Analysis of Common Stocks Investments and Portfolio Management (MB 72)

Outline Process of Valuation of a Financial Asset Process of Valuation of Common Stocks Determining parameters of models How to determine the growth rate? Length of growth period How to determine the required rate of return Models for Stock Valuation Dividend Discount Models Price-Earnings Models Free Cash Flow to Equity Valuation Models

Valuation of Financial Assets Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows Three step process: Estimate the expected cash flows Determine the appropriate interest rate or interest rates to discount the cash flows Compute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2

Estimating Cash Flows Holding aside the risk of bankruptcy, the cash flows of a common stock are: Payment of dividend so long as we hold the stock Sale price of common stock when we sell the stock Is it difficult to estimate the cash flows of a common stock?

Value of a Common Stock Fair Market Value of a common stock depends on PV of cash flows from a stock PV of an infinite dividend stream OR PV of a finite dividend stream plus PV of the sale price of the stock

Discounted Cash Flow Valuation Value of any asset—a function of 3 variables How it generates its cash flows? When these cash flows are expected to occur? Uncertainty of these cash flows t=n CF t Value =  t=1 (1+r) t

Dividend Discount Model (DDM) Value of a share of common stock is the present value of all future dividends n DPS t Value per share of stock=  t=1 (1+r) t What if the stock is not held for an infinite period? One year holding period Multiple year holding periods

Dividend Discount Model Two types of cash flows Dividends during the holding period Expected price at the end of holding period—this itself is dependent on future dividends How to determine the value of a share of common stock?

Infinite Holding Period What will be the value of a share of common stock? Present value of an infinite stream of anticipated dividends Simplified assumptions to simply valuation model Zero Growth Model Constant Growth Model Two-stage growth model Three-stage growth model

Zero Growth Model Dividend every year will be the same Investor anticipates to receive the same amount dividend per year forever DPS V = r cs

Constant Growth Model Assume that firm grows at a stable growth rate of g per year forever DPS 1 V = r - g

Two-Stage DDM In general version of the model, two stages of growth An initial period of extraordinary growth After initial period, a period of stable growth n DPS t P n P 0 =  t=1 (1+r) t (1 + r) n DPS n+1 Where P n = (r – g n )

Three-stage growth model

Four Basic Inputs Length of high growth period Dividends per share each period Required rate of return by stockholders each period Terminal price at the end of high growth period

High Growth Rate and Stable Growth Rate Stable Growth Rate? Growth rate expected to last forever Firm’s other measures of performance including can be expected to grow at the same rate What growth rate is reasonable as a “stable” growth rate? A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy Length of High Growth Period? How much is the current growth rate? Source of high growth?

High Growth Period The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth period The larger the current size of the firm, the shorter the high-growth period.

Guide to Length of High-Growth Period Current Growth Length of High RateGrowth Period  1% higher than stableNo high growth 1 – 10% higher than stable 5 years > 10% higher than stable10 years

How do we Estimate Growth Rate? g = b[ROA+D/E(ROA-I (1-t))] Where b refers to the retention ratio ROA is the return on assets D/E is the debt to equity ratio in book value terms i = interest expense/book value of debt

FCFE Valuation Model The cash flow that the firm can afford as dividends and contrasted with actual dividends—may not payout as dividends The residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and create new assets for future growth.

FCFE = Net Income + Depreciation – Capital Spending -  Working Capital – Principal Repayments + New Debt Issues If there is a target debt ratio,  FCFE = Net Income - (1 -  )(Capital Expenditure – Depreciation) - ( 1-  )  Working Capital

FCFE Model n FCFE t P n P 0 =  t=1 (1+r) t (1 + r) n FCFE n+1 Where P n = (r – g n )