1. FIN303 Vicentiu Covrig 1 Stocks and their valuation (chapter 9)

2. FIN303 Vicentiu Covrig 2 Facts about common stock Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock price

3. FIN303 Vicentiu Covrig 3 Intrinsic Value and Stock Price Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s intrinsic value (P 0 ). 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 its intrinsic value are undervalued Buy or Sell? - Stocks with a price above its intrinsic value are overvalued Buy or Sell?

4. FIN303 Vicentiu Covrig 4 Dividend growth model Value of a stock is the present value of the future dividends expected to be generated by the stock. r s is the required rate of return (think the one from CAPM)

5. FIN303 Vicentiu Covrig 5 Constant growth stock A stock whose dividends are expected to grow forever at a constant rate, g. D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D 0 (1+g) t If g is constant, the dividend growth formula converges to:

6. FIN303 Vicentiu Covrig 6 What happens if g > r s ? If g > r s, the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if: - r s > g - g is expected to be constant forever

7. FIN303 Vicentiu Covrig 7 If r RF = 7%, r M = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? Use the SML to calculate the required rate of return (r s ): r s = r RF + (r M – r RF )β = 7% + (12% - 7%)1.2 = 13%

8. FIN303 Vicentiu Covrig 8 If D 0 = $2 and g is a constant 6%, What is the stock’s market value? Using the constant growth model:

9. FIN303 Vicentiu Covrig 9 What is the expected dividend yield, capital gains yield, and total return during the first year? Dividend yield = D 1 / P 0 = $2.12 / $30.29 = 7.0% Capital gains yield = (P 1 – P 0 ) / P 0 = ($32.10 - $30.29) / $30.29 = 6.0% Total return (r s ) = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

10. FIN303 Vicentiu Covrig 10 What would the expected price today be, if g = 0? The dividend stream would be a perpetuity.

11. FIN303 Vicentiu Covrig 11 Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%? Can no longer use just the constant growth model to find stock value. However, the growth does become constant after 3 years.

12. FIN303 Vicentiu Covrig 12 Valuing common stock with nonconstant growth r s = 13% g = 30% g = 6%  P  0.06 $66.54 3 4.658 0.13   2.6/(1+0.13) = 2.301 2.647 3.045 66.54/(1+0.13)^3 = 46.114 54.107 = P 0 ^ 01234 D 0 = 2.00 2.6 3.380 4.394... 4.658

13. FIN303 Vicentiu Covrig 13 Calculations: D1 = D0*(1+g1)= 2x(1+0.3)= 2.6 D2 = D1*(1+g1)= 2.6x(1+0.3)= 3.38 D3 = D2*(1+g1)= 3.38x(1+0.3)= 4.394 D4 = D3*(1+g2)= 4.394x(1+0.06) = 4.658 Present Value of D1= 2.6/(1+0.13) = 2.301 Present Value of D2= 3.38/(1+0.13)^2 = 2.647 Present Value of D3= 4.394/(1+0.13)^3 = 3.045

14. FIN303 Vicentiu Covrig 14 Exam type question The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on equity (rs) is 12 percent. What is the current price of Klein’s common stock? a.$21.00 b.$33.33 c.$42.25 d.$50.16 *

15. FIN303 Vicentiu Covrig 15 Corporate value model 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. FCF = NOPAT – Net capital investment 1. Find the market value (MV) of the firm. - Find PV of firm’s future FCFs 2. Subtract MV of firm’s debt and preferred stock to get MV of common stock. - MV of = MV of – MV of debt and common stock firm preferred 3. Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value). - P 0 = MV of common stock / # of shares

16. FIN303 Vicentiu Covrig 16 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 (TV n ) represents value of firm at the point that growth becomes constant.

17. FIN303 Vicentiu Covrig 17 Given the long-run g FCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value. g = 6% r = 10% 21.20 01234 -5 10 20... 416.942 -4.545 8.264 15.026 398.197 21.20 530 = = TV 3 0.100.06 -

18. FIN303 Vicentiu Covrig 18 Calculations: Present Value of CF1= -5/(1+0.1) = -4.545 Present Value of CF2= 10/(1+0.1)^2 = 8.264 Present Value of CF3= 20/(1+0.1)^3 = 15.026 CF 4= CF3*(1+g)=20*(1+0.06)= 21.2 Present Value of Terminal Value in 3 years (at time 3)= = 530/(1+0.1)^3 = 388.197

19. FIN303 Vicentiu Covrig 19 If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share? MV of equity= MV of firm – MV of debt = $416.94m - $40m = $376.94 million Value per share= MV of equity / # of shares = $376.94m / 10m = $37.69

20. FIN303 Vicentiu Covrig 20 Exam type question An analyst is trying to estimate the intrinsic value of the stock of Harkleroad Technologies. The analyst estimates that Harkleroad’s free cash flow during the next year will be $25 million. The analyst also estimates that the company’s free cash flow will increase at a constant rate of 7 percent a year and that the company’s cost of capital is 10 percent. Harkleroad has $200 million of long-term debt, and 30 million outstanding shares of common stock. What is the estimated per-share price of Harkleroad Technologies’ common stock? a.$ 1.67 b.$ 5.24 c.$18.37 d.$21.11 *

21. FIN303 Vicentiu Covrig 21 Exam type question Which of the following statements is most correct? a.If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but the two classes must have the same voting rights. b.An IPO occurs whenever a company buys back its stock on the open market. c.The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of common stock. * d.Statements a and b are correct.

22. FIN303 Vicentiu Covrig 22 Learning objectives Read from the text the following topics: control of the firm; types of common stock; The market for common stock Know how to apply the dividend growth model, constant and non-constant growth Know how to calculate total return, dividend yield and capital gains Know how to use corporate value model to value common stock Recommended end-of-chapter problems: ST-1, Questions 9-3, 9-4; Problems 9-1 to 9-5, 9-11,9-1 to 9-17