Stock valuation

Samuel Mongrut, Ph.D.

 Learning objectives
 How can we apply the Gordon growth model for
stock Valuation?
 What is the P/E ratio and why is useful?
 How can we use the growing opportunities model?
 How to use the free cash flow model?
 How can we use the residual income model?
 How can we read the stock information given in
stock market?
 Content
 Definition of stock
 Stock’s sources of returns
 Type of stocks and payout policies
 Stock Splits
 Stock Valuation with the dividend Discount model
 The growing opportunities model
 The free cash flow model
 The residual income model
 Reading the market information
Equity Securities
 Represent ownership claims on a Company’s net
assets (residual claim)

Liabilities
Assets

Equity
Equity securities
 Main sources of total return: (i) Dividends, (ii) Capital gain/loss.
 Return is uncertain (Company has no obligation to pay dividends).
 When the Company is in operation, share issuance is a source of
funding that allows the company to acquire assets that may increase
shareholder’s wealth.
 Share issuance can also be used to incentivize employees as
compensation.
 Shares have a book value, a market value and a fundamental value

Type of equity securities
 Common shares: Predominant type.
 Dividends

 Voting rights

 Claim on Company’s net assets in case of liquidation

 Preferred stock: Rank above common shares (dividends

and liquidation). Can be convertible. Generally:
 No voting rights

 Fixed dividends (Cumulative, participating, etc)

Payout policy

 Different forms of cash distributions to

shareholders
 Dividends

 Share repurchases

 Stock dividends
Dividends vs. Share repurchases
 Investors regard dividends as a signalling device: healthier
firms can afford to pay higher dividends.
 The firm’s dividend payout ratio will determine its
investors … its tax clientele.
 Share repurchases are a tax efficient form of distributing
surplus cash-flow to shareholders.
 Stock splits
 Increasing the number of the
outstanding shares by
reducing its nominal value.
Its main objective is to
increase the stock liquidity.
Example: 2:1 split
 A rationale for a stock split:
makes stocks cheaper for
small investors! Does this
happens in reality?
Fuenzalida D., S. Mongrut y M. Nash (2008) Stock Splits en la Bolsa de Valores de Lima:
¿afectan los rendimientos y la liquidez de los títulos? Estudios Gerenciales, Vol. 24, No
109, 11-36
 Stock valuation
 Dividend Discount Model (DDM) – Myron
Gordon
 Valuation of Different Types of Stocks
 Zero Growth
 Constant Growth
 Differential Growth
 Case 1: Zero Growth
Assume that dividends will remain at the
same level forever

Div1  Div2  Div3  

Since future cash flows are constant, the
value of a zero growth stock is the present
value of a perpetuity:
Div1 Div 2 Div 3
P0    
(1  r ) (1  r ) (1  r )
1 2 3

Div
P0 
r
 Case 2: Constant Growth
Assume that dividends will grow at a
constant rate, g, forever. i.e.
Div1  Div0 (1  g )
   
Div2 Div1 (1 g ) Div0 (1 g )
2

   
Div3 Div2 (1 g ) Div0 (1 g )
3
.
..
Since future cash flows
grow at a constant rate Div1
forever, the value of a P0 
constant growth stock is the r g
present value of a growing
perpetuity:
 Case 3: Differential Growth
 Assume that dividends will grow at different rates in
the foreseeable future and then will grow at a
constant rate thereafter.
 To value a Differential Growth Stock, we need to:
 Estimate future dividends in the foreseeable
future.
 Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
 Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
Case 3: Differential Growth
Assume that dividends will grow at
rate g1 for N years and grow at rate
g2 thereafter
Div1  Div0 (1  g1 )

   
Div2 Div1 (1 g1 ) Div0 (1 g1 )
2

   
DivN DivN 1 (1 g1 ) Div0 (1 g1 )
N

DivN 1  DivN (1  g2 )  Div0 (1  g1 )N (1  g2 )

 Case 3: Differential Growth
We can value this as the sum of:
an N-year annuity growing at rate g1

Div 1  (1  g1)
N

PA  1
 N 
r  g1  (1  r ) 

plus the discounted

value of a perpetuity  DivN 1 
 
growing at rate g2  r  g2 
that starts in year PB 
N+1 
(1 r ) N
 Case 3: Differential Growth

A growing annuity and a perpetuity!

