fund.finance lecture 4 valuing stock s1.2011

8/13/2019 Fund.finance Lecture 4 Valuing Stock S1.2011

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STOCKS ND THEIR

V LU TION

LECTURE 5


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Primary market : the market in which firms originallyissue new securities.

Secondary market : the market in which investors buyand sell securities that have been issued.

Primary market is the pre-condition for secondary market.In turn, the development of secondary market affectdevelopment of primary market.

2


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3

Debt securities represent a legally enforceableclaim.

Debt securities offer fixed or floating cash flows.

Bondholders do not have voting right inimportant company decisions.


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4

No claim to earnings or assets until all senior

claims are paid in full High risk, but historically also high return

Common stockholders are residual claimants.

Debt and equity have substantially different marginalbenefits and marginal costs


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5

Fixed returnContractual interestrate

Fixed lifeRedeemed on

maturity dateSecurityPaid beforeshareholders

Variable returnDividends only whendeclared

Indefinite lifeNo maturity date

SecurityResidual claim onassets


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Proxy fight : when earning is poor and shareholders dissatisfied, anoutside group may attempt to getting shareholders to grant the group

authority to vote their shares to replace the current management.

Proxy : common shareholders often transfer their right to vote to anotherperson by mean of a proxy.

Stockholders have voting rights on important company decisions andownership interest.


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Re-emptive right : give the common stockholders theright to buy any additional shares issued by thecorporation.

Stockholders have the re-emptive right .

Preventing the management of a corporation seizecontrol of the corporation and frustrate the will of thecurrent stockholders.

Protecting the stockholders against a dilution of value

Reasons of re-emptive right:


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8

Little economic relevance today.Par value

The shares of a companys stock that shareholdersand the board authorize the firm to sell to the

public.

Shares authorized

The shares of a companys stock that have beenissued or sold to the public.Shares issued

The shares of a companys stock that are currentlyheld by the public.Shares outstanding

The amount of money the firm received fromselling stock, above and beyond the stocks par

value.

Additional paid-incapital


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Preferred stock have some features similar to debt andother features similar to equity.


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Dividend payments are not tax deductible.

Annual dividend yield as a percentage of par value

Preferred dividends must be paid before common dividends

If cumulative preferred, all missed past dividends must be paid before common dividends can be paid.

Unlike common stock, no ownership interest

Second to debt holders and senior to stockholders on claim oncompanys assets in the event of bankruptcy.

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Book Value

Net worth of the firm according to the balance sheet. It doesnot capture the true value of business (extra earning power,value of future investment), intangible assets,

Liquidation Value

What company could raise if they sell all its assets and payoff all its debt

Market value

The amount that investors are willing to pay, depending onthe earning power of today and the expected profit ability offuture investment

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Discounted cash flow techniques

Present value of dividend (DDM) Present value of operating cash flows (OCF)

Present value of free cash flows (FCFF or FCFE)

Relative valuation techniques

Price/Earning ratio (P/E) Price/cash flow ratio (P/CF) Price/Book value ratio (P/BV) Price/Sale ratio (P/S) 12


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Making decisionBuy if estimated value

> market price

Not buy if estimated

value < market price

Hold if estimated

value = market price

Compare to the intrinsic (or economic) value to market price

Calculating intrinsic value of a stocks by discounting expected futurecash flows at required rate of return

Evaluate the investment

Estimate the expected cash flows Determine required rate of return

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All discounted-cash flow techniques are based on thebasic present value model:

Where:- Vj = value of stock j- n = life of the asset- CFt = cash flow in period t- k = the discount rate that is equal to the required rate of return for asset

determined by the uncertainty (risk) of the stocks cash flows 14


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Common stock represents an ownership interest in a corporation, but from perspective of typical

investors, common stock is a piece of paper thatcan give them:

Dividend : receive only earnings out ofdividend and choose to pay dividend

Capital when selling stock: higher purchaseprice => capital gain. Lower than purchaseprice => capital loss


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Suppose that an investor buys a stock today for price P 0 ,receives a dividend equal to D1 at the end of one year,and immediately sells the stock for price P 1.

16

111

0 )1( r P D

P Value of aShare of

Common Stock

0

011

P P P D

r Return oninvestment


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ExampleCurrent forecasts are for XYZ Company to pay

dividends of $3, $3.24, and $3.50 over the next three years,respectively.

At the end of three years you anticipate selling your stock ata market price of $94.48. What is the price of the stockgiven a 12% expected return?

PV

PV

3 001 12

3 241 12

3 50 94 481 12

00

1 2 3.

( . ).

( . ). .( . )

$75.


