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Stock Valuation

Stock Valuation . Stock Valuation . Fundamental Analysis – looks at financials, product, mgt., history, etc. PE ratio – Price / E.P.S. Zero-Growth Dividend (preferred stock) Constant Growth Dividend (DCF) Nonconstant Growth. Technical Analysis – uses charts to predict future prices.

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Stock Valuation

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  1. Stock Valuation

  2. Stock Valuation • Fundamental Analysis – looks at financials, product, mgt., history, etc. • PE ratio – Price / E.P.S. • Zero-Growth Dividend (preferred stock) • Constant Growth Dividend (DCF) • Nonconstant Growth

  3. Technical Analysis – uses charts to predict future prices

  4. PE Ratio • Industry Average PE X Company’s EPS • If company EPS = $2.20 and industry average PE = 20, stock should sell around $_____. • Factors affected a company’s PE include: • Risk • Expected future growth • Management • Dividends

  5. Common vs. Preferred Stock • Preferred has preference in claims to assets and dividends – must be paid before common. • Preferred dividends – fixed • Common dividends – fluctuate • Preferred usually have no voting rights

  6. 52 Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾ s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾ 237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ... 7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8-1/8 0 1 2 3  P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31 237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ... Valuing Preferred Stock P0 = Value of Preferred Stock = PV of ALL dividends discounted at investor’s Required Rate of Return

  7. 52 Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾ s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾ 237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ... 7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8-1/8 0 1 2 3  2.31 (1+ rp) 2.31 (1+ rp )2 2.31 (1+ rkp )3 P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31 P0 = + + +···  237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ... Valuing Preferred Stock If an investor expects a 10% return, how much are they willing to pay for the stock?

  8. 52 Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾ s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾ 237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ... 7¼ 5½ RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8-1/8 0 1 2 3  2.31 (1+ rp) 2.31 (1+ rp )2 2.31 (1+ rkp )3 P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31 P0 = + + +···  237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ... D R 2.31 10% = $23.10 = P0 = Valuing Preferred Stock Zero-Growth Div. Model

  9. P0 D1 D2 D3 D D1 (1+ rs ) D2 (1+ rs )2 D3 (1+ rs )3 P0 = + + +··· 0 1 2 3  Valuing Common Stock P0 = PV of ALL expected dividends discounted at investor’s Required Rate of Return Investors do not know the values of D1, D2, .... , DN. The future dividends must be estimated.

  10. D1=D0 (1+g) D2=D0 (1+g)2 D3=D0 (1+g)3 D=D0 (1+g) D0 0 1 2 3  Constant Growth Dividend Model (Discounted Cash Flow) Assume that dividends grow at a constant rate (g).

  11. D1=D0 (1+g) D2=D0 (1+g)2 D3=D0 (1+g)3 D=D0 (1+g) D0 D0 (1+ g)3 (1+ rs )3 D0 (1+ g) (1+ rs ) D0 (1+ g)2 (1+ rs )2  P0 = + + + ··· + D0(1+g) r– g D1 r– g P0 = = 0 1 2 3  Constant Growth Dividend Model Reduces to: Requires r> g

  12. Cisco just paid $3.00 in dividends. If they expect to grow at a constant rate of 4% a year, what is the most an investor would pay if they require a 10% return? Constant Growth Dividend Model

  13. Gordon Growth Company - I • Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%. • What is the current price?

  14. Gordon Growth Company - II • What is the price expected to be in year 4?

  15. Nonconstant or Supernormal Growth Model Used with companies that have very high growth rates. Calculate the PV of cash flows or dividends for the high growth period. Solve for the PV of cash flows during the constant growth period that are a perpetuity. The sum of these two is the stock price.

  16. Google’s Financials

  17. If Apple justpaid a $2.00 dividend and estimates to have growth of 30% for 3 years, then a constant growth (g) of 6%, what is P0? r is 13% Can no longer only use constant growth model. However, growth becomes constant after 3 years.

  18. Supernormal growth followed by constant growth: 0 1 2 3 4 r=13% g = 30% g = 30% g = 30% g = 6% D0 = 2.00 2.60 3.38 4.39 4.66 ^ = P0

  19. Supernormal growth followed by constant growth: 0 1 2 3 4 r =13% g = 30% g = 30% g = 30% g = 6% D0 = 2.00 2.60 3.38 4.39 4.66 ^ = P0

  20. Supernormal growth followed by constant growth: 0 1 2 3 4 rs=13% g = 30% g = 30% g = 30% g = 6% D0 = 2.00 2.60 3.38 4.39 4.66 2.30 2.65 3.05 46.11 ^ 54.11 = P0 Do not add in D0

  21. Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P0? 0 1 2 3 4 ... rs=13% g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12    P 3 .

