Valuing Stocks

by Luis Molina
 Esta foto de Autor desconocido está bajo licencia CC BY-NC

Knowledge
What Is a Stock?

A stock (also known as equity) is a

security that represents the
ownership of a fraction of
a corporation. This entitles the
owner of the stock to a proportion of
the corporation's assets and profits
equal to how much stock they
own. Units of stock are called
"shares."
KEY TAKEAWAYS

• A stock is a form of security that

indicates the holder has
proportionate ownership in the
issuing corporation.
• Corporations issue (sell) stock to
raise funds to operate their
businesses. There are two main
types of stock: common and
preferred.
• Stocks are bought and sold
predominantly on stock exchanges,
though there can be private sales as
well, and they are the foundation of
nearly every portfolio.
What Is Common
Stock?

• Common stock is a security that

represents ownership in a corporation.
Holders of common stock elect the board
of directors and vote on corporate
policies.
 What Is Common
Stock?

KEY TAKEAWAYS

• Common stock is a security that represents ownership in a

corporation.
• In a liquidation, common stockholders receive whatever
assets remain after creditors, bondholders, and preferred
stockholders are paid.
• There are different varieties of stocks traded in the market.
For example, value stocks are stocks that are lower in price in
relation to their fundamentals. Growth stocks are companies
that tend to increase in value due to growing earnings.
• Investors should diversify their portfolio by putting money
into different securities based on their appetite for risk.
Understanding
Common Stock
• With common stock, if a company goes
bankrupt, the common stockholders do
not receive their money until the
creditors, bondholders, and preferred
shareholders have received their
respective share.
• This makes common stock riskier than
debt or preferred shares
What Are Preference
Shares ?
• Preference shares (preferred stock) are
company stock with dividends that are
paid to shareholders before common
stock dividends are paid out.
• Preference shares are ideal for risk-
averse investors, and they are callable
(the issuer can redeem them at any
time).
 1 Stock Prices, Returns, and the
Investment Horizon

Chapter 2 The Dividend-Discount Model

Outline

3 Total Payout and Free Cash

Flow
Valuation Models

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 9-9

1 Stock Prices, Returns,
and the Investment Horizon
• A One-Year Investor
• Potential Cash Flows
• Dividend
• Sale of Stock
• Timeline for One-Year Investor

• Since the cash flows are risky, we must discount them at the equity cost of capital.
9.1 Stock Prices, Returns,
and the Investment Horizon (cont'd)
• A One-Year Investor
 Div1 + P1 
P0 =  
 1 + rE 

• If the current stock price were less than this amount, expect investors to rush
in and buy it, driving up the stock’s price.
• If the stock price exceeded this amount, selling it would cause the stock price
to quickly fall.
Dividend Yields, Capital Gains,
and Total Returns
Div1 + P1 Div1 P1 − P0
rE = − 1 = +
P0 P0 P0
Dividend Yield Capital Gain Rate

• Dividend Yield
• Capital Gain
• Capital Gain Rate
• Total Return
• Dividend Yield + Capital Gain Rate
• The expected total return of the stock should equal the expected
return of other investments available in the market with equivalent
risk.
Example 1

9-13
Example 1 (cont'd)
A Multi-Year Investor
• What is the price if we plan on holding the stock for two years?

Div1 Div2 + P2
P0 = +
1 + rE (1 + rE ) 2
A Multi-Year Investor (cont'd)
• What is the price if we plan on holding the stock for N years?

Div1 Div2 DivN PN

P0 = + + + +
1 + rE (1 + rE ) 2
(1 + rE ) N
(1 + rE ) N
• This is known as the Dividend Discount Model.
• Note that the above equation holds for any
horizon N. Thus all investors (with the same beliefs) will attach the same value to the
stock, independent of their
investment horizons.
A Multi-Year Investor (cont'd)

Div1 Div2 Div3 Divn
P0 =
1 + rE
+
(1 + rE ) 2
+
(1 + rE ) 3
+ = 
n =1 (1 + rE ) n

• The price of any stock is equal to the present value of

the expected future dividends it will pay.
2 The Discount-Dividend Model
• Constant Dividend Growth
• The simplest forecast for the firm’s future dividends states that they will grow
at a constant rate, g, forever.

9-18
2 The Discount-Dividend Model (cont'd)
• Constant Dividend Growth Model
Div1
P0 =
rE − g

Div1
rE = + g
P0

• The value of the firm depends on the current dividend level, the cost of
equity, and the growth rate.
Example 2
Example 2 (cont'd)

9-21
Dividends Versus Investment and Growth
• A Simple Model of Growth
• Dividend Payout Ratio
• The fraction of earnings paid as dividends each year

Earningst
Divt =  Dividend Payout Ratet
Shares Outstandingt
EPSt
Dividends Versus Investment
and Growth (cont'd)
• A Simple Model of Growth
• Assuming the number of shares outstanding is constant, the firm can do two
things to increase
its dividend:
• Increase its earnings (net income)
• Increase its dividend payout rate
Dividends Versus Investment
and Growth (cont'd)
• A Simple Model of Growth
• A firm can do one of two things with its earnings:
• It can pay them out to investors.
• It can retain and reinvest them.
Thanks