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Basic valuation model : Stock value is the present value of all expected future cash flows:1. Dividend

2. Price investors expected to receive when sellingthe stock

P

Div

r

Div

r

Div P

r H H

H 0

1

1

2

21 1 1

( ) ( ) ... ( )

H - Time horizon for your investment.


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How to determine P H ?

P Div

r Div

r Div P

r H H

H 01

12

21 1 1

( ) ( )...

( )


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How is P H determined? PV of expected stock price P 2, plus dividends P 2 is the PV of P 3 plus dividends, etc. Repeating this logic over and over, you will find that todays price

equals the PV of the entire dividend stream that the stock will payin the future:

The formula:

now becomes:

20....

)1()1()1()1()1( 5

54

43

32

21

10

r

D

r

D

r

D

r

D

r

D P

s s s s s

P Div

r

Div

r

Div P

r

H H H 0

11

22

1 1 1

( ) ( )...

( )


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There are three versions of dividend discountmodel (DDM)

Zero GrowthConstant Growth- Infinite Preiod Model (IPM)

Differential Growth (Nonconstant Growth)- Temporary supernormal growth model

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Assume that dividends will remain at the same level forever

D1 = D2 = ... = D

If we forecast no growth, and plan to hold out stock indefinitely,we will then value the stock as a PERPETUITY .

r EPS

or r

D P Perpetuity 10

Assumes all earnings are paid toshareholders.

....)1()1()1()1()1( 543210 r

Dr

D

r

D

r

D

r

D P

s s s s s


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Assumes dividends will grow at a constant rate ( g) that isless than the required return (r):

D1 = D 0 (1+g)D2 = D 1 (1+g) = D 0 (1+g) 2

D3 = D 2 (1+g) = D 0 (1+g)3

1

g r D

P s

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Commonly called the Gordon growth model

If dividends grow at a constant rate forever, you can value stock as agrowing perpetuity, denoting next years dividend as D 1:


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Dynasty Corp. pays a $3 dividend in one year. If investors expect thatdividend to remain constant forever, and they require a 10% return onDynasty stock, what is the stock worth?

30$1.03$1

sr D P

24

86.42$03.010.0

3$1 g r

D P

s

What is the stock worth if investors expect Dynastys dividends to growat 3% per year?


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When a firm retains earning and acquires additionalassets, the total earnings of the firm will increase becauseits asset base is larger

The grow th in earn ing s depends upo n:

1. proportion of earning reinvested2. the rate of return its earns on its new assets

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Grow th rate g = retent io n rate x ROE

1- pay ou t ra t io


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Example

Our company forecasts to pay a $5.00 dividend next year, whichrepresents 100% of its earnings. This will provide investors with a 16%expected return.

Instead, we decide to pay out 30% of the earnings at the firms current

return on equity of 20%.What is the value of the stock before and after the plowback decision?

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25.31$16.5

0 P

No Growth With Growth

00.75$14.16.

5.1

14.70.20.

0 P

g


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Example conti nued

If the company did not plowback some earnings, the stock price would remain at $31.25. With the plowback, the pricerose to $75.00.

The difference between these two numbers (75.00-31.25=43.75) is called the Present Value of GrowthOpportunities ( PVGO ).

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Example

What is the value of a stock that expects to pay a $3.00 dividendnext year, and then increase the dividend at a rate of 8% per year,indefinitely? Assume a 12% expected return.

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00.75$08.12.

00.3$10

g r

D P


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Example- continued

If the stock that expects to pay a $3.00 dividend next year, isselling for $100 in the stock market, what might the market beassuming about the growth in dividends? Assume a 12% expectedreturn

$100 $3.

.

.

0012

09

g

g

AnswerThe market isassuming thedividend will grow at9% per year,indefinitely.


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Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant ratethereafter.

To value a Differential Growth Stock, we need to:Estimate future dividends in the foreseeable future.

Estimate the future stock price when the stock becomesa Constant Growth Stock (case 2).

Compute the total present value of the estimated futuredividends and future stock price at the appropriatediscount rate.

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nn

n

i i

i

r g r

D

r

D P

1

1

1 21

10


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n

n

n

n

r g r

D

r

g

g r

D P

)1(

1

1

11

2

11

1

1

0

Pn


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Preferred stock is an equity security that is expected to pay afixed annual dividend indefinitely.

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p

p0

r

D = PS

PS 0 = Preferred stocks market price Dp = next periods dividend payment r p = discount rate

Using the formula for valuing a perpetuity:

An example : Investors require an 11% return on a preferred stock thatpays a $2.30 annual dividend. What is the price?

share==r

D = PS

p

p0 /90.20$

11.03.2$


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S TOCK VALUATION

What if there are no dividends?

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fund.finance lecture 4 valuing stock s1.2011

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