analysis of common stocks investments and portfolio management (mb 72)
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Analysis of Common Stocks
Investments and Portfolio Management (MB 72)
OutlineProcess of Valuation of a Financial AssetProcess of Valuation of Common StocksDetermining parameters of models
How to determine the growth rate?Length of growth periodHow to determine the required rate of return
Models for Stock ValuationDividend Discount ModelsPrice-Earnings ModelsFree Cash Flow to Equity Valuation Models
Valuation of Financial AssetsProcess of determining the fair market value of a financial asset on the basis of present value of the expected cash flowsThree step process:
Estimate the expected cash flowsDetermine the appropriate interest rate or interest rates to discount the cash flowsCompute 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 stockPV of an infinite dividend stream ORPV 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 CFt
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 DPSt
Value per share of stock= ---------- t=1 (1+r)t
What if the stock is not held for an infinite period?
One year holding periodMultiple year holding periods
Dividend Discount Model
Two types of cash flowsDividends during the holding periodExpected 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 ModelConstant Growth ModelTwo-stage growth modelThree-stage growth model
Zero Growth Model
Dividend every year will be the sameInvestor anticipates to receive the same amount dividend per year forever
DPSV = -------------
rcs
Constant Growth Model
Assume that firm grows at a stable growth rate of g per year forever
DPS1
V = --------- r - g
Two-Stage DDMIn general version of the model, two stages of growth
An initial period of extraordinary growthAfter initial period, a period of stable growth
n DPSt Pn
P0 = ---------- + --------- t=1 (1+r)t (1 + r)n
DPSn+1
Where Pn = -----------------
(r – gn)
Three-stage growth model
Four Basic Inputs
Length of high growth periodDividends per share each periodRequired rate of return by stockholders each periodTerminal price at the end of high growth period
High Growth Rate and Stable Growth Rate
Stable Growth Rate?Growth rate expected to last foreverFirm’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 periodThe larger the current size of the firm, the shorter the high-growth period.
Guide to Length of High-Growth Period
Current Growth Length of HighRate Growth Period
1% higher than stable No high growth1 – 10% higher than stable 5 years> 10% higher than stable 10 years
How do we Estimate Growth Rate?
g = b[ROA+D/E(ROA-I (1-t))]Where b refers to the retention ratioROA is the return on assetsD/E is the debt to equity ratio in book value termsi = 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 dividendsThe 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 FCFEt Pn
P0 = ---------- + ---------
t=1 (1+r)t (1 + r)n
FCFEn+1
Where Pn = -----------------
(r – gn)