Monday 3.00 p.m.

Tutorial 2, Group 5

Stocks and Their Valuation

1

Group Photo
Galen Lee Nabil Syukri

Feng Yuyun

Tay Jie Hao

Recap
3 approaches for estimating intrinsic value
of stocks
Discounted Dividend Rate (DDM)
Constant growth
Non-constant growth

Corporate Valuation Model

Multiples of Comparable firms

LEE YI GUO GALEN

Discounted Dividend (constant

growth)
Intrinsic
Value of stock

Where is the required return on stock

In general
Where g is the growth rate
Take note this method works only if and remains
constant

LEE YI GUO GALEN

Discounted Dividend method (nonconstant)

LEE YI GUO GALEN

Corporate Valuation Method

To calculate we must first find Market value of Firm

Find MV of common stock

MV of common stock=MV of firm-MV of firms debt and preferred stock

We then proceed to find the intrinsic value of the common stock

LEE YI GUO GALEN

Comparisons between methods

LEE YI GUO GALEN

Multiple Firm model

P/E ratio
Price per share/ Earnings per share
However this may be subject to
manipulation hence other ratios are used
additionally

P/CF
Price per share/ Cash flow
P/Sales
Price per share/Sales per share
LEE YI GUO GALEN

Market Equilibrium
No tendency to buy or sell
Current market stock price is equal to its
intrinsic value
Expected return = required return

LEE YI GUO GALEN

Q10-2

Is the following equation correct for finding the

value of a constant growth stock? Explain.

Answer: No, the equation above is incorrect.

NABIL SYUKRI BIN NORMAN

10

Using

Discounted Dividend Model,

Constant growth stock,

Substituting these equations into the first

equation will yield:

NABIL SYUKRI BIN NORMAN

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Sum

of Geometric Progression where:

First term,
Common ratio,
Intrinsic value of stock,

NABIL SYUKRI BIN NORMAN

12

Q10-4
Two investors are evaluating GEs stock for
possible purchase. They agree on the expected
value of D1 and also on the expected future
dividend growth rate. Further, they agree on
the riskiness of the stock. However, one
investor normally holds stocks for 2 years,
while the other holds stocks for 10 years. On
the basis of the type of analysis done in this
chapter, should they both be willing to pay the
same price for GEs stock? Explain.
NABIL SYUKRI BIN NORMAN

13

What the two investors agree on:

1. Expected value of D1
2. Expected future dividend growth rate
3. Riskiness of the stock
What differentiates the two investors:
Investor A: Normally holds stock for 2 years
Investor B: Normally holds stock for 10 years
Should they both be willing to pay the same
price for GEs stock?
Answer: Yes, they should be willing to pay the
same price for GEs stock.
NABIL SYUKRI BIN NORMAN

14

Intrinsic value of stock:

Present value of the future dividends expected
to be generated by the stock
Therefore, logically, if the two investors expect
the same future dividend stream, and they
agree on the stocks riskiness, then they should
reach similar conclusions as to the stocks
value.

NABIL SYUKRI BIN NORMAN

15

Another

way to look at this is by examining the

intrinsic value formula for constant growth model:

D1 is similar because they agree on it. g is also

similar because they agree on the expected dividend
growth rate. rs is also similar because for the same
level of riskiness, investors will expect the same
amount of required return. There is no where in this
formula that takes into account the normal duration
of holding the stock as its variable. Hence, given all
these, the two investors will be willing to pay the
NABIL SYUKRI BIN NORMAN

16

P10-8
Drill Corporation issued perpetual preferred
stock with a 5 percent annual dividend. The
stock currently yields 10 percent, and its par
value is $120.
a.What is the preferred stocks value?
b.Suppose interest rates rise and pull the
preferred stocks yield up to 14 percent.
What is its new market value?
AW CHEN CHEN

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a.What is the preferred stocks value?

From the question, we can know

that:
Perpetual preferred stock
5% annual dividend
10% current yield ()
Par value= $120

AW CHEN CHEN

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Preferred Dividend = Par Value x percentage of annual

dividend
= $120 x 5%
= $6
Since the Preferred Dividend is constant.
Therefore, D1=D2=Dn=D , and growth of dividend, g = 0
Using the formula
60
Ans : The the preferred stocks value is $60.00

AW CHEN CHEN

19

b. Suppose interest rates rise and pull

the preferred stocks yield up to 14
percent.
What
is its new market value?

The new stock yield, = 14% = 0.14

Using the formula

Ans: The new stock market value is $42.86

AW CHEN CHEN

20

P10-18(a)

Taussig Technologies Corporation (TTC)

has been growing at a rate of 20
percent per year in recent years. This
same growth rate is expected to last for
another 2 years, then to decline to
=6%.

a. If = $1.60 and = 10%, what is TTCs

stock worth today?

