Last Study Topics

• PV Calculation Short Cuts

• Numeric Examples
 Today’s Study Topics
• How To Value Common Stock
• Valuing Common Stock
• Capitalization Rates
• Returns Measurements
 Principles of Corporate Finance
Brealey and Myers Sixth Edition

 The Value of Common Stocks

Slides by
Asad abbas Chapter 4
Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000
 Common stocks
• 9.9 Bn shares of General electronics (GE),
owned by 2.1 M shareholders;
• E.g;
– Large pension funds, insurance companies;
• The more shares you own, the larger your
“share” of the company;
• Sales of new shares to raise new capital are
said to occur in the primary market;
 Continue
• The market for secondhand shares is known
as the secondary market.
• Since buying stock is a risky occupation – how
to choose the stocks?
– To answer this question you got to answer;
• How the common stocks are values?
– (DCF) is just to same for valuing common stock
Present value.
 How to Value Common Stocks
• Shareholders receive cash from the company
in the form of a stream of dividends;
– PV(stock) = PV(Expected future dividends)

• Is there any application for the capital gain

that the Shareholders are expected to earn?
– Market Capitalization rate
 Valuing Common Stocks
Expected Return - The percentage yield that an
investor forecasts from a specific investment over a
set period of time. Sometimes called the market
capitalization rate.
 Continue
• The cash payoff to owners of common stocks
comes in two forms:
– (1) cash dividends and;
– (2) capital gains or losses;
• Suppose that the current price of a share is
P0, that the expected price at the end of a year
is P1, and that the expected dividend per share
is DIV1.
 Valuing Common Stocks
Expected Return - The percentage yield that an
investor forecasts from a specific investment over a
set period of time. Sometimes called the market
capitalization rate.

Div1  P1  P0
Expected Return  r 
P0
 Example
• Suppose Fledgling Electronics stock is selling
for $100 a share (P0 = 100).
• Investors expect a $5 cash dividend over the
next year (DIV1 = 5). They also expect the
stock to sell for $110 a year hence (P1 = 110).
– Then the expected return to the stockholders is 15
percent:

5  110  100
E[R]  r   .15or15%
100
 Valuing Common Stocks
The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

 Valuing Common Stocks
The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

Div1 P1  P0
Expected Return  r  
P0 P0
 Continue
• On the other hand, if you are given investors’
forecasts of dividend and price and the
expected return offered by other equally risky
stocks, you can predict today’s price:

Div1  p1
Price  P 0 
(1  r 1)
 Example
• For Fledgling Electronics DIV1 = 5 and P1 = 110.
If r, the expected return on securities in the
same risk class as Fledgling, is 15 percent,
then today’s price should be $100:

5  110
Price  P 0   $100
1 .15
 Continue
• What happen when the price of the stock
calculated > than $100;
– What happened to the rate of return?

• Think of the situation where the price < than

the $100;
– What happened to the rate of return?
 Continue
• In fact we can look as far out into the future as
we like, removing P’s as we go.
• Let us call this final period H. This gives us a
general stock price formula:
 As H approaches infinity
• The present value of the terminal price ought
to approach zero;
• We can, therefore, forget about the terminal
price entirely and express today’s price as the
present value of a perpetual stream of cash
dividends.
• This is usually written as;
 Valuing Common Stocks
Capitalization Rate can be estimated using the
perpetuity formula, given minor algebraic
manipulation.
 Valuing Common Stocks
Capitalization Rate can be estimated using the
perpetuity formula, given minor algebraic
manipulation.

