Download - presentation of stock valuation
MC11-253
Muhammad NAWAZ
HAILEY COLLEGE OF COMMERCE PUNJAB UNIVERSITY LAHORE PAKISTAN
Common Stock Valuation
Common Stock
A security that represents ownership in a company. Holders of common stock exercise control by electing a board of directors. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders have been paid in full.
What is Value
In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller.
Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset.
Valuation of Financial Assets
Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flowsThree step process:1. Estimate the expected cash flows.2. Determine the appropriate interest rate to
discount the cash flows.3. Compute the present value of the
expected cash flows by discounted them with interest rate determine in step 2.
Intrinsic Value
Maximum price which an investor is ready to pay for purchase of a security.
Intrinsic value is present value and is also called estimated value or economic value.
Intrinsic Value
Intrinsic value is compared with market value of security and is based on these factors:
Future cash inflows Timing of return Required rate of return i.e. ’’k’’ k=risk free rate of return + risk
premium.
Discounted Cash Flow Model
This technique estimates the value of a security by discounting its expected future cash flows back to the present value and adding them together.The estimated value of a security = present value of future cash flows
t=n expected cash flowValue = V0 = -----------------------------
t=1 (1+k)t
Discounted Cash Flow Model
To use this model, an investor must:Estimate the amount of future cash
flowsEstimate the timing of future cash flowsEstimate an appropriate discount rateUsing above components value of a
security is calculated which is then compared to the current market price of the security
This calculated value is denoted by V0 and is called intrinsic value
Discounted Cash Flow Model
Dividend Discount Model(DDM)Value of a common stock is the present value of all future dividends.
D1 D2 Dn
Value of stock= ------- + ------- + --- + --------
(1+k)1 (1+k)2 (1+k)n
n Dn
Value of stock = ---------- t=1 (1+k)n
Dividend Discount Model(DDM)
Types of dividend discount model:
1.Zero dividend growth2.Constant growth3.Variable growth
Zero Growth Model
Dividend every year will be the sameInvestor anticipates to receive the same amount dividend per year forever
D1
Vcs = ------------- where D1 =D0 (1+g)
Kcs
Dividend Discount Model(DDM)
Dividend Discount Model(DDM)
Constant Growth Model
Assume that firm grows at a stable growth rate of g per year forever
D1
Vcs = ---------
Kcs - g
Variable growth rate
Assume that firm’s growth rate is variable
D0(1+g1 )t Dn +1 1
Vcs = ------------ + ---------- ---------
( 1+Kcs )t Kcs – g2 (1+Kcs )n
g1 = growth in 1st phase
g2 = growth in 2nd phase
Dividend Discount Model(DDM)
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Intrinsic Value & Market Value
When market value is less than or equal to intrinsic value then common stock must be retained or purchased.
When market value is greater than intrinsic value then common stock must be sold or avoid.
Other Valuation Methods
Some companies do not pay dividends, or the dividends are unpredictable.In these cases we have several other possible valuation models:
Free Cash Flow ModelP/E approachPrice to Sales (P/S)
The Free Cash Flow Model
Free cash flow is the cash flow that’s left over after making all required investments in operating assets:
Where NOPAT is net operating profit after taxNote that the total value of the firm equals the value of its debt plus preferred plus common:
CapOpNOPATFCF
CSPD VVVV
The Free Cash Flow Model
We can find the total value of the firm’s operations (not including non-operating assets), by calculating the present value of its future free cash flows:
Now, add in the value of its non-operating assets to get the total value of the firm:
gk
gFCFVOps
10
NonOpsNonOpsOps V
gk
gFCFVVV
10
The Free Cash Flow Model
Now, to calculate the value of its equity, we subtract the value of the firm’s debt and the value of its preferred stock:
Since this is the total value of its equity, we divide by the number of shares outstanding to get the per share value of the stock.
PDNonOpsCS VVV
gk
gFCFV
10
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Price/Earnings Ratio
Alternative approach often used by security analystsP/E ratio is the strength with which investors value earnings as expressed in stock price
Divide the current market price of the stock by the latest 12-month earnings
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To estimate share value
P/E ratio can be derived from
Indicates the factors that affect the estimated P/E ratio
11 /E P Eo P/E rati justified
earnings estimated P
o
o
k - g/ED
/E or Pk - gD
P oo11
11
P/E Ratio Approach
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P/E Ratio Approach
The higher the payout ratio, the higher the justified P/E
Payout ratio is the proportion of earnings that are paid out as dividends
The higher the expected growth rate, g, the higher the justified P/EThe higher the required rate of return, k, the lower the justified P/E
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P/E Ratios and Interest Rates
A P/E ratio reflects investor optimism and pessimism
Related to the required rate of return
As interest rates increase, required rates of return on all securities generally increaseP/E ratios and interest rates are indirectly related
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Other Valuation Methods
Price-to-book value ratioRatio of share price to stockholder equity as measured on the balance sheet
Price-to-sales ratioRatio of a company’s total market value (price times number of shares) divided by salesMarket valuation of a firm’s revenues
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Which Approach Is Best?
Best estimate is probably the present value of the (estimated) dividends
P/E multiplier remains popular for its ease in use and the objections to the dividend discount model