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Stock Valuation. FIL 341 Prepared by Keldon Bauer. Introduction. The valuation of all financial securities is based on the expected PV of future cash flows. Equity Valuation.

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Stock valuation l.jpg

Stock Valuation

FIL 341

Prepared by Keldon Bauer


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Introduction

  • The valuation of all financial securities is based on the expected PV of future cash flows.


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Equity Valuation

  • Because equity has no stated maturity, the value of the security can be seen as the present value of a kind of perpetuity:


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Equity Valuation

  • To use the equation above, one would have to forecast every dividend (or cash flow) forever, which is not realistic.

  • To estimate the equity value, simplifying assumptions can be made.

    • If we allow dividends (cash flows) to grow at a constant rate.

    • If ks is fixed over the life of the stock.


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[1]

[2]

Equity Valuation

  • The Gordon Constant Growth Model:


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Gordon Constant Growth Model

  • Subtracting [2] from [1]:



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Gordon Constant Growth Model

  • Assumptions:

    • g must be less than ks (or P0 = ¥)

    • ks must be fixed

    • Dividend growth must be smooth (constant)

  • Note that this model works for any growth rate less than ks - including g=0


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Gordon Growth Model-Example

  • If a share currently pays $1.50 in annual dividends, is expected to grow at a rate of 5% per year, and has a required return of 14%, what should its share price be?


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Equity Valuation

  • The Gordon Growth Model suggests that valuation is a function of:

    • Dividend (or free cash flow),

    • Growth in dividends (or free cash flows),

    • Discount rate.

  • How does current stock news affect the market’s estimates of these three measures?


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Equity Valuation

  • Some have suggested that a company should not just have one constant growth rate.

  • As a partial answer to that problem the same solution has been solved (virtually the same way) for a two stage growth valuation model.

    • The solution is as follows:


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Two-Stage Dividend Growth Model

Where: P0 = Price of stock today.

D0= Most recent dividend (or cash flow).

g1 = Growth rate over the first growth period.

k = Required rate of return for common equity.

T = Length of time the first growth rate is expected to last.

g2 = Growth rate over the second growth period.


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Non-Constant Growth Valuation

  • Since constant growth is unlikely, we will now consider how to value stock under non-constant growth.

  • First, project dividends (or free cash flows) as far as practical.

  • From there estimate a constant growth rate.

  • Then take the PV as in chapter 6.


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Non-Constant Growth - Example

  • If Buford’s Bulldozer is expected to pay the following dividends, and then grow indefinitely at 4.5% (assuming a discount rate of 14.50%), what would its stock value be?


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Non-Constant Growth - Example

  • First we consider the price of the stock at time five.


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Non-Constant Growth - Example

  • Next we sum all period cash flows.


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$ 1.09

2

3

4

5

0

1

14.5%

$ 2.10

$ 1.00

$ 1.63

$1.25

$2.75

$1.50

$2.80

$36.64

$18.62

Non-Constant Growth - Example

$24.44 = Present Value


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Non-Constant Growth Valuation

  • If the cash flows or dividends can be estimated for a short-term, after which a two-stage growth model is appropriate, then a similar procedure can be employed to estimate the value, only using a two-stage formula in the terminal cash flow, rather than the Gordon Growth Model.


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