Div1
Capitaliza tion Rate  P0 
rg
Div1
r g
P0
 Case: Pinnacle West Corp.
• In May 2013, its stock was selling for about
$49 per share. Dividend payments for the next
year were expected to be $1.60 a share. Thus
it was a simple matter to calculate the first
half of the DCF formula:

– Div Yield = DIV / P0

– = .033 or 3.3%.
 Continue
• The expected rate of dividend growth
forecasted to be annual growth of 6.6 %;
• The ‘r’ or cost of equity capital becomes;
– r = Div1 / P0 + g
– = .033 + .066
– = .099 or 9.9%
 Continue
• An alternative approach to estimating long-run
growth starts with the payout ratio, the ratio of
dividends to earnings per share (EPS), i.e.
– For Pinnacle, this was forecasted at 43%.
• Or
– Plowback ratio = 1 – payout ratio
– = 1 - DIV / EPS

= 57%
 Valuing Common Stocks
Return Measurements
Also, Pinnacle’s ratio of earnings per share to
book equity per share was about 11 percent.

Return on Equity  ROE

EPS
ROE 
Book Equity Per Share
 Dividend growth rate
• If Pinnacle earns 11 percent of book equity
and reinvests 57 percent of that, then book
equity will increase by;
– .57 x .11 = .063, or 6.3 %.

• Dividend growth rate;

– g = plowback ratio x ROE
– =
– =
 Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equals the
present value of all expected future dividends.
 Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equals the
present value of all expected future dividends.

Div1 Div 2 Div H  PH

P0    ...
(1  r ) (1  r )
1 2
(1  r ) H

H - Time horizon for your investment.

 Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the next three
years, respectively. At the end of three years you
anticipate selling your stock at a market price of
$94.48. What is the price of the stock given a 12%
expected return?
 Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and
$3.50 over the next three years, respectively. At the end of three years
you anticipate selling your stock at a market price of $94.48. What is the
price of the stock given a 12% expected return?

3.00 3.24 .  94.48

350
PV   
(1.12) (1.12)
1 2
(1.12) 3

PV  $75.00
 Valuing Common Stocks
If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.
 Valuing Common Stocks
If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.

Div1 EPS1
Perpetuity  P0  or
r r
Assumes all earnings are
paid to shareholders.
 Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a constant
rate (Gordon Growth Model).
 Valuing Common Stocks
Example- continued
If the same stock is selling for $100 in the stock
market, what might the market be assuming about
the growth in dividends?

$3.00 Answer
$100 
.12  g The market is
assuming the dividend
g .09 will grow at 9% per
year, indefinitely.
 Case: Fly Paper’s Stock
• In March 2001, Fly Paper’s stock sold for
about $73. Security analysts were forecasting
a long-term earnings growth rate of 8.5
percent. The company was paying dividends
of $1.68 per share.

– P0 = $73
– Div1 = $1.68
– g = 8.5%
 Continue
• a. Assume dividends are expected to grow
along with earnings at g = 8.5 percent per
year in perpetuity. What rate of return r were
investors expecting?
– Using the growing perpetuity formula, we have:
– P0 = Div1 / (r -g)
– =
– =
– = 10.80%
 Continue
• b. Fly Paper was expected to earn about 12
percent on book equity and to pay out about
50 percent of earnings as dividends. What do
these forecasts imply for g? For r?

– plowback ratio = 1.0 – payout ratio

– =
– =
 Continue
• g can be calculated as;
– g = 0.5 x 12%
– = 0.06 = 6%
• r can be calculated as;
– P0 = Div1 / (r -g)
– =
– =
– = 8.30%
 Valuing Common Stocks
• If a firm elects to pay a lower dividend, and reinvest
the funds, the stock price may increase because
future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as

dividends
Plowback Ratio - Fraction of earnings retained by the
firm.
 Valuing Common Stocks
Growth can be derived from applying the
return on equity to the percentage of earnings
plowed back into operations.

g = return on equity X plowback ratio

 Valuing Common Stocks
Example
Our company forecasts to pay a $5.00
dividend next year, which represents
100% of its earnings. This will provide
investors with a 12% expected return.
Instead, we decide to plow back 40% of
the earnings at the firm’s current
return on equity of 20%. What is the
value of the stock before and after the
plowback decision?
 Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a 12%
expected return. Instead, we decide to plow back 40% of the earnings at
the firm’s current return on equity of 20%. What is the value of the stock
before and after the plowback decision?

