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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

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
• 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.

[1]

[2]

Equity Valuation
• The Gordon Constant Growth Model:
Gordon Constant Growth Model
• Subtracting [2] from [1]:
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.

\$ 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

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.