Less: Income Tax (24%) 667.9 728.0 786.3 841.3 891.8 936.4
Plus: Depreciation
Less: Capital Expenditures
Less: Increase in NWC (10%
Δ Sales) 253.0 250.5 242.7 229.3 210.3 185.8
Free Cash Flow 1,862.1 2,055.0 2,247.2 2,434.8 2,613.7 2,779.4

Cash Flow
Execute (cont’d):
 Because capital expenditures are expected to equal depreciation, lines 7 and 8
in the spreadsheet cancel out. We can set them both to zero rather than
explicitly forecast them.
 Given our assumption of constant 5% growth in free cash flows after 2018 and a
weighted average cost of capital of 10%, we can compute a terminal enterprise
value:
Cash Flow
Execute (cont’d):
 Nike’s current enterprise value is the present value of its free cash flows plus
the firm’s terminal value:
 We can now estimate the value of a share of Nike’s stock:

Cash Flow
Evaluate:
 The total value of all of the claims, both debt and equity,
on the firm must equal the total present value of all cash
flows generated by the firm, in addition to any cash it
currently has. The total present value of all cash flows to
be generated by Nike is $42,881.5 million and it has
3,300 million in cash. Subtracting off the value of the
debt claims (1,200 million), leaves us with the total
value of the equity claims and dividing by the number of
shares produces the value per share.
The Discounted Free Cash Flow Model
 Connection to Capital Budgeting
 Free cash flow is the sum of the free cash flows from the firm’s
current and future investments, so enterprise value is the sum
of the present value of existing projects and the NPV of future
new ones
 NPV of any investment represents its contribution to the firm’s
enterprise value
 To maximize share price, we should accept projects that have a positive
NPV
The Discounted Free Cash Flow Model
 We must forecast all the inputs to free cash flow
 This process gives us flexibility to incorporate many
details
 However, some uncertainty surrounds each assumption
 Given this fact, sensitivity analysis is important
 Translates the uncertainty into a range of values for the
stock
Sensitivity Analysis for Stock Valuation
Problem:
 In previous example Nike’s EBIT was assumed to be 10% of sales. If Nike can
reduce its operating expenses and raise its EBIT to 11% of sales, how would the
estimate of the stock’s value change?
Solution:
Plan:
 In this scenario, EBIT will increase by 1% of sales
compared to previous example. From there, we can use
the tax rate (24%) to compute the effect on the free cash
flow for each year. Once we have the new free cash
flows, we repeat the approach to arrive at a new stock
price.
Execute:
 In year 1, EBIT will be 1% X $27,830 million = $278.3 million
higher. After taxes, this increase will raise the firm’s free cash flow
in year 1 by (1-0.24) X $278.3 million = $211.5 million, to
$2,073.6 million. Doing the same calculation for each year, we
get the following revised FCF estimates:
Year 2013 2014 2015 2016 2017 2018

FCF 2,073.6 2,285.5 2,496.2 2,701.2 2,896.1 3,075.9

Evaluate:
 Nike’s stock price is fairly sensitive to changes in
the assumptions about its profitability. A 1%
permanent change in its margins affects the firm’s
stock price by 10%.
Comparison of Stock Valuation
Methods
Valuation Based on Comparable Firms
 Investors often attempt to apply the “Law of One Price” to
stock valuation by comparing the relationship between the
price of one company’s stock to another company’s stock by
using the idea of comparable firms.
 If two firms are identical in every respect, they should have the
same value.
 Since no two firms are identical comparable valuation
attempts to adjust for differences through the use of
“multiples.”
Valuation Multiples
Different Multiples are used in :
 P/E Ratio
 Trailing or past earnings
 Estimates of next year’s earnings
 Enterprise Value/EBITDA
 Trailing or past EBITDA
 Next Year’s estimated EBITDA
 Enterprise Value/Sales
 Other multiples
 Multiples of sales can be useful if it is reasonable to
assume margins are similar in the future
 Price-to-book value of equity can be used for firms
with substantial tangible assets
 Some multiples are specific to an industry
 e.g. Cable TV – Enterprise value per subscriber
 GMV, MAU
Valuation Multiples
Example
 Suppose furniture manufacturer RC Willey, has earnings
per share of $1.65. If the average P/E of comparable
furniture stocks is 24.8, estimate a value for RC Willey’s
stock using the P/E as a valuation multiple. What are the
assumptions underlying this estimate?
Valuation Multiples
Solution
 P0 =EPS×P/E= $1.65 × 24.8 = $40.92.
 This estimate assumes that RC Willey will have similar
future risk, payout rates, and growth rates to comparable
firms in the industry.
 To see this,
Price P P D1 1
= = = × Payout Rate
EPS E D1 E rE − g
Valuation Multiples
 Enterprise value multiples use a measure of earnings before
interest payments are made
 When expected free cash flow growth is constant, we can

