Fundamental Analysis and Stock Valuation

Fundamental Analysis Examination of a firm ’ s accounting statements and other financial and economic information to assess the economic value of a company ’ s stock. Dividend Discount models –Finite horizon –Constant growth –Constant perpetual growth Price ratio models –Price/earnings (P/E) –Price/cash flow (P/CF) –Price/sales (P/S) –Price/book (P/BV)

Different Types of Dividends Many companies pay a regular cash dividend. –Public companies often pay quarterly. –Sometimes firms will throw in an extra cash dividend. –The extreme case would be a liquidating dividend. Often companies will declare stock dividends. –No cash leaves the firm. –The firm increases the number of shares outstanding. Some companies declare a dividend in kind. –Wrigley ’ s Gum sends around a box of chewing gum. –Dundee Crematoria offers shareholders discounted cremations.

Standard Method of Cash Dividend Payment Record Date - Person who owns stock on this date received the dividend. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Cash Dividend - Payment of cash by the firm to its shareholders.

Procedure for Cash Dividend Payment 25 Oct.1 Nov.2 Nov.6 Nov.7 Dec. Declaration Date Cum- dividend Date Ex- dividend Date Record Date Payment Date … Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend. Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

Price Behavior around the Ex- Dividend Date In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. $P$P $P - div Ex- dividend Date The price drops by the amount of the cash dividend -t … … Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

Company earnings may be reinvested in the firm or distributed to stockholders. What percentage should be distributed? What do investors prefer? Keep in mind that firm ’ s objective is to maximize shareholder value. If the firm increases the payout ratio, D 1 will increase. This should increase the stock ’ s price if everything else is held constant. However, if the firm increases D 1 there will be less money available for reinvestment causing “ g ” to decline. (Since g = b x ROE ) If g falls this will lower the stock ’ s price. The financial manager must strike a balance between current dividends and future growth which maximize the firm ’ s stock price. Dividend Policy P 0 = D 1 k s - g ?

Three theories describing investor preference 1) Dividend irrelevance theory Merton Miller and Franco Modigliani (M&M) state that dividend policy has no effect on the firm ’ s stock price, hence dividend policy is irrelevant. If the firm ’ s cash dividend is too big, you just take the excess cash received to buy more of the firm ’ s stock. In the other way, if the cash dividend u received is too small, you can sell a little bit of your stock to get cash. You should note that the dividend irrelevance theory only holds in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares. Dividend Policy

Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers $3 cash dividend. Bob ’ s homemade dividend strategy: –Sell 2 shares ex-dividend homemade dividends Cash from dividend$160 Cash from selling stock$80 Total Cash$240 Value of Stock Holdings $40 × 78 = $3,120 $3 Dividend $240 $0 $240 $39 × 80 = $3,120 Homemade Dividends

Dividend Policy is Irrelevant Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm. In the above example, Bob Investor began with total wealth of $3,360:  After a $3 dividend, his total wealth is still $3,360:  After a $2 dividend, and sale of 2 ex-dividend shares,his total wealth is still $3,360:

2) The bird-in-hand theory Myron Gordon and John Lintner believe that k s decreases as the dividend payout increases.They think that investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component (D 1 /P 0 ) is less risky than the growth component (g) in the total expected return equation : k s = (D 1 /P 0 ) + g Investors prefer cash dividend rather than capital gain. Dividend Policy

3) Tax preference theory There are three tax related reasons why investors might prefer the shares of firms offering a low payout; - Capital gains are taxed at lower rate than dividend - Capital gains taxes are not paid until they are realized. Thus, retentions are allowed to accumulate in a tax- free environment. However, in contrast to this theory, some investors who subject to low or no taxes (like pensions) may prefer cash dividends rather than capital gain. Dividend Policy

The optimal payout ratio cannot be determined quantitatively. In a perfect capital market, dividend policy is irrelevant due to the homemade dividend concept. A firm should not reject positive NPV projects to pay a dividend. Personal taxes and issue costs are real-world considerations that favor low dividend payouts. Many firms appear to have along-run target dividend- payout policy. There appears to be some value to dividend stability and smoothing. There appears to be some information content in dividend payments. Dividend Policy

Where P 0 = the fair value or theoretical value of the stock D t = the expected dividend for year t P N = the expected sale price in the horizon year N N = the number of years in the horizon r t = the appropriate discount rate for year t Basic Dividend Discount Model If market price < fair price, then stock is undervalued. If market price > fair price, then stock is overvalued. If market price = fair price, then stock is fairly valued. P 0 = D1D1 (1+r 1 ) 1 + D2D2 (1+r 2 ) 2 + DNDN (1+r N ) N + PNPN... +

Notes; P N is the present value of all future dividends after N which is D N+1, D N+2, …, D infinity If an investor sells the stock, the purchaser of the stock is just buying the remaining dividend stream. Hence, the stock ’ s value is still determined by the dividends it pays. If a company declares it will never pay dividends, the shares of the company should theoretically be worthless. Basic Dividend Discount Model

