fin303 vicentiu covrig 1 stocks and their valuation (chapter 9)

FIN303Vicentiu Covrig

11

Stocks and their valuationStocks and their valuation(chapter 9)(chapter 9)


22

Facts about common stockFacts about common stock

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock

price


33

Intrinsic Value and Stock PriceIntrinsic Value and Stock Price Outside investors, corporate insiders, and analysts use a variety of

approaches to estimate a stock’s intrinsic value (P0). 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 overvaluedBuy or Sell?


44

Dividend growth modelDividend 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)

)r(1

D ...

)r(1

D

)r(1

D

)r(1

D P

s3

s

32

s

21

s

10

^


55

Constant growth stockConstant growth stock A stock whose dividends are expected to grow forever at a

constant rate, g.

D1 = D0 (1+g)1

D2 = D0 (1+g)2

Dt = D0 (1+g)t

If g is constant, the dividend growth formula converges to:

g -r

D

g -r

g)(1D P

s

1

s

00

^


66

What happens if g > rWhat happens if g > rss??

If g > rs, the constant growth formula leads to a negative stock price, which does not make sense.

The constant growth model can only be used if:- rs > g

- g is expected to be constant forever


77

If rIf rRFRF = 7%, r = 7%, rMM = 12%, and = 12%, and ββ = 1.2, what is = 1.2, what is the required rate of return on the firm’s the required rate of return on the firm’s

stock?stock?

Use the SML to calculate the required rate of return (rs):

rs = rRF + (rM – rRF)β

= 7% + (12% - 7%)1.2

= 13%


88

If DIf D00 = $2 and g is a constant 6%, = $2 and g is a constant 6%, What is What is the stock’s market value?the stock’s market value?

Using the constant growth model:

$30.29

0.07

$2.12

0.06 - 0.13

$2.12

g - r

D P

s

10


99

What is the expected dividend yield, capital What is the expected dividend yield, capital gains yield, and total return during the first gains yield, and total return during the first

year?year?

Dividend yield= D1 / P0 = $2.12 / $30.29 = 7.0%

Capital gains yield= (P1 – P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0%

Total return (rs)= Dividend Yield + Capital Gains Yield

= 7.0% + 6.0% = 13.0%


1010

What would the expected price today What would the expected price today be, if g = 0?be, if g = 0?

The dividend stream would be a perpetuity.

$15.38 0.13

$2.00

r

PMT P

^

0


1111

Supernormal growth:Supernormal growth:What if g = 30% for 3 years before What if g = 30% for 3 years before achieving long-run growth of 6%?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.


1212

Valuing common stock with Valuing common stock with nonconstant growthnonconstant growth

rs = 13%

g = 30% g = 30% g = 30% g = 6%

P 0.06

$66.543

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 = P0

^

0 1 2 3 4

D0 = 2.00 2.6 3.380 4.394

...

4.658


1313

Calculations:

D1 = D0*(1+g1)= 2x(1+0.3)= 2.6D2 = D1*(1+g1)= 2.6x(1+0.3)= 3.38D3 = 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) = 2.301Present Value of D2= 3.38/(1+0.13)^2 = 2.647Present Value of D3= 4.394/(1+0.13)^3 = 3.045


1414

Exam type questionExam type questionThe 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. $21.00b. $33.33c. $42.25d. $50.16 *


1515

Corporate value modelCorporate 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 preferred3. Divide MV of common stock by the number of shares outstanding to get

intrinsic stock price (value).

- P0 = MV of common stock / # of shares


1616

Issues regarding the corporate Issues regarding the corporate value modelvalue 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 (TVn) represents value of firm at the point that growth becomes constant.


1717

Given the long-run gGiven the long-run gFCFFCF = 6%, and WACC = 6%, and WACC of 10%, use the corporate value model to of 10%, use the corporate value model to

find the firm’s intrinsic value.find the firm’s intrinsic value.

g = 6%

r = 10%

21.20

0 1 2 3 4

-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20

530 = = TV30.10 0.06-


1818

Calculations:Present Value of CF1= -5/(1+0.1) = -4.545Present Value of CF2= 10/(1+0.1)^2 = 8.264Present 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


1919

If the firm has $40 million in debt and has 10 If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s million shares of stock, what is the firm’s

intrinsic value per share?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


2020

Exam type questionExam type questionAn 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. $ 1.67b. $ 5.24c. $18.37d. $21.11 *


2121

Exam type questionExam 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.


2222

Learning objectivesLearning 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

fin303 vicentiu covrig 1 stocks and their valuation (chapter 9)

Documents

fin303 vicentiu covrig

stock value

r s g g

constant growth stock

stock price slide

r rf r

dividend growth model

constant growth model