A Differential Growth Example

 A common stock just paid a dividend of

$2. The dividend is expected to grow at
8% for 3 years, then it will grow at 4% in
perpetuity.

 What is the stock worth? The discount

rate is 12%.
 With the Formula
 DivN 1 
 
Div1  (1 g1 )   r  g2
 N

P 1   
  N
r g1  (1 r )  (1 r )  N

 $2(1.08)3 (1.04) 

 

$2 (1.08)  (1.08)3
  
.12 .04 
P  1
  3 


.12 .08  (1.12)  (1.12) 3

$32.75 
P  $54 1 .8966 3
(1.12)
P  $5.58  $23.31 P  $28.89
 Estimates of Parameters in the
Dividend-Discount Model
 The value of a firm depends upon its
growth rate, g, and its discount rate, r.

 Where does r come from?

 Where does g come from?

 Implicit expected equity return

 It must meet that g < r. Why? What are the limits in g?

 What is the appropriate discount rate (r)?
 The rate of return required by investors (their cost of opportunity) or,

equivalently, the cost of capital of the company.

 The implicit expected equity return can be obtained (given P and
0
assumptions about g and D1)
 Exxon Mobile
 Example: At the end of August 2012, Exxon's
stock was priced at $ 87.20. The company paid
dividends of $ 2.28 for the prior year, and let's
say that investors expect a growth rate of
5.3%. What is the implicit expected equity
return of Exxon?
 Where does the growth come
from?
 How do we determine the growth rate g?
 Consider the first year net income NI1, the reinvestment rate of b, and the
dividend payout of d=1-b. That is, b of every dollar earned is reinvested
(retention ratio) and d is paid as dividend (dividend payout)
 Assume a constant and perpetual ROE on your b * NI1 reinvestments
 The second year net income will be equal to

 The growth rate of net income (NI) between years is equal to:
Deriving the (fundamental) ratio
of P/E
 If:
EPSt = NI/ # Stocks outstanding = Earnings per share
b = reinvestment rate
1-b = dividend payment rate
ROE = return on equity
 Where:
Dt = EPSt * (1-b)
g = ROE * b
 Deriving the P/E ratio
 Let’s consider the DDM:

 If we substitute the equivalence of the

dividend of next year:
 Fundamental P/E ratio
 Finally let’s divide both sides by EPS1:

 What can we learn from this simple relation?

 Higher cost of equity capital (r), that is, higher risk →

lower P/E ratio

 Higher ROE → higher growth → higher P/E ratio

 Intuitively: What happens if the dividend payment ratio (1-

b) increases?
 Example: Exxon again
 In August 2012
 The Exxon share costed $ 87.20. The P/E ratio was 9.16
 Profit of $8.09 was expected the following year, assuming ROE constant 29.02%,
reinvestment rate of 17% and given that we have an expected return on equity of 8%
 The Exxon’s P/E will be:

 Firms whose shares are “in fashion” sell at high multiples. Growth stocks for example.
 Firms whose shares are out of favor sell at low multiples. Value stocks for example.
 DDM limitations
 The practical utility of DDM is limited by the difficulty of
predicting the dividend growth in the long run (and also,
to some extent, the estimation of r)
 For example, when is startup X going to start paying

dividends?
 Widely defined variables
 Profits, free cash flow, ...but constant ROE!!

 However, Gordon's model is usually used in practice to

estimate the terminal value after explicit predictions for
the dividends of short and medium term (5-10 years).
 Growth Opportunities
 Growth opportunities are opportunities to
invest in positive NPV projects.
 The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100-percent of its earnings as dividends and
the net present value of the growth
opportunities.
EPS
P  NPVGO
r
The Dividend Growth Model and
the NPVGO Model
 We have two ways to value a stock:

 The dividend discount model.

 The price of a share of stock can be calculated as

the sum of its price as a cash cow plus the per-
share value of its growth opportunities.
 The Dividend Growth Model
and the NPVGO Model
 Consider a firm that has EPS of $5 at the end of the
first year, a dividend-payout ratio of 30%, a required
return on equity of 16%, and a return on retained
earnings (ROE) of 20%.
 The dividend at year one will be $5 × .30 = $1.50 per
share.
 The retention ratio (b) is .70 ( = 1 -.30) implying a
growth rate in dividends of 14% (.70 × 20%)
 From the dividend growth model, the price of a share
is:
Div1 $1.50
P0    $75
r  g .16 .14
 The NPVGO Model
First, we must calculate the
value of the firm as a cash
Div1 $5
cow.
P0    $ 31. 25
r . 16
Second, we must calculate the value
of the growth opportunities.