write EV to EBITDA as:
FCF1
V0 rwacc − g FCF FCF1 / EBITDA1
= =
EBITDA1 EBITDA1 rwacc − g FCF
Weaknesses of Comparable Valuation
 Although valuation multiples are simple to use, they rely on
some very strong assumptions about the similarity of the
comparable firms to the firm you are valuing.
 It is important to consider these assumptions are likely to be
reasonable—and thus to hold—in each case.
 It only tells you the relative price compared to some
“comparable” stocks, not the absolute price.
Stock Prices and Multiples for the Footwear
Industry (excluding Nike), July 2013
 Comparison with Discounted Cash Flow Methods
 Valuation multiple does not take into account
material differences between firms
 Talented managers
 More efficient manufacturing processes
 Patents on new technology
 Comparison with Discounted Cash Flow Methods
 Discounted cash flow methods allow us to incorporate
specific information about cost of capital or future
growth
 Potential to be more accurate
 Stock Valuation Techniques: The Final Word
 No single technique provides a final answer
regarding a stock’s true value
 Practitioners use a combination of these
approaches
 Confidence comes from consistent results from
a variety of these methods
Information, Competition and Stock
Prices
 Efficient markets hypothesis: The idea that competition
among investors works to eliminate all positive-NPV trading
opportunities. It implies that securities will be fairly priced,
based on their future cash flows, given all information that
is available to investors.
 Public, Easily Available Information: Information
available to all investors includes information in news reports,
financial statements, corporate press releases, or other public
data sources.
 Private or Difficult-to-Interpret Information
Information, Competition, and Stock
Prices
Prices
 Example
 Myox Labs announces that it is pulling one of its leading
drugs from the market, owing to the potential side effects
associated with the drug. As a result, its future expected free
cash flow will decline by $85 million per year for the next 10
years. Myox has 50 million shares outstanding, no debt, and
an equity cost of capital of 8%. If this news came as a
complete surprise to investors, what should happen to
Myox’s stock price upon the announcement?
Prices
 The decline in expected free cash flow will reduce
Myox’s enterprise value by
1  1 
$8.5 million × 1 − 10 
= $570 million
1.08  1.08 
 Since this is a public information, the share price should
fall by $570/50 = $11.40 immediately.
Prices
 Private or Difficult-to-Interpret Information
 Example: Phenyx Pharmaceuticals had just announced the
development of a new drug for which the company is seeking
approval from the FDA
 If the drug is approved future profits will increase Phenyx’s
market value by $15 per share
 Suppose the announcement comes as a surprise to investors,
and average likelihood of FDA approval is 10%
 The announcement should lead to a 10% × $15.00=
$1.50 per share immediate stock price increase
Prices
 Over time, investors will make their own
assessments of the probable efficacy of the drug
 If they conclude that the drug looks more (less)
promising than average, they will buy (sell) the
stock and the price will drift higher (lower)
over time
 At the time of the announcement, uninformed
investors do not know which way it will go
Prices

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Corporate Finance

Lecture: Stock Valuation

 Dividends are periodic payments, usually in the form of cash that

 Note the Div1 and P1 are based on the investor’s expectation at

Div1 + P1 0.56 + 45.50

 As a two-year investor, we care about the dividends at year 1

 The expected capital gain rate is equal to g, the expected

P3 = P0 × (1 + g ) 3 = 48.925 ×1.033 = 53.46

 Therefore, a firm can increase dividends (per share) in three

New Investment = Earnings × (1 - Dividend Payout Rate)

g = Earning Growth Rate

g = (1 − Dividend Payout Rate) × rI = 25% ×12% = 3%

 By decreasing the dividend payout rate, Crane takes

 Question: If the future value of the stock is a function of dividends,

DIV1 DIV2 DIV3 DIVt Pt

PV (Total Dividends + Share Repurchases)

V0 = PV (Future Free Cash Flow of Firm)

Year 2012 2013 2014 2015 2016 2017 2018

Sales 25,300.0 27,830.0 30,334.7 32,761.5 35,054.8 37,158.1 39,016.0

EBIT (10% of sales) 2,783.0 3,033.5 3,276.1 3,505.5 3,715.8 3,901.6

Free Cash Flow 1,862.1 2,055.0 2,247.2 2,434.8 2,613.7 2,779.4

 We can now estimate the value of a share of Nike’s stock:

Year 2013 2014 2015 2016 2017 2018

 When expected free cash flow growth is constant, we can

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