Chapter 6 Common Stock Valuation PDF

Chapter 6 Common Stock Valuation 6-1 Copyright © 2021 McGraw-Hill Education. All rights reserved  The Stock Market “If a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.” –Warren Buffett “Pred...

Chapter 6 Common Stock Valuation 6-1 Copyright © 2021 McGraw-Hill Education. All rights reserved  The Stock Market “If a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.” –Warren Buffett “Prediction is difficult, especially about the future.” –Niels Bohr (among others) 6-2  Learning Objectives Separate yourself from the commoners by having a good understanding of these security valuation methods: 1. The basic dividend discount model. 2. The two-stage dividend growth model. 3. The residual income model and free cash flow model. 4. Price ratio analysis. 6-3  Common Stock Valuation Our goal in this chapter is to examine the methods commonly used by financial analysts to assess the economic value of common stocks. These methods are grouped into four categories: 1. Dividend discount models 2. Residual Income model 3. Free Cash Flow model 4. Price ratio models 6-4  Security Analysis: Be Careful Out There  Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock.  The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell.  In practice however, such stocks may in fact be correctly priced for reasons not immediately apparent to the analyst. 6-5  The Dividend Discount Model  The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by discounting all expected future dividend payments. The basic DDM equation is: D1 D2 D3 DT P0     1  k  1  k  1  k  2 3 1  k T  In the DDM equation:  P0 = the present value of all future dividends  Dt = the dividend to be paid t years from now  k = the appropriate risk-adjusted discount rate 6-6  Example: The Dividend Discount Model  Suppose that a stock will pay three annual dividends of $100 per year; the appropriate risk- adjusted discount rate, k, is 15%.  In this case, what is the value of the stock today? D1 D2 D3 P0   2  1  k  1  k  1  k 3 $100 $100 $100 P0    3 $228.32 1.15 1.15 1.15 2 6-7  The Dividend Discount Model: The Constant Growth Rate Model  Assume that the dividends will grow at a constant growth rate g. The dividend in the next period, (t + 1), is: D t 1 D t 1 g So, D 2 D1 (1  g) D0 (1  g) (1  g)  For constant dividend growth for “T” years, the DDM formula is: = if k ≠ g 6-8 if k = g  Example: The Constant Growth Rate Model  Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly dividends, and the appropriate discount rate is 8%.  What is the value of the stock, based on the constant growth rate model? T D 0 (1  g)   1  g   P0  1     k  g   1  k   $10 1.10   20  1.10   P0  1     $243.86.08 .10   1.08   6-9  The Dividend Discount Model: The Constant Perpetual Growth Model  Assuming that the dividends will grow forever at a constant growth rate g.  For constant perpetual dividend growth, the DDM formula becomes: D 0 1  g D1 P0   (Important : g  k) k g k g 6-10  Example: Constant Perpetual Growth Model  Think about the electric utility industry.  In 2019, the dividend paid by the utility company, DTE Energy (DTE), was $3.78.  Using D0 =$3.78, k = 5%, and g = 2%, calculate an estimated value for DTE. = $128.52 Note: the actual early-2019 stock price of DTE was $109.17. What are the possible explanations for the difference? 6-11  The Dividend Discount Model: Estimating the Growth Rate The growth rate in dividends (g) can be estimated in a number of ways:  Using the company’s historical average growth rate.  Using an industry median or average growth rate.  Using the sustainable growth rate. 6-12 The Historical Average Growth Rate  Suppose the Broadway Joe Company paid the following dividends:  2019: $2.20 2016: $1.75  2018: $2.00 2015: $1.70  2017: $1.80 2014: $1.50  The spreadsheet below shows how to estimate historical average growth Year: Dividend: Pct. Chg: rates, using arithmetic and geometric averages. 2019 2018 $2.20 $2.00 10.00% 11.11% 2017 $1.80 2.86% Grownat 2016 $1.75 2.94% Year: 7.96% 2015 $1.70 13.33% 2014 $1.50 2014 $1.50 2015 $1.62 2016 $1.75 ArithmeticAverage: 8.05% 2017 $1.89 2018 $2.04 GeometricAverage: 7.96% 2019 $2.20 6-13  The Sustainable Growth Rate Sustainable Growth Rate ROE Retention Ratio ROE (1 - Payout Ratio)  Return on Equity (ROE) = Net Income / Equity  Payout Ratio = Proportion of earnings paid out as dividends  Retention Ratio = Proportion of earnings retained for investment (i.e., NOT paid out as dividends) 6-14  Example: Calculating and Using the Sustainable Growth Rate, I.  