No Growth With Growth

5
P0   $41.67
.12
 Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a 12%
expected return. Instead, we decide to blow back 40% of the earnings at
the firm’s current return on equity of 20%. What is the value of the stock
before and after the plowback decision?

No Growth With Growth

5 g .20.40 .08
P0   $41.67
.12
3
P0   $75.00
.12 .08
 Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, the
stock price would remain at $41.67. With the
plowback, the price rose to $75.00.

The difference between these two numbers (75.00-

41.67=33.33) is called the Present Value of Growth
Opportunities (PVGO).
 Valuing Common Stocks
Present Value of Growth Opportunities (PVGO) -
Net present value of a firm’s future
investments.

Sustainable Growth Rate - Steady rate at which

a firm can grow: plowback ratio X return on
equity.
 Stock Price & EPS
• Growth Stocks – Investors interested in the
future growth of earnings rather than in next
years' dividends.

• Income Stock – Investors interested primarily

for the cash dividends.
 Firm doesn’t grow
• Expected return can be calculated as, if the
dividend is $10 a share and the stock price is
$100, then;

– E(r) = Dividend Yield = earnings-price ratio

– = Div1 / P0 = EPS1 / P0;

– Price =
 Firm Does grow
• Expected return can be calculated in a same
way that equal the earnings-price ratio;
– Earnings reinvested = market capitalization rate
• Suppose the Co. opt an opportunity of $10 a
share next year and assumed the dividend
could increased to $11 a share;
• If the 10% rate assumed to an opportunity
cost of the investment;
 Continue
• NPV value of the per share at year 1 becomes;
– NPV = -10 + 1 / 10
– = 0.
• Share price which assume to increase from
$10 to $11 in coming year will not increase
because of the nil dividend in year 1;
– Market capitalization rate equals the earnings-
price ratio;
– r = EPS1 / P0 = $10 / $100 = .10
 Continue
• In general, we can think of stock price as the
capitalized value of average earnings under a
no-growth policy, plus PVGO, the present
value of growth opportunities:

– P0 = EPS1 + PVGO
r
It will underestimate r if PVGO is positive and
overestimate it if PVGO is negative.
 Summary
• How To Value Common Stock
• Valuing Common Stock
• Capitalization Rates
• Returns Measurements
 FCF and PV
• Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
• FCF is a more accurate measurement of PV
than either Div or EPS.
• The market price does not always reflect the
PV of FCF.
• When valuing a business for purchase, always
use FCF.
 FCF and PV
Valuing a Business
The value of a business is usually computed as the
discounted value of FCF out to a valuation horizon
(H).
• The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H
 FCF and PV
Valuing a Business

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

PV (free cash flows) PV (horizon value)

 FCF and PV
Example
Given the cash flows for Concatenator Manufacturing
Division, calculate the PV of near term cash flows, PV
(horizon value), and the total value of the firm. r=10% and g=
6%
Year
1 2 3 4 5 6 7 8 9 10
Asset Value 10.00 12.00 14.40 17.28 20.74 23.43 26.47 28.05 29.73 31.51
Earnings 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.36 3.57 3.78
Investment 2.00 2.40 2.88 3.46 2.69 3.04 1.59 1.68 1.78 1.89
Free Cash Flow - .80 - .96 - 1.15 - 1.39 - .20 - .23 1.59 1.68 1.79 1.89
.EPS growth (%) 20 20 20 20 20 13 13 6 6 6
 FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate the
PV of near term cash flows, PV (horizon value), and the total value of the
firm. r=10% and g= 6%
.

1  1.59 
PV(horizon value)  6    22.4
1.1  .10  .06 
.80 .96 1.15 1.39 .20 .23
PV(FCF)  -     
1.1 1.1 2
1.1 1.1 1.1 1.1 6
3 4 5

 3.6
 FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate the
PV of near term cash flows, PV (horizon value), and the total value of the
firm. r=10% and g= 6%
.

PV(busines s)  PV(FCF)  PV(horizon value)

 -3.6  22.4
 $18.8