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CHAPTER 9

Stocks and Their Valuation
Stocks and Their Valuation

Features of common stock Determining common stock values Preferred stock

Facts about common stock

Facts about common stock  Represents ownership  Ownership implies control  Stockholders elect directors 

Represents ownership Ownership implies control Stockholders elect directors Directors elect management

Management’s goal: Maximize the stock price

Intrinsic Value and Stock

Price
Price

Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s intrinsic value (P 0 ).

In equilibrium we assume that a stock’s price equals its intrinsic value.

Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or sell.

Stocks with a price below (above) its intrinsic value are undervalued (overvalued).

9-3

Determinants of Intrinsic Value and Stock Prices

(Figure 1-1)
(Figure 1-1)

Different approaches for estimating the intrinsic value of a common stock

Different approaches for estimating the intrinsic value of a common stock  Dividend growth model 

Dividend growth model Corporate value model

Using the multiples of comparable firms

Dividend growth model
Dividend growth model

Value of a stock is the present value of the future dividends expected to be generated by the stock.

^

P

0

=

D

1

(1

+

r )

s

1

+

D

2

(1

+

r )

s

2

+

D

3

(1

+

r )

s

3

+

...

+

D

(1

+

r )

s

Constant growth stock
Constant growth stock

A stock whose dividends are expected to grow forever at a constant rate, g.

D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D 0 (1+g) t

If g is constant, the dividend growth formula converges to:

^

P

0

=

D (1

0

+

g)

=

D

1

r - g

s

r - g

s

Future dividends and their

present values
present values
$ D = D ( 1 + g ) t 0 D 0.25 t PVD =
$
D
= D
( 1 + g )
t
0
D
0.25
t
PVD =
t
t
( 1
+
r )
P = PVD
0
t
0

t

Years (t)

What happens if g > r s ?

What happens if g > r ?  If g > r , the constant growth

If g > r s , the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if:

r s > g g is expected to be constant forever

If r RF = 7%, r M = 12%, and b = 1.2, what is the required rate of return

on the firm’s stock?
on the firm’s stock?

Use the SML to calculate the required rate of return (r s ):

r s

= r RF + (r M – r RF )b = 7% + (12% - 7%)1.2 = 13%

0

g

,

find the expected dividend stream for the next 3 years, and

their PVs.
their PVs.
0 1 2 3 g = 6%
0
1
2
3
g = 6%

D 0 = 2.00

1.8761

1.7599

1.6509

2.12

  • 2.247 2.382

g , find the expected dividend stream for the next 3 years, and their PVs. 0
r s = 13%
r s = 13%
g , find the expected dividend stream for the next 3 years, and their PVs. 0
g , find the expected dividend stream for the next 3 years, and their PVs. 0

What is the stock’s intrinsic value?

What is the stock’s intrinsic value?  Using the constant growth model: ˆ P 0 =

Using the constant growth model:

ˆ

P

0

=

D

1

=

r - g

s

$2.12

0.13 - 0.06

$2.12

=

0.07

= $30.29

What is the expected market price of the stock, one year from now?

What is the expected market price of the stock, one year from now?  D will

D 1 will have been paid out already. So, P 1 is the present value (as of year 1) of D 2 , D 3 , D 4 , etc.

^

P

1

D

2

$2.247

0.13 - 0.06

= r - g = $32.10

=

s

Could also find expected P 1 as:

^

P

1 =

P (1.06) $32.10

0

=

What are the expected dividend yield, capital gains yield, and total

return during the first year?
return during the first year?

Dividend yield

= D 1 / P 0 = $2.12 / $30.29 = 7.0%

Capital gains yield

= (P 1 – P 0 ) / P 0 = ($32.10 - $30.29) / $30.29 = 6.0%

Total return (r s )

= Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

What would the expected

price today be, if g = 0?
price today be, if g = 0?

The dividend stream would be a perpetuity.

0

1

2

3

r s = 13% ... 2.00 2.00 2.00
r s = 13%
...
2.00
2.00
2.00

^

P 0 =

PMT

=

r

$2.00

0.13

= $15.38

Supernormal growth:

What if g = 30% for 3 years before

achieving long-run growth of 6%?
achieving long-run growth of 6%?

Can no longer use just the constant growth model to find stock value.

However, the growth does become constant after 3 years.