In 2019, American Electric Power (AEP) had an ROE of 10.5%, had earnings per share of $3.97, and had a dividend level of $2.68. What was AEP’s:  Retention rate?  Sustainable growth rate?  Payout ratio = $2.68/ $3.97 =.675 or 67.5%  So, retention ratio = 1 −.675 =.325 or 32.5%  Therefore, AEP’s sustainable growth rate =.105 .325 =.0341, or about 3.41% 6-15  Example: Calculating and Using the Sustainable Growth Rate, II.  What is the value of AEP stock using the perpetual growth model and a discount rate of 5.00%? = $174.30 The actual early-2019 stock price of AEP was $73.05.  In this case, using the sustainable growth rate to value the stock gives an extremely poor estimate.  What can we say about the values of g and k in this example? 6-16  Analyzing ROE  To estimate a sustainable growth rate, you need the (relatively stable) dividend payout ratio and ROE.  Changes in sustainable growth rate likely stem from changes in ROE.  The DuPont formula separates ROE into three parts: profit margin, asset turnover, and equity multiplier NetIncome NetIncome Sales Assets ROE   Equity Sales Assets Equity  Managers can increase the sustainable growth rate by:  Decreasing the dividend payout ratio  Increasing profitability (Net Income / Sales)  Increasing asset efficiency (Sales / Assets)  Increasing debt (Assets / Equity) 6-17  The Two-Stage Dividend Growth Model  The two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T years, and thereafter, it will grow at a rate g2 < k during a perpetual second stage of growth.  The Two-Stage DividendT GrowthT Model D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 ) formulaP0 is:  1       k  g1   1  k    1 k  k  g2 6-18  Using the Two-Stage Dividend Growth Model, I.  Although the formula looks complicated, think of it as two parts:  Part 1 is the present value of the first T dividends (it is the same formula we used for the constant growth model).  Part 2 is the present value of all subsequent dividends.  So, suppose Tower Inc., has a current dividend of D0 = $5, which is expected to shrink at the rate, g1 = −10%, for 5 years then grow at the rate, g2 = 4%, forever.  With a discount rate of k = 10%, what is the present value of the stock? 6-19  Using the Two-Stage Dividend Growth Model, II. T D 0 (1  g1 )   1  g1    1  g1  T D 0 (1  g 2 ) P0  1       k  g1   1  k    1  k  k  g2 5 $5.00(0.90)   0.90    0.90  5 $5.00(1.04) P0  1       0.10  ( 0.10)   1.10    1. 10  0.10  0.04 $14.25  $31.78 $46.03. The total value of $46.03 is the sum of a $14.25 present value of the first five dividends, plus a $31.78 present value of all subsequent dividends. 6-20  Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth, I.  Chain Reaction, Inc., has been growing at a phenomenal rate of 30% per year.  You believe that this rate will last for only three more years.  Then, you think the rate will drop to 10% per year.  Total dividends just paid were $5 million.  The required rate of return is 20%.  What is the total value of Chain Reaction, Inc.? 6-21  Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth, II.  First, calculate the total dividends over the “supernormal” growth period: Year Total Dividend: (in $millions) 1 $5.00 × 1.30 = $6.50 2 $6.50 × 1.30 = $8.45 3 $8.45 × 1.30 = $10.985  Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as: P3 = [D3 × (1 + g)] / (k − g) P3 = [$10.985 × 1.10] / (0.20 − 0.10) = $120.835 6-22  Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth, III.  To determine the present value of the firm today, we need the present value of $120.835 and the present value of the dividends paid in the first 3 years: D1 D2 D3 P3 P0     1  k  1  k 2 1  k 3 1  k 3 $6.50 $8.45 $10.985 $120.835 P0     1  0.20  1  0.20 2 1  0.20 3 1  0.20 3 $5.42  $5.87  $6.36  $69.93 $87.58 million. If there are 20 million shares outstanding, the price per share is $4.38. 6-23  The H-Model, I.  For Chain Reaction, Inc., we assumed a supernormal growth rate of 30 percent per year for three years, and then growth at a perpetual 10 percent.  The growth rate is more likely to start at a high level and then fall over time until reaching its perpetual level.  