1. The value of common stocks4
The value of common stocks
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 4-1 how common stocks are traded
Primary Market
New securities
Secondary Market
Previously-issued securities
Common Stock
Ownership shares in publicly-held corporation

3. 4-1 how common stocks are traded
Electronic Communication Networks (ECNs)
Computer networks that allow electronic trading
Exchange-Traded Funds (ETFs)
Stock portfolios bought/sold in single trade
SPDRs (Standard & Poor’s Depository Receipts or “spiders”)
ETFs tracking several S&P indexes

4. 4-2 How common stocks are valued
Book Value
Net worth of firm according to balance sheet
Dividend
Periodic cash distribution from firm to the shareholders
P/E Ratio
Price per share divided by earnings per share
Market Value Balance Sheet
Financial statement that uses market value of assets and liabilities

5. 4-2 How common stocks are valued
Discounted Cash Flow (DCF) Formula
Value of a stock = present value of future cash flows

6. 4-2 How common stocks are valued
Expected Return
Percentage yield forecast from specific investment over time period
Sometimes called market capitalization rate

7. 4-2 How common stocks are valued
Example
Fledgling Electronics sells for $100 per share today; they are expected to sell for $110 in one year. What is expected return if dividend in one year is forecasted to be $5.00?

8. 4-2 How common stocks are valued
Price of share of stock is present value of future cash flows
For a stock, future cash flows are dividends and ultimate sales price

9. 4-2 How common stocks are valued
Example
Fledgling Electronics price

10. 4-2 How common stocks are valued
Market Capitalization Rate
Estimated using perpetuity formula
Also called cost of equity capital

11. 4-2 How common stocks are valued
Dividend Discount Model
Computation of today’s stock price: share value equals present value of all expected future dividends
H: Time horizon for investment

12. 4-2 How common stocks are valued
Modified Formula

13. 4-2 How common stocks are valued
Example
Fledgling Electronics forecasted to pay $ dividend at end of year 1 and $5.50 dividend at end of year 2. End-of-second-year stock will be sold for $121. Discount rate is 15%. What is the price of stock?

14. 4-2 How common stocks are valued
Example
XYZ Company will pay dividends of $3, $3.24, and $3.50 over next three years. After three years, stock sells for $ What is the price of stock given 12% expected return?

15. 4-2 How common stocks are valued

16. 4-3 Estimating cost of equity capital
Dividend Yield
Expected return on stock investment plus expected dividend growth
Similar to capitalization rate

17. 4-3 Estimating cost of equity capital
Example
Northwest Natural Gas shares sold for $ at start of Dividend payments for were $1.86 a share with no growth. What is dividend yield?

18. 4-3 Estimating cost of equity capital
Example
Northwest Natural Gas shares sold for $47.30 at start of Dividend payments for 2013 were $1.86 a share with 6.1% growth. What is dividend yield?

19. 4-3 Estimating cost of equity capital
Return Measurements

20. 4-3 Estimating cost of equity capital
Dividend Growth Rate
Derived by applying return on equity to percentage of earnings reinvested in operations
g = return on equity × plowback ratio

21. 4-3 Estimating cost of equity capital
Valuing Non-Constant Growth

22. 4-3 Estimating cost of equity capital
Example
Phoenix pays dividends in three consecutive years of 0, .31, and .65. Year-4 dividend is estimated at .67 with perpetuity growth at 4%. With 10% discount rate, what is stock price?

23. 4-4 stock price and earnings per share
If firm pays lower dividend and reinvests funds, stock price may increase due to higher future dividends
Payout Ratio
Fraction of earnings paid out as dividends
Plowback Ratio
Fraction of earnings retained by firm

24. 4-4 stock price and earnings per share
Example
Company plans $8.33 dividend next year (100% of earnings). Investors will get 15% expected return. Instead, company plows back 40% of earnings at firm’s current return on equity of 25%. What is the stock value before and after plowback decision?

25. 4-4 stock price and earnings per share
Example, continued
No Growth
With Growth

26. 4-4 stock price and earnings per share
Example, continued
Stock price remains at $55.56 with no earnings plowed back
With plowback, price is $100.00
Difference is called present value of growth opportunities (PVGO)

27. 4-4 stock price and earnings per share
Present Value of Growth Opportunities (PVGO)
Net present value of firm’s future investments
Sustainable Growth Rate
Steady rate at which firm can grow: plowback ratio x return on equity

28. 4-5 Valuing a business Valuing a Business or Project
Usually computed as discounted value of FCF to valuation horizon (H)
Valuation horizon sometimes called terminal value and calculated like PVGO

29. 4-5 Valuing a business Valuing a Business or Project
PV (free cash flows)
PV (horizon value)

30. 4-5 Valuing a business Example
Given cash flows for Concatenator Manufacturing Division, calculate PV of near- term cash flows, PV (horizon value), and total value of firm; r = 10% and g = 6%

31. 4-5 Valuing a business
Example, Continued

32. 4-5 Valuing a business
Example, Continued