FM 04 StockValuation

FM
– Fall 2022 9/12/2022
Dr. N Amin
Overview
Stocks and Their
Valuation Features of Common Stock
Chapter 9
Intrinsic Value and Stock Price
Determining Common Stock Values
Discounted Dividend Model
Corporate Valuation Model
Other Approaches
Preferred Stock
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Facts About Common Stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price
 CONTROL OF THE FIRM

• Proxy Fight & Takeover (see pages 317-319)
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
3 4
Different Approaches for Estimating the Intrinsic

Intrinsic Value and Stock Price Value of a Common Stock
 Outside investors, corporate insiders, and

analysts use a variety of approaches to estimate Discounted dividend model
a stock’s intrinsic value ( P̂0 ).
 In equilibrium we assume that a stock’s price Corporate valuation model
equals its intrinsic value.
• Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy Models based on market multiples
and/or sell.
• Stocks with a price below (above) its intrinsic
value are undervalued (overvalued).
Please read: OTHER APPROACHES TO VALUING
COMMON STOCKS p 340.
Enterprise & Economic Value added (EVA)
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FM – Fall 2022 9/12/2022
Dr. N Amin
Discounted Dividend Model Constant Growth Stock
 Value of a stock is the present value of the  A stock whose dividends are expected to grow
future dividends expected to be generated by forever at a constant rate, g.
the stock.
D1 = D0(1 + g)1
D1 D2 D3 D D2 = D0(1 + g)2
P̂0  1
 2
 3
 ...  
(1  rs ) (1  rs ) (1  rs ) (1  rs ) Dt = D0(1 + g)t
 If g is constant, the discounted dividend
formula converges to:
D 0 (1  g) D
P̂0   1
rs  g rs  g
7 8
Future Dividends and Their Present Values What happens if g > rs?
$  If g > rs, the constant growth formula leads to a

Dt = D0 (1 + g)t negative stock price, which does not make
sense.
 The constant growth model can be used only if:

0.25 Dt • rs > g
PVD t 
( 1  r )t • g is expected to be constant forever.
P0   PVDt
0 Years (t)
9 10
Bon Temps: Use the SML to Calculate the Required Find the Expected Dividend Stream for the Next 3
Rate of Return (rs) Years and Their PVs
 If rRF = 3%, rM = 8%, and b = 1.2, what is the D0 = $2 and g is a constant 4%.
required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b

0 g = 4% 1 2 3
= 3% + (8% – 3%)1.2
= 9% 2.08 2.1632 2.24973
1.9083
rs = 9%
1.8207
1.7372
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FM – Fall 2022 9/12/2022
Dr. N Amin
What is the stock’s expected value, one year from

What is the stock’s intrinsic value? now?
 Using the constant growth model:  D1 will have been paid out already. So, expected
P1 is the present value (as of Year 1) of D2, D3,
D4, etc.
D1 $2.08
P̂0   P̂1 
D2

$2.1632
rs  g 0.09  0.04 rs  g 0.09  0.04
$2.08  $43.26

0.05
 Could also find expected P1 as:
 $41.60
P̂1  P0 (1.04)  $43.26
13 14
Find Expected Dividend Yield, Capital Gains Yield, and What would the expected price today be,
Total Return During First Year if g = 0?
 Dividend yield The dividend stream would be a perpetuity.

= D1/P0 = $2.08/$41.60 = 5.0%
 Capital gains yield 0 rs = 9% 1 2 3
= (P1 – P0)/P0
2.00 2.00 2.00
= ($43.26 – $41.60)/$41.60 = 4.0%
 Total return (rs)
PMT $2.00
= Dividend yield + Capital gains yield P̂0    $22.22
r 0.09
= 5.0% + 4.0% = 9.0%
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Bon Temps: Supernormal Growth Valuing Common Stock with Nonconstant Growth
 What if g = 30% for 1 yr, 20% for 1 yr, and D0 = $2.00.

10% for 1 yr before achieving long-run growth
of 4%? 0 rs = 9% 1 2 3 4
• Can no longer use just the constant growth
model to find stock value. g = 30% g = 20% g = 10% g = 4%
• However, the growth does become constant after 2.600 3.120 3.432 3.5693
3 years. 2.385
2.626
2.650
55.123 3.5693
P̂3   $71.39
62.784 = P̂ 0.09  0.04
0
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3
FM – Fall 2022 9/12/2022
Dr. N Amin
Find Expected Dividend and Capital Gains Yields Nonconstant Growth: What if g = 0% for 3 years
During the First and Fourth Years before long-run growth of 4%?
 Dividend yield (first year) D0 = $2.00.