Present value,
TAY JIE HAO

21

P10-18(a)
According to the question, D0 = $1.60 and
rs = 10% ,
gn =
gn =
gn =
gn =
4
020% 1 20% 2 6% 3 6%
D0=$1.60 D1
D4

rs=$10
D1 = D0(1+g)
D1(1+g) = D0(1+g)2
= $1.60(1+0.2)
$1.92(1+0.2)
= $1.92

D2

D3

Dt = D0(1+g)t
D2 =
=
TAY JIE HAO

=$

22

P10-18(a)

D3 = D0(1+g)3

D3 = D2(1+g)
= $2.304(1+0.0
= $2.44224

=
$1.60(1+0.2)3
= $2.7648

Note: This is a non constant growth stock

valuation. The growth rate was 20% for 2 years
then fell to a constant 6% afterward hence
dividend after 2 years will flow at a slower rate.
TAY JIE HAO

23

0 g=20 1 g=20 2 g=6 3 g=6 4

%

D0=$1.6
D4 ..
rs =10%

D1=$1.92

D2=$2.304 D3=$2.44224

(Present value of future dividends

during the constant growth
period)

= $61.056
TAY JIE HAO

24

Stock Price

=$54.109090
= $54.11

TAY JIE HAO

Remember that
we have
assumed that D0
has been paid,
hence D0 not
included in our
calculation.

25

What are its expected dividend and capital

gains yields at this time, that is, during
Year 1?

Expected Dividend Yield = =

=$1.920/$54.11
=3.55%

Capital Gains Yield= = 10% - 3.55%

= 6.45%

TAY JIE HAO

26

P10-18(b)

Now assume that TTCs period of

supernormal growth is to last for 5 years
rather than 2 years. How would this affect
the price, dividend yield and capital gains
yield? Answer in words only.

TAY JIE HAO

27

Since the supernormal growth lasts for 5 years, dividends over the 5
years will also be much higher since it has been compounded more
times. As a result, the present value of the dividend also increases.
Expected dividend yield(rs)= D1 / P0
With a higher P0 for the stock with 5 years of supernormal growth as
compared to the one with only 2 years, the expected dividend yield
will be smaller since D1 becomes a smaller proportion as compared
to the price.
Capital Gain Yield= Expected return- dividend yield, since dividend
yield is smaller for 5 years of supernatural growth, capital gain yield
will be a greater.
TAY JIE HAO

28

P10-18(c)

What will TTCs dividend and capital gains

yields be once its period of supernormal
growth ends?
Once its supernormal growth period ends,
TTCs stock will be a constant growth stock
with gn =6% which equal to the constant
growth
in dividends.

rs= Dividend Yield() + Capital Gains Yield (g)

Capital Gains Yield = g = 6%
Dividend Yield = rs g
= 10%-6%
= 4%
TAY JIE HAO

29

P10-19
Barrett Industries invests a large sum of money in
R&D, and as a result it retains and reinvests all of
its earnings. In other words, Barrett does not pay
any dividends, and it has no plans to pay
dividends in the near future. A major pension fund
is interested in purchasing Barretts stock. The
pension fund manager has estimated Barretts
free cash flows for the next 4 years as
follows: $3 million, $6 million, $10 million,
and $15 million. After the fourth year, free cash
flow is projected to grow at a constant 7
percent. Barretts WACC is 12 percent, the
market value of its debt and preferred stock
FENG YUYUN
totals $60 million, and
it has 10 million shares30

Recap

Corporate

Valuation Model (free cash flow

method)
It suggests the value of the entire firm equals the
present value of the firms free cash flows.
FCF = [EBIT(1-T) + depr. and amort.] [capital
expenditure + NOWC]
Issues regarding the Corporate Valuation Model
often preferred to the discounted dividend model,
especially when considering number of firms that
do not pay dividends or when dividends are hard to
forecast.
FENG YUYUN

31

a. What is the PV of the FCF projected during the

next 4 WACC=1
years?
g=7
0 2%1
2
3
4 % 5

3
PV

1
0

PV1 = = $2.679 million

PV3 = = $7.118 million

1
5

16.05

PV2 = = $4.783 million

PV4 = = $9.533 million

Ans. PV =
2.679+4.783+7.118+9.533=$24.113
FENG YUYUN
million

32

b. What is the firms horizon/terminal or

continuing
value?
g=7
WACC=1
0 2%1
2
3
4 % 5

1
0

1
5

16.05

Horizon Value represents value of firm at the point (4th

year) that growth becomes constant
HV

= = = $321 million

FENG YUYUN

33

c. What is the firms total value today?

g=7
WACC=1
0 2%1
2
3
4 % 5

16.05
1
1
0 firms
5 future FCFs
MV of firm = PV of the
MVfirm

24.113 +

= $228.114 million
FENG YUYUN

34

WACC=1
0 2%1

g=7
4 % 5

1
0

1
5

$2.679
m
$4.783
m
$7.118
m
$9.533
m
$204.001
m
$228.114 m

16.05

$321 m

FENG YUYUN

35

d. What is an estimate of Barretts price per

share?
MV of common stock = MV of firm MV of
firms debt and preferred stock
MVfirm = $228.114 million
MVdebt and pref. stock = $60 million
MVcommon stock = 228.114 60 = $168.114
million

FENG YUYUN

36

Hence to find the stocks intrinsic value, use the

equation:
=
No. of shares = 10 million
=
=$16.811

FENG YUYUN

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