Valuation Part 1

What we already know?

Value of any project, stock, bond, etc. is the
discounted value of its future cash flows

Discount rate reflects the project’s riskiness

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What’s next?
How to implement the formula for stock
valuation?

1. Dividend discount model

2. Relative valuation

3. Discounted cash-flow

Why valuation?

Stock Public
research offerings
Buy/Sell/Hold Debt/Equity

Valuation

M&A/ Divestitures
How much to pay/sell for
our company/division?

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Dividend discount model (DDM)
Stock value is the discounted value of all
future cash-flows (dividends)

Dividends should be interpreted in the broad

sense of all cash-flows including repurchases,
special dividends, liquidating dividends, etc.

DDM and capital gains

Doesn’t one buy stocks for both cash-flows
(dividends) and capital gain (price
appreciation)?
• Yes; DDM does not ignore the latter

is the future stock price and is the price

change

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DDM and the discount rate
What is in the formula?

 It is the cost of capital for the equity. Also

called as:
• Expected rate of return on equity, or
• Required rate of return on equity, or
• Discount rate

 Usually obtained through CAPM

DDM: No growth firm

Mature firm with no growth prospects. Pays
constant dividends of

• Same formula as a perpetuity

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DDM: No growth firm – example
 Firm pays $5 per share in dividends
 Cost of capital is 15%
 The stock price is:

What are the earnings per share of this firm?

DDM: Constant growth firm

Mature firm with constant growth

 Has just paid dividends of this year

 Pays dividends of:

• next year
• in two years, and so on

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DDM: Constant growth firm …
Gordon growth formula

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DDM: Constant growth firm – Example

 Firm will pay $3 in dividends next year
 Cost of capital is 15%, growth rate is 8%
 The stock price is:

What are the earnings per share of this firm?

• Why did I change the dividends from $5 in the
previous example to $3 in this example?

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Gordon growth formula

Stock price will be higher:

• Higher are the dividends (more money)
• Lower is the cost of capital (less risky)
• Higher is the growth rate (more money in the
future)

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Growth
Where does growth come from?

 Ultimately, from investments in positive NPV

projects
 Practically, from the rate of return on the
money reinvested in the company

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Growth and reinvestment

Earnings

Dividends Remainder
Paid to shareholders Reinvested in company

Earns rate of return

and generates more
earnings next year
(≡ growth)
= reinvestment rate, plowback ratio
= return on equity = Net Income/Book Equity
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Earnings growth example (1)

 A firm has projected EPS of $4.63 per share
today (period 0)
 It pays out 60% or $2.78 as dividend and
keeps $1.85 for reinvestment

 Dividend payout ratio = 1.85/4.63 = 60%

 Reinvestment rate = 1.85/4.63 = 40%

 The ROE is 20% and the cost of capital is

15%
• Why are these two different?

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Earnings growth example (2)
What is the next period EPS?

 With no plowback, next period EPS =$4.63

 Extra earnings generated from $1.85
reinvestment =20% (ROE) of $1.85 =$0.37
 Total next period EPS =$4.63+$0.37=$5.00
 Earnings growth
=($5.00−$4.63)/$4.63=8%

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Earnings growth example (3)

When the firm has a constant dividend pay
out policy, its dividend growth will be equal to
the EPS growth

 EPS grows like:

• $4.63→$5.00→$5.40→$5.83→$6.30

 Since the firm pays out 60%, dividend

grows like:
• $2.78→$3.00→$3.24→$3.50→$3.78

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Earnings growth example (4)

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Earnings growth example version 2

What if the company increases the
reinvestment rate to 50%?
• Growth rate = 20%×50% = 10% (higher than before)
• Next period earnings = $4.63×(1+10%) = $5.09
(higher than before)

• Next period dividends = $5.09×50% = $2.55

(lower than before)

Why did the price increase when dividends /

cash-flows declined?
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Earnings growth example version 3
What if the company’s ROE falls 10% (but the
reinvestment rate stays at 40%)?
• Growth rate = 10%×40% = 4% (lower than before)
• Next period earnings = $4.63×(1+4%) = $4.81
(lower than before)

• Next period dividends = $4.81×60% = $2.89

(lower than before)

Why did the price decrease to even lower

than the price of $33.3 for no growth?
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ROE and NPV

 ROE is how much the company makes
 RE is how much the investors’ desire it to
make

When ROE>RE, the company should reinvest

• These are positive NPV projects
▪ In real life, ROE would tend to decline with increasing
investment
• Your 1st best idea (project) gives very good ROE; your 10th
best idea is usually not very good quality

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No growth
Consider again the no growth firm

 What is its reinvestment rate?

 What is its ROE?

 What are its earnings?

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Uneven growth rates

How to value a company that has high
growth rates for next years before
becoming a mature firm growing at constant
growth rate after year ?

 Make explicit forecasts of dividends for the

next years
 Forecast the value of the company at the
end of years
• Known as the terminal value or the continuation
value

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Uneven growth rates …
Value today is the sum of discounted value of
explicitly forecast dividends and future
continuation value

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Continuation value
After year , the firm is expected to grow at
the rate
• This is predicted future growth rate after year

The projected value can be obtained using

the Gordon growth formula

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