Example; What is the value of a stock that last year paid a $1 dividend, if you think next year ’ s dividend will be 10% higher and the stock will be sold at $25 at year- end. Assume one year t-bill is 5%, market rate of return is 10% and the stock ’ s beta is 1.2 ? Solution; Step1 : from CAPM, calculate the discount rate using k = r f + b (r m -r f ) = (0.10 – 0.05) = 0.11 Step2 : using DDM P 0 = $1(1.10) / (1.11) 1 + $25 / (1.11) 1 = $ $22.52 = $23.51 D1D1 P1P1 P0P0 k = 11% Basic Dividend Discount Model

Suppose D(t+1) = D(t) x (1 + g) Then: Which is the Constant Growth Rate Model Constant Growth DDM

Example: Suppose D(0) = $2; k = 12%; g = 6% and dividends will continue for 30 years. Solution: D(1) = ($2.00 x 1.06) = $2.12 V(0) = = $35.33 x.8083 = $28.56 Constant Growth DDM

Constant Perpetual Growth Model Sometimes called the “ Gordon growth model ” Suppose T =  and g < k Advantage –easy to compute Disadvantages –not usable for firms paying no dividends –not usable when g > k –sensitive to choice of g and k –k and g may be very difficult to estimate –constant perpetual growth is often unrealistic,where; P 0 = D1D1 ( r – g ) D 1 = D 0 (1+g)

Constant Perpetual Growth Model Assumptions; 1. Future dividends grow at constant rate (g) 2. A single discount rate is used. ( r is a constant) Constraints; 1. Attribute bias characteristic is assumed. i.e. low P/E ratio, high dividend yield, or high book value ratio 2. Investor ’ s time horizon matches with model time horizon. 3. (r-g) is estimated accurately. Inaccuracy of estimating either “ r ” or “ g ” implies a significantly difference to terminal value.

Dividend Discount Model Example; For 1 st year to 4 th year, g = 20% after that the dividend will grow 5%. The stock will pay $1 for next year (D 1 ). Given k = 10%, what is P 0 ? Solution; Step1 : specify the dividend each year D 1 = $1.00 D 2 = $1.20 ($1.00 x 1.20) D 3 = $1.44 ($1.20 x 1.20) D 4 = $1.73 ($1.44 x 1.20) D 5 = $1.82 ($1.73 x 1.20) D1D1 P0P0 k = 10% D2D2 D3D3 D4D4 D5D5 g = 20%g = 5% D infinity

Dividend Discount Model Solution (Continued); Step2 : using constant growth DDM to find P 4 which is valued by D 5, D 6, …, D infinity Step3 : using present value to find P 0 which is valued by D 1, D 2, D 3, D 4, and P 4 D1D1 k = 10% D2D2 D3D3 D4D4 D5D5 g = 20%g = 5% P 4 = D 5 / (k-g) P 4 = $1.82 / (.10 –.05) P 4 = $36.40 D infinity PV D 1 : FV $1.00; n = 1; i= 10%; PV = $0.91 PV D 2 : FV $1.20; n = 2; i= 10%; PV = $0.99 PV D 3 : FV $1.44; n = 3; i= 10%; PV = $1.08 PV D 4 : FV $1.73; n = 4; i= 10%; PV = $1.18 PV P 4 : FV $36.40; n = 4; i= 10%; PV = $24.86 Hence, P 0 = Sum of the future cash flow = $29.02

Sustainable Growth Rate Sustainable Growth Rate : A dividend growth rate that can be sustained by a company ’ s earnings. Using the sustainable growth rate to estimate g: Sustainable growth rate = ROE x retention ratio ROE = return on equity ROE = net income / book equity Payout ratio = Dividends per share / EPS Retention ratio = 1 - payout ratio Sustainable growth rate = ROE x (1 - Payout ratio)

Sustainable Growth Rate Example Assume ROE = 11%; EPS = $3.25; and D(0) = $2.00 SGR =.11 x ( /3.25) = 4.23%

Earning Multiplier Model (P/E ratio) P 0 = D1D1 ( r – g ) P0P0 (D 1 / E 1 ) ( r – g ) = E1E1 Where ; D 1 / E 1 = Dividend payout ratio r = the required rate of return on the stock g = the expected growth rate of dividends Note ; If you project next year’s earnings and multiply it by this P/E ratio, you will get an estimate of the current value of the stock.

Earning Multiplier Model (P/E ratio) P/E ratio - Price to earnings ratio –current stock price divided by annual EPS Earnings yield = E/P Growth Stock  high P/E Value Stock  low P/E

Price Ratio Analysis Price/Cash flow ratio –cash flow = net income + depreciation = operating cash flow Price/Sales –current stock price divided by annual sales per share Price/Book (market to book ratio) –price divided by book value of equity, which is measured as assets - liabilities

Price-Ratio Analysis for ABC Corp.

EstP = P/E ratio x EPS x (1 + Earnings growth rate) Earnings growth rate = ($3.88/$2.95) 1/4 - 1 = 7.09% Expected price = x $3.88 ( ) = $60.33 EstP = P/CF ratio x CFPS x (1 + CF growth rate) CF growth rate = ($6.45 / $4.74) 1/4 -1 = 8.01% Expected price = 8.91 x $6.45 ( ) = $62.07 EstP = P/S ratio x SPS x (1 + Sales growth rate) Sales growth rate = ($46.85/$38.06) 1/4 -1 = 5.33% Expected price = 1.20 x $46.85 ( ) = $59.22 Price-Ratio Analysis for ABC Corp.