There are many possible ways to assume how the growth rate declines.  A popular way is the H-model, which assumes a linear growth rate decline. 6-24  The H-Model, II.  Let’s revisit Chain Reaction, Inc.  Suppose the growth rate begins at 30% and reaches 10% in year 4 and beyond.  Using the H-model, we would assume that the company’s growth rate would decline by 20% from the end of year 1 to the beginning of year 4.  If we assume a linear decline:  the growth rate falls by 6.67% per year (20%/3 years).  growth estimates would be 30%, 23.33%, 16.66%, and 10%.  Using these growth estimates, you should find that the firm value is $75.93 million, or $3.80 per share.  The value is lower than before because of the lower growth rates in years 2 and 3. 6-25  Discount Rates for Dividend Discount Models  The discount rate for a stock can be estimated using the capital asset pricing model (CAPM ).  We will discuss the CAPM in a later chapter.  We can estimate the discount rate for a stock with this formula: Discount rate = time value of money + risk premium = U.S. T-bill Rate + (Stock Beta × Stock Market Risk Premium) T-bill Rate: return on 90-day U.S. T-bills Stock Beta: risk relative to an average stock Stock Market Risk Premium: risk premium for an average stock 6-26  Observations on Dividend Discount Models, I. Constant Perpetual Growth Model:  Simple to compute  Not usable for firms that do not pay dividends  Not usable when g > k  Is sensitive to the choice of g and k  k and g may be difficult to estimate accurately.  Constant perpetual growth is often an unrealistic assumption. 6-27  Observations on Dividend Discount Models, II. Two-Stage Dividend Growth Model:  More realistic in that it accounts for two stages of growth  Not usable when g > k in the first stage  Not usable for firms that do not pay dividends  Is sensitive to the choice of g and k  k and g may be difficult to estimate accurately. 6-28  Residual Income Model (RIM), I.  We have valued only companies that pay dividends.  But, there are many companies that do not pay dividends.  What about them?  It turns out that there is an elegant way to value these companies, too.  The model is called the Residual Income Model (RIM).  We call its Major Assumption the Clean Surplus Relationship (CSR): The change in book value per share is equal to earnings per share minus dividends. 6-29  Residual Income Model (RIM), II.  Stockholders have a required rate of return over time, k  Their Required Earnings Per Share is the Book Equity at the beginning of the period times the required rate of return.  The difference between actual earnings and required earnings is called Residual Income, which is also known as Economic Value Added, EVA. 6-30  Residual Income Model (RIM), III.  Inputs needed:  Earnings per share at time 0, EPS0  Book value per share at time 0, B0  Earnings growth rate, g  Discount rate, k  There are two equivalent formulas for the Residual Income Model: EPS 0 (1  g)  B 0 k P0 B 0  k g BTW, it turns out that or the RIM is EPS 1  B 0 g mathematically the P0  k g same as the constant perpetual growth model. 6-31  Using the Residual Income Model  Quackenbush, Inc. (DUCK). DUCK pays no dividends.  It is July 1, 2019—shares are selling in the market for $10.94.  Using the RIM, and these inputs:  EPS 0 (1  g)  B 0 k EPS0 = $1.20 P0 B 0  k g  DIV = 0  B0 = $5.886 $1.20 (1 .09)  $5.886 .13 P0 $5.886  .13 .09 g = 0.09  k =.13 $1.308  $.7652 P0 $5.886  $19.46..04  What can we say about the market price of DUCK? 6-32  The Growth of DUCK Using the information from the previous slide, what growth rate results in a DUCK price of $10.94? EPS 0 (1  g)  B 0 k P0 B 0  k g $1.20 (1  g)  $5.886 .13 $10.94 $5.886 .13  g $5.054 (.13  g) 1.20  1.20g .7652 $.6570  5.054g 1.20g .4348.2222 6.254g g .0355 or 3.55%. 6-33  Free Cash Flow, I.  We can value companies that do not pay dividends using the residual income model.  Note: We assume positive earnings when we use the residual income model.  But there are companies that do not pay dividends and have negative earnings.  Do negative earnings imply zero value?  We calculate earnings based on accounting rules and tax codes.  It is possible that a company has:  negative earnings,  positive cash flows,  and therefore, a positive value. 6-34  