Presentation on theme: "Stocks and Their Valuation"— Presentation transcript:
1 Stocks and Their Valuation Chapter 9Stocks and Their Valuation
2 Topics Covered Common and Preferred Stock Properties Valuing Preferred StocksValuing Common Stocks - the Dividend Growth ModelNo growthConstant growthNon-constant or supernormal growthValuing the Entire Corporation – Free Cash Flow ApproachStock Market Equilibrium222232
3 Facts about common stock Represents ownershipOwnership implies controlStockholders elect directorsDirectors elect managementManagement’s goal: Maximize the stock price
4 Preferred Stock Characteristics Unlike common stock, no ownership interestSecond to debt holders on claim on company’s assets in the event of bankruptcy.Annual dividend yield as a percentage of par valuePreferred dividends must be paid before common dividendsIf cumulative preferred, all missed past dividends must be paid before common dividends can be paid.
5 Intrinsic Value and 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).
6 Preferred Stock Valuation Promises to pay the same dividend year after year forever, never matures.A perpetuity.VP = DP/rPExpected Return: rP = DP/P0Example: GM preferred stock has a $25 par value with a 8% dividend yield. What price would you pay if your required return is 7%?
7 What do investors in common stock want? Periodic cash flows: dividends, and…To sell the stock in the future at a higher priceManagement to maximize their wealth
8 Stock Valuation: Dividend Growth Model Stock Value = PV of Future Expected Dividends65
9 Stock Valuation: Dividend Patterns For Valuation: we will assume stocks fall into one of the following dividend growth patterns.Constant growth rate in dividendsZero growth rate in dividends, like preferred stockVariable (non-constant) growth rate in dividends76
10 Stock Valuation Case Study: Doh! Doughnuts We have found the following information for Doh! Doughnuts:current dividend = $2.00 = Div0The current T-bill rate is 5% and investors demand an 9% market risk premium.Doh!’s beta = 1.2.
11 Analysts Estimates for Doh! Doughnuts NEDFlanders predicts a constant annual growth rate in dividends and earnings of zero percent (0%)Barton Kruston Simpson predicts a constant annual growth rate in dividends and earnings of 10 percent (9%).Homer Co. expects a dramatic growth phase of 30% annually for each of the next 3 years followed by a constant 10% growth rate in year 4 and beyond.
12 Our Task: Valuation Estimates What should be each analyst’s estimated value of Doh! Doughnuts?
13 Valuing Common Stocks: No Growth If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.Assumes all earnings are paid to shareholders.38
14 Ned Flanders’ Valuation D0 = $2.00, rS = 15.8% or 0.158, g = 0%
15 Constant Growth Valuation Model Assumes dividends will grow at a constant rate (g) that is less than the required return (rS )If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next year’s dividend as D1:Commonly called the Gordon growth model
17 Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains YieldD1/P0 = Expected Dividend Yieldg = Expected Capital Gains Yieldr = (D1/P0) + g = (D0(1+g)/P0) + g
18 ExampleBurns International’s stock sells for $80 and their expected dividend is $4. The market expects a return of 15%.What constant growth rate is the market expecting for Burns International?
19 Variable Growth Stock Valuation Framework: Assume Stock has period of non- constant growth in dividends and earnings and then eventually settles into a normal constant growth pattern (gc).0 g g g gc gc 5 gc ...D D D3Non-constant Growth Period Constant Growth1514
20 Today’s agenda Supernormal (non-constant) dividend growth valuation Corporate value approach to stock valuationStock Market Equilibrium
21 Homer Co. Valuation Variable (non-constant) growth Years 1-3 expect 30% growthAfter year 3: constant growth of 10%
22 Variable Growth Valuation Process 3 Step ProcessEstimate Dividends during non-constant growth period.Estimate Price, which is the PV of the constant growth dividends, at the end of non-constant growth period which is also the beginning of the constant growth period. This is called the horizon or terminal value.Find the PV of non-constant dividends and horizon value. The total of these PVs = Today’s estimated stock value.1615
23 Back to Homer Co’s Valuation: Step 1 D0 = $2.00, g = 30% or 0.3 for next 3 years
24 Homer Co’s Valuation: Step 2 Find Horizon Value which is the constant growth stock value at the end of year 3.
26 Corporate value modelAlso 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 investmentFCF = NOPAT – Net capital investment
27 Applying the corporate value model Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs at the company’s weighted average cost of capital, WACC.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).
28 Issues regarding the corporate value model Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast.Similar to dividend growth 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.
29 An Example: Advanced Micro Devices (AMD) AMD’s debt market value is $692 million.No preferred stock486 million shares outstandingCurrent free cash flow is $286 million.Assume that AMD will experience 21% year 1, 19% year 2 and 18% FCF growth in year 3 and 11% constant annual growth thereafter.AMD’s WACC is approximately 17%.
30 An Example: AMD Projected FCFs($millions) End of YearGrowth StatusGrowth Rate (%)FCF Calculation1Variable21$286(1.21) = $346.1219$346.1 x (1.19) = $411.8318$411.8 x (1.18) = $485.94Constant11$485.9 x (1.11) = $539.4Use non-constant growth to estimate AMD’s corporate value.
32 AMD’s Stock Value per share MV of firm = $6513 millionMV of debt = $692 millionMV of equity (stock) = $ $692 = $5821 million486 million shares outstandingP0 = MV of equity/shares = $5821/486 = $11.98Recent price = $13.50
33 Stock Market Equilibrium In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell.In equilibrium, two conditions hold:The current market stock price equals its intrinsic value (P0 = P0).Expected returns must equal required returns.
34 How is market equilibrium established? If price is below intrinsic value …The current price (P0) is “too low” and offers a bargain.Buy orders will be greater than sell orders.P0 will be bid up until expected return equals required return.
35 Doh! In equilibrium? Doh! Doughnuts current stock price is $30. Required return = 5% + 9%(1.2) = 15.8%Let’s assume the 2nd analyst is correct and Doh! Has a constant growth rate of 9% and its current dividend is $2.Is Doh! Doughnuts’ current stock price in equilibrium?
36 Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains YieldD1/P0 = D0(1+g)/P0 = Expected Dividend Yieldg = Expected Capital Gains YieldFrom our example, D1=$2(1.09) = $2.18, P0=$30, g = 9% or 0.09DOH! Doh! Doughnuts1211
37 The Effect On the Stock Price Expected Return needs to fall to the required return of 15.8%. This means the stock price must rise to the equilibrium price that yields the required return of 15.8%New Price = D1/(rs- g)=$2.18/( )= $32.062423
38 Stock Valuation Summary Looked at Dividend Discount Model: Value = PV of future expected dividends. All else equal:Higher interest rates (rs) yields lower stock prices (inverse relationship)Higher growth rate yields higher stock price.Other Stock Valuation Methods“Multiples” Method: P/E, P/CF, P/SFor example: Price Estimate = PE Ratio x expected EPS