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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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Introduction

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

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:

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.

Gordon Constant Growth Model

- Subtracting [2] from [1]:

Gordon Constant Growth Model

- Solving for PV:

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

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?

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?

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:

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.

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.

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?

Non-Constant Growth - Example

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

Non-Constant Growth - Example

- Next we sum all period cash flows.

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

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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