Stocks and their valuation

1

• Stocks and their valuation
• (chapter 9)

2
Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Managements goal Maximize the stock price

3
Intrinsic Value and Stock Price

• Outside investors, corporate insiders, and
  analysts use a variety of approaches to estimate
  a stocks intrinsic value (P0).
• In equilibrium we assume that a stocks 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 its intrinsic value are
  undervalued
• Buy or Sell?
• Stocks with a price above its intrinsic value are
  overvalued
• Buy or Sell?

4
Dividend growth model

• Value of a stock is the present value of the
  future dividends expected to be generated by the
  stock.
• r s is the required rate of return (think the
  one from CAPM)

5
Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• If g is constant, the dividend growth formula
  converges to

6
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

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If rRF 7, rM 12, and ß 1.2, what is the
required rate of return on the firms stock?

• Use the SML to calculate the required rate of
  return (rs)
• rs rRF (rM rRF)ß
• 7 (12 - 7)1.2
• 13

8
If D0 2 and g is a constant 6, What is the
stocks market value?

• Using the constant growth model

9
What is 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

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What would the expected price today be, if g 0?

• The dividend stream would be a perpetuity.

11
Supernormal growthWhat if g 30 for 3 years
before 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.

12
Valuing common stock with nonconstant growth
2.6/(10.13) 2.301
2.647
3.045

P
66.54/(10.13)3 46.114

54.107 P0
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Calculations D1 D0(1g1) 2x(10.3) 2.6 D2
D1(1g1) 2.6x(10.3) 3.38 D3 D2(1g1)
3.38x(10.3) 4.394 D4 D3(1g2)
4.394x(10.06) 4.658 Present Value of D1
2.6/(10.13) 2.301 Present Value of D2
3.38/(10.13)2 2.647 Present Value of D3
4.394/(10.13)3 3.045
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Exam type question
The last dividend paid by Klein Company was
1.00. Kleins growth rate is expected to be a
constant 5 percent for 2 years, after which
dividends are expected to grow at a rate of 10
percent forever. Kleins required rate of return
on equity (rs) is 12 percent. What is the
current price of Kleins common stock?
a. 21.00 b. 33.33 c. 42.25 d. 50.16
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Corporate value model

• Also called the free cash flow method. Suggests
  the value of the entire firm equals the present
  value of the firms free cash flows.
• FCF NOPAT Net capital investment
• 1. Find the market value (MV) of the firm.
• Find PV of firms future FCFs
• 2. Subtract MV of firms debt and preferred stock
  to get MV of common stock.
• MV of MV of MV of debt andcommon
  stock firm preferred
• 3. Divide MV of common stock by the number of
  shares outstanding to get intrinsic stock price
  (value).
• P0 MV of common stock / of shares

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Issues regarding the corporate value model

• Often preferred to the dividend growth model,
  especially when considering number of firms that
  dont 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 (TVn) represents value of firm at
  the point that growth becomes constant.

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Given the long-run gFCF 6, and WACC of 10,
use the corporate value model to find the firms
intrinsic value.
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Calculations Present Value of CF1 -5/(10.1)
-4.545 Present Value of CF2 10/(10.1)2
8.264 Present Value of CF3 20/(10.1)3
15.026 CF 4 CF3(1g)20(10.06)
21.2 Present Value of Terminal Value in 3 years
(at time 3) 530/(10.1)3 388.197
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If the firm has 40 million in debt and has 10
million shares of stock, what is the firms
intrinsic value per share?

• MV of equity MV of firm MV of debt
• 416.94m - 40m
• 376.94 million
• Value per share MV of equity / of shares
• 376.94m / 10m
• 37.69

20
Exam type question
An analyst is trying to estimate the intrinsic
value of the stock of Harkleroad Technologies.
The analyst estimates that Harkleroads free cash
flow during the next year will be 25 million.
The analyst also estimates that the companys
free cash flow will increase at a constant rate
of 7 percent a year and that the companys cost
of capital is 10 percent. Harkleroad has 200
million of long-term debt, and 30 million
outstanding shares of common stock. What is the
estimated per-share price of Harkleroad
Technologies common stock? a. 1.67 b.
5.24 c. 18.37 d. 21.11
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Exam type question

• Which of the following statements is most
  correct?
• If a company has two classes of common stock,
  Class A and
• Class B, the stocks may pay different dividends,
  but the two classes must
• have the same voting rights.
• b. An IPO occurs whenever a company buys back its
  stock on the open market.
• The preemptive right is a provision in the
  corporate charter that gives
• common stockholders the right to purchase (on a
  pro rata basis) new issues of
• common stock.
• d. Statements a and b are correct.

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Learning objectives

• Read from the text the following topics control
  of the firm types of common stock The market
  for common stock
• Know how to apply the dividend growth model,
  constant and non-constant growth
• Know how to calculate total return, dividend
  yield and capital gains
• Know how to use corporate value model to value
  common stock
• Recommended end-of-chapter problems ST-1,
  Questions 9-3, 9-4
• Problems 9-1 to 9-5, 9-11,9-1 to 9-17