CHAPTER 9 Stocks and Their Valuation

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CHAPTER 9Stocks and Their Valuation

• Features of common stock
• Determining common stock values
• Preferred stock

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Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management

3
Corporate Organization
1-3
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Intrinsic Value and Stock Price

• 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.
• Investors 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).

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Different approaches for estimating the intrinsic
value of a common stock

• Dividend growth model
• Corporate value model

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Dividend growth model

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

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Common Stock Valuation
Div 2
Div 8
Div 3
k
k
k
k
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Bond Valuation (a comparison)
Pmt 2
Pmt 20
Pmt 3

k
k
k
k
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Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D1 (1g)1
• D3 D2 (1g)1

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If D0 2 and g is a constant 6, find the
expected dividend stream for the next 3 years,
and their PVs (assume rs 13.
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Div 8
rs
A, D1 D0(1g)1 2.00 (10.06)
2.12
B, D2 D1(1g)1 2.12(10.06)
2.247
C, D3 D2(1g)1 2.247 (10.06)1
2.382
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Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D1 (1g)1
• D3 D2 (1g)1
• If g is constant, the dividend growth formula
  converges to

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What is the stocks intrinsic value?

• Using the constant growth model

A , D0 (1g) 2.0 (10.06) 2.12
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What would the expected price today be, if g 0?

• The dividend stream would be a perpetuity.

P0 D rs-g If g 0
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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.

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Common Stock Valuation
g 30
8
g 6
D8
D2
D3
D4
rs
rs
rs
P3 Present value of all future cash
flows to be received beyond Yr 3
rs
P3 D4 rs-g D3 (16) rs-g
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Valuing common stock with nonconstant growthp
(example 1)
rs13, n1
rs13, n2
A D3 (1g) 4.394(16) 4658
rs13, n3

rs13, n3
P

B FV66.54, n3, I/yr13, PV?
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Nonconstant growth (example 2)What if g 0
for 3 years before long-run growth of 6?
rs13, n1
rs13, n2
rs13, n3
rs13, n3
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Super normal growth (example 3)G 40 for 5
years before achieving L-r growth of 7
G 40
G 7
D8
D2
D3
D4
D5
D6
P5 Present value of all future cash
flows to be received beyond Yr 5
P5 D6 rs-g D5 (17) rs-g
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What are the expected dividend yield, capital
gains yield, and total return during the first
year(assume D1 2.12, P1 32.10 P0 30.29)?

• 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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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.

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Preferred stock Valuation

• If a preferred stock pays an annual dividend
  of RM5 a share and market interest rate is 10,
  what is the preferred stocks current price?
• Vp D/rp
• D 5
• rp10 , Vp RM5/ 10
• Vp RM50

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If preferred stock with an annual dividend of 5
sells for 50, what is the preferred stocks
expected return?

• Vp D / rp
• 50 5 / rp
• rp 5 / 50
• 0.10 10

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What would be the intrinsic price for this stock,
one year from now (assume long-run growth of x
until )?
8
D8
D0
D1
D2
One year from now- to determine the intrinsic
value(p1)
Today
If today P0 D1 rs - g
If one year P1 D2 from now rs - g
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What is the expected market price of the stock,
one year from now(p1)?

• Assume D0 2, g 6, rs 13
• P1 is the present value (as of year 1) of D2, D3,
  D4, etc.
• Could also find expected P1 as

D2 D1 (1g) 2.12 (10.06) 2.247
D1 D0 (1g) 2.00 (10.06) 2.12
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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.
• Remember, free cash flow is the firms after-tax
  operating income less the net capital investment
• FCF NOPAT Net capital investment

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• FCF NOPAT Net capital invest
• FCF EBIT(1-T) Depreciation exp
• - capital exp working capital

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Applying the corporate value model

• Find the market value (MV) of the firm, by
  finding the PV of the firms future FCFs.
• Subtract MV of firms 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).

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Given the long-run beyond yr 3 is gFCF 6, and
WACC of 10, use the corporate value model to
find the firms intrinsic value.
FCF Y1 -5 Y2 10 Y3 20
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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
• 416.94 - 40
• 376.94 million
• Value per share MV of equity / of shares
• 376.94 / 10
• 37.69

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How is market equilibrium established?

• If price is below intrinsic value
• The current price (P0) is too low.
• If price is above intrinsic value
• The current price (P0) is too high