Valuing common stock with

nonconstant growth
nonconstant growth
0 1 2 3 4 r = 13% s ... g = 30% g = 30%
0
1
2
3
4
r
= 13%
s
...
g = 30%
g = 30%
g = 30%
g = 6%
D 0 = 2.00
2.600
3.380
4.394
4.658
2.301
2.647
3.045
4.658
46.114
P
=
= $66.54
3
0.13
0.06
^
54.107
=
P 0

Find expected dividend and capital gains yields during the first and

fourth years.
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

yield and capital gains yield are not

constant, and capital gains yield ≠ g.

After t = 3, the stock has constant

growth and dividend yield = 7%, while

capital gains yield = 6%.

Nonconstant growth:

What if g = 0% for 3 years before

long-run growth of 6%?
long-run growth of 6%?
0 1 2 3 4 r = 13% s ... g = 0% g = 0%
0
1
2
3
4
r
= 13%
s
...
g = 0%
g = 0%
g = 0%
g = 6%
D 0 = 2.00
2.00
2.00
2.00
2.12
1.77
1.57
1.39
2.12
20.99
=
= $30.29
P  3
0.13
0.06
^
25.72
=
P 0

Find expected dividend and capital gains yields during the first and

fourth years.
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%.

p negative growth (g = -6%), would anyone buy the stock, and what is its value?

p negative growth (g = -6%), would anyone buy the stock, and what is its value?

The firm still has earnings and pays

dividends, even though they may be

declining, they still have value.

^

P

0

=

D

1

=

r - g

s

D

0 g )

( 1 + r - g

s

=

$2.00 (0.94)

=

0.13 - (-0.06)

$1.88

= $9.89
0.19

Find expected annual dividend

and capital gains yields.
and capital 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 gains yield are constant.

Dividend yield is sufficiently large

(19%) to offset a negative capital

gains.

9-22

Corporate value model
Corporate value model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows.

Remember, free cash flow is the firm’s after-tax operating income less the net capital investment

FCF = NOPAT – Net capital

investment

9-23

Applying the corporate value model

Applying the corporate value model  Find the market value (MV) of the firm, by finding

Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs.

Subtract MV of firm’s debt and preferred stock to get MV of common stock.

Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).

9-24

Issues regarding the

corporate value model
corporate value model

Often preferred to the dividend growth

model, especially when considering

number of firms that don’t pay

dividends or when dividends are hard to

forecast.

Similar to dividend growth model,

assumes at some point free cash flow

will grow at a constant rate.

Terminal value (TV N ) represents value of

firm at the point that growth becomes

9-25

constant

Given the long-run g FCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s

intrinsic value.
intrinsic value.
0 1 2 3 4 r = 10% ... g = 6% -5 10 20 21.20
0
1
2
3
4
r = 10%
...
g = 6%
-5
10
20
21.20
-4.545
8.264
15.026
21.20
398.197
530 =
= TV 3
0.10
-
0.06
416.942

If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per

share?
share?

MV of equity

= MV of firm – MV of debt

= $416.94 - $40

= $376.94 million

Value per share

shares

= MV of equity / # of

= $376.94 / 10

= $37.69

Firm multiples method
Firm multiples method

Analysts often use the following

multiples to value stocks.

P / E P / CF P / Sales

EXAMPLE: Based on comparable

firms, estimate the appropriate P/E.

Multiply this by expected earnings to

back out an estimate of the stock

price.

9-28

What is market equilibrium?
What is market equilibrium?

In equilibrium, stock prices are stable

and there 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 (P 0 = P 0 ).

^

Expected returns must equal required

^

returns.

1

+

D

r s =

P

0

g

=

r

s

=

r

RF

+

(r

M

r

RF

)b

Market equilibrium
Market equilibrium

Expected returns are determined by estimating dividends and expected capital gains.

Required returns are determined by estimating risk and applying the CAPM.

How is market equilibrium

established?
established?

If price is below intrinsic value …

The current price (P 0 ) is “too low” and offers a bargain.

Buy orders will be greater than sell orders.

P 0 will be bid up until expected return equals required return.

How are the equilibrium

values determined?
values determined?

Are the equilibrium intrinsic value and expected return estimated by managers or are they determined by something else?

Equilibrium levels are based on the

market’s estimate of intrinsic value

and the market’s required rate of

return, which are both dependent

upon the attitudes of the marginal

investor.

Preferred stock
Preferred stock

Hybrid security.

Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders.

However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

9-33

If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected

return?
return?

V p

= D / r p

$50= $5 / r p

^

r p

= $5 / $50 = 0.10 = 10%