 3.50 .20 
3.50  .16  $.875
P0    $43.75
r g .16 .14
Finally, P0  31.25  43.75  $75
 The Free Cash Flow Model (FCF)
(VL=D+E)
Cash flow identity: FCF = CTC + FCO

D CTC
A (Debt)
FCF
(Assets) E
(Equity) FCO

FCF: Free Cash Flows

CTC: Cash Flow to Creditors
FCO: Free Cash Flow to Firm’s Owners
Detailed Balance Sheet for a levered firm

C/LOp
C/L
C/A C/LFin L
A LTD

NFA C/S
R/E E

C/A: Current Assets C/Lop: Current Operating Liabilities

NFA: Net Fixed C/Lfin: Current Financial Liabilities
Assets LTD: Long Term Debt
C/S: Social Capital
R/E: Retained Earnings
Free Cash Flow Model (FCF)

EBIT: Earnings before interest and taxes

t: Income tax rate
Dep: Depreciation
dNOWC: Change in net operacting working capital
CAPEX: Capital expenditures
dC/A: Change in current assets
dC/Lop: Change in current operating liabilities
dNFA: Change in net fixed assets
The Weighted Average Cost of
Capital (WACC)

D: Market value of debt

E: Market value of equiy
rd: Cost of debt
r: Cost of equity
VL: Levered value of the company
The Free Cash Flow Model (FCF)
 The Free Cash Flow Model (FCF) consists in calculating
the levered value of the company (VL), then subtract the
market value of debt (D) to obtain the market value of
equity (E). Finally we divide the market value of equity
(E) by the number of stocks outstanding (N) to calculate
the fundamental price of the stock (Po):
The Free Cash Flow Model (FCF)
 Cagiati Enterprises has FCF of USD 700 million, its
before-tax cost of debt is 5.7%, and its required rate of
return for equity is 11.8%
 The company expects a target capital structure consisting
of 20% debt financing and 80% equity financing. The tax
rate is 33.33% percent, and FCF is expected to grow
forever at 5%.
 Cagiati Enterprises has debt outstanding with a market
value 2.2 billion and has 200 million outstanding
common shares. What is the company value per share
using the FCF approach?
The Free Cash Flow Model (FCF)
 We first calculate the company’s WACC, then its levered
value and finally the fundamental current stock price:
The Residual Income Model (RIM)
 Residual income (RI) reflects net income (NI) minus a
deduction for the required return on common equity or
equity charge (EC) where the EC is in turn the company
Equity (E) times its cost of equity (r). While a firm may
show positive earnings, the company would not generate
true economic profit in the event that its net income is
less than its capital charge.
The Residual Income Model (RIM)
 The fundamental stock price (Po) is equal to the book
value per stock (BVo) plus the present value of the
residual income divided by the number of stocks
outstanding (N). This in turns could be expressed in
perpetual terms assuming a constant residual income (RI)
The Residual Income Model (RIM)
 Axis Manufacturing Company, Inc. (AXCI), has total
assets of USD 2 million financed 50 percent with debt
and 50 percent with equity capital. The cost of debt is 7%
before taxes, the cost of equity is 12% and the income tax
rate is 30%.
 AXCI just had a net income of USD 91,000 and its book
value of equity is USD 1 million with 100,000 shares
outstanding. Earnings will continue at the current level
indefinitely and all net income is distributed as dividends.
 Given the previous information, what would be the
current fundamental price per stock of AXCI?
The Residual Income Model (RIM)
 We use the previous formula with perpetuity value for the Residual Income (RI) per stock:

 Note that whenever the RI is negative the company destroys value (-29,000 dollars) and the stock price should fall.
 Stock Market Reporting
52 WEEKS YLD VOL N ET
HI LO STOCKSYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap pays a
dividend of 9 Gap ended trading
Gap has
cents/share at $19.25, down
been as
$1.75 from
high as Given the
yesterday’s close
$52.75 in current price,
the last the dividend
year. yield is ½ %
Gap has Given the
current price, the 6,517,200 shares
been as low traded hands in the
as $19.06 in PE ratio is 15
times earnings last day’s trading
the last year.