  22. Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P0? 0 1 2 3 4 ... rs=13% g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 2.12    P 30.29 3 0 . 07

  23. Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P0? 0 1 2 3 4 ... rs=13% g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 1.77 1.57 2.12 1.39    P 30.29 20.99 3 0 . 07 25.71

  24. Terminal Value – the (present) value, at the horizon date, of all future dividends after that date.

  25. Nonconstant Growth • Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock? • Remember that we have to find the PV of all expected future dividends.

  26. Nonconstant Growth – Solution • Compute the dividends until growth levels off • D1 = 1(1.2) = $1.20 • D2 = 1.20(1.15) = $1.38 • D3 = 1.38(1.05) = $1.449 • Find the expected future price at the beginning of the constant growth period: • P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66 • Find the present value of the expected future cash flows • P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

  27. Nonconstant + Constant growth

  28. ^ P2 = = $9.66 0.20 – 0.05 Nonconstant growth followed by constant growth: 0 1 2 3 R= 20% g = 20% g = 15% g = 5% D0 = 1.00 1.20 1.38 1.449 1.00 0.96 $1.449 6.71 8.67 = P0

  29. The Jones Company has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share. If the required return on this stock is currently 20 percent, what should be the stock's market value?

  30. The Jones Company has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share. If the required return on this stock is currently 20 percent, what should be the stock's market value? 5 ∕ .20 = 25

  31. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50, what is the nominal annual rate of return?

  32. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50, what is the nominal annual rate of return? 2.5 X 4 = 10/year 10/50 = 20%

  33. D1 R– g P0 = McKenna Motors is expected to pay a $1.00 per-share dividend at the end of the year (D1 = $1.00). The stock sells for $20 per share and its required rate of return is 11 percent. The dividend is expected to grow at a constant rate, g, forever. What is the growth rate, g, for this stock?

  34. McKenna Motors is expected to pay a $1.00 per-share dividend at the end of the year (D1 = $1.00). The stock sells for $20 per share and its required rate of return is 11 percent. The dividend is expected to grow at a constant rate, g, forever. What is the growth rate, g, for this stock? D1/(R-g) = 20 1/(.11-g) = 20 1 = 2.2 – 20g -1.2 = -20g -1.2/-20 = g .06 = g

  35. A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15%, and if investors require a 19% rate of return, what is the price of the stock?

  36. A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15%, and if investors require a 19% rate of return, what is the price of the stock? 2.00 X (1.15) = 2.30 = D1 P = 2.30 / (.19 - .15) P = 2.30 / .04 P = $57.5

  37. Finding the Required Return Example • A firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. • What is the required return?

  38. Finding the Required Return Example • P0 = $10.50. • D0 = $1 • g = 5% per year. • What is the required return?

  39. Finding the Required Return Example • P0 = $10.50 • D0 = $1 • g = 5% per year • What is the dividend yield? 1(1.05) / 10.50 = 10% • What is the capital gains yield? g = 5% Dividend Capital Gains Yield Yield

  40. The Stock Markets • Primary vs. Secondary Markets • Primary = new-issue market • Secondary = existing shares traded among investors • Dealers vs. Brokers • Dealer: Maintains an inventory Ready to buy or sell at any time Think “Used car dealer” • Broker: Brings buyers and sellers together Think “Real estate broker”

  41. New York Stock Exchange (NYSE) • NYSE • Merged with Euronext in 2007 • NYSE Euronext merged with the American Stock Exchange in 2008 • Members (Historically) • Buy a trading license (own a seat) • Designated market makers, DMMs (formerly known as “specialists”) • Floor brokers

  42. NYSE Operations • Operational goal = attract order flow • NYSE DMMs: • Assigned broker/dealer • Each stock has one assigned DMM • All trading in that stock occurs at the “DMM’s post” • Trading takes place between customer orders placed with the DMMs and “the crowd” • “Crowd” = Floor brokers

  43. Index vs Actively Managed Funds

  44. Index vs Actively Managed Funds Index funds outperform active funds 80 – 90% of the time.

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