= $2.60/$62.78 = 4.14% 0 r = 9% 1 2 3 4
s
 Capital gains yield (first year) g = 0% g = 0% g = 0% g = 4%
= 9.00% – 4.14% = 4.86% 2.00 2.00 2.00 2.08

1.84
 During nonconstant growth, dividend yield and 1.68
capital gains yield are not constant, and capital
gains yield ≠ g. 1.55
2.08
32.12 P̂3   $41.60
 After t = 3, the stock has constant growth and 0.09  0.04
dividend yield = 5%, while capital gains yield = 4%. 37.19 = P̂0
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Find Expected Annual Dividend and Capital Gains

Yields Corporate Valuation Model
 Capital gains yield  Also called the free cash flow method. Suggests
the value of the entire firm equals the present
= g = -4.00% value of the firm’s free cash flows (which is the
MV of its operations) plus the market value of
 Dividend yield its non-operating assets.
= 9.00% – (-4.00%) = 13.00%  Remember, free cash flow is the firm’s after-tax
operating income less the net capital
 Since the stock is experiencing constant growth, investment.
dividend yield and capital gains yield are
constant. Dividend yield is sufficiently large
(13%) to offset negative capital gains.
21 22
Applying the Corporate Valuation Model Issues Regarding the Corporate Valuation Model
 Find the market value (MV) of the firm’s  Often preferred to the discounted dividend
operations, by finding the PV of the firm’s future model, especially when considering number of
FCFs. firms that don’t pay dividends or when
dividends are hard to forecast.
 Add the market value of the firm’s non-
operating assets.  Similar to discounted dividend model, assumes
at some point free cash flow will grow at a
 Subtract MV of firm’s debt and preferred stock constant rate.
to get MV of common stock.
 Horizon value (HVN) represents value of firm’s
 Divide MV of common stock by the number of operations at the point that growth becomes
shares outstanding to get intrinsic stock price constant.
(value).
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4
FM – Fall 2022 9/12/2022
Dr. N Amin
What is the firm’s intrinsic value per share? Firm Multiples Method
 Analysts often use the following multiples to

The firm has $40 million total in debt and preferred value stocks.
stock, $5 million of non-operating assets, and 10 • P/E
million shares of common stock. • P/CF
MV of equity  MV of operations  MV of nonoperating assets  MV of debt and preferred • P/Sales
 $877.50  $5  $40  EXAMPLE: Based on comparable firms,
 $842.50 million estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate of
Value per share  MV of equity/# of shares the stock price.
 $842.50 /10  Enterprise-Based Multiples
 $84.25
• EV/EBITDA
25 26
If preferred stock with an annual dividend of $5 sells

Preferred Stock for $100, what is the preferred stock’s expected
return?
D
Hybrid security Vp 
rp
$5
$100 
Like bonds, preferred stockholders receive a fixed rp
dividend that must be paid before dividends are paid
to common stockholders.
$5
r̂p 
However, companies can omit preferred dividend $100
payments without fear of pushing the firm into  0.05  5%
bankruptcy.
27 28
End of Chapter 9
Don’t forget to go
through
APPROACHES TO
VALUING COMMON
STOCKS
Appendix 9A-Stock
Market Equilibrium
& it’s problems
© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5
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FM 04 StockValuation

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FM

Determining Common Stock Values

Discounted Dividend Model

Corporate Valuation Model

Facts About Common Stock

 CONTROL OF THE FIRM

Different Approaches for Estimating the Intrinsic

 Outside investors, corporate insiders, and

Discounted Dividend Model Constant Growth Stock

$  If g > rs, the constant growth formula leads to a

 The constant growth model can be used only if:

rs = rRF + (rM – rRF)b

What is the stock’s expected value, one year from

 Dividend yield The dividend stream would be a perpetuity.

 What if g = 30% for 1 yr, 20% for 1 yr, and D0 = $2.00.

 Dividend yield (first year) D0 = $2.00.

 Capital gains yield (first year) g = 0% g = 0% g = 0% g = 4%

= 9.00% – 4.14% = 4.86% 2.00 2.00 2.00 2.08

Find Expected Annual Dividend and Capital Gains

 Analysts often use the following multiples to

If preferred stock with an annual dividend of $5 sells

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