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Stocks and Their Valuation

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Chapter 9

- Features of Common Stock
- Determining Common Stock Values
- Preferred Stock

- Represents ownership
- Ownership implies control
- Stockholders elect directors
- Directors elect management
- Management’s goal: Maximize the stock price

- Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s intrinsic value (P0).
- In equilibrium we assume that a stock’s 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 (above) its intrinsic value are undervalued (overvalued).

“True” Investor Returns

“True” Risk

“Perceived” Investor Returns

“Perceived” Risk

Managerial Actions, the Economic Environment, Taxes, and the Political Climate

Stock’s Intrinsic Value

Stock’s Market Price

Market Equilibrium:Intrinsic Value = Stock Price

- Discounted dividend model
- Corporate valuation model
- Using the multiples of comparable firms

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

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

$

0.25

0

Years (t)

- 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.

- If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firm’s stock?
rs= rRF + (rM – rRF)b

= 7% + (12% – 7%)1.2

= 13%

0

1

2

3

g = 6%

D0 = 2.00

2.12

2.247

2.382

1.8761

rs = 13%

1.7599

1.6509

D0 = $2 and g is a constant 6%.

Using the constant growth model:

- D1 will have been paid out already. So, P1 is the present value (as of Year 1) of D2, D3, D4, etc.
- Could also find expected P1 as:

- 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%

0

1

2

3

rs = 13%

2.00

2.00

2.00

The dividend stream would be a perpetuity.

- Can no longer use just the constant growth model to find stock value.
- However, the growth does become constant after 3 years.

2.301

2.647

3.045

46.114

54.107 =

0

1

2

3

4

rs = 13%

g = 30%

g = 30%

g = 30%

g = 6%

D0 = 2.00 2.600 3.380 4.394

4.658

- Dividend yield (first year)
= $2.60/$54.11 = 4.81%

- Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%

- During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ≠ g.
- After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

0

1

2

3

4

rs = 13%

g = 0%

g = 0%

g = 0%

g = 6%

D0 = 2.00 2.00 2.00 2.00

2.12

1.77

1.57

1.39

20.99

25.72 =

- Dividend yield (first year)
= $2.00/$25.72 = 7.78%

- Capital gains yield (first year)
= 13.00% – 7.78% = 5.22%

- After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

- Yes. Even though the dividends are declining, the stock is still producing cash flows and therefore has positive value.

- Capital gains yield
= g = -6.00%

- Dividend yield
= 13.00% – (-6.00%) = 19.00%

- Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.

- Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows.
- Remember, free cash flow is the firm’s after-tax operating income less the net capital investment.
FCF = EBIT(1 – T) – Net capital investment

- Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs.
- Subtract MV of firm’s 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).

- Often preferred to the discounted dividend model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast.
- Similar to discounted dividend 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.

r= 10%

g = 6%

-4.545

8.264

15.026

398.197

416.942

Given: Long-Run gFCF = 6% and WACC = 10%

0

1

2

3

4

-5

10

20

21.20

The firm has $40 million total in debt and preferred stock and has 10 million shares of stock.

- Analysts often use the following multiples to value stocks.
- P/E
- P/CF
- P/Sales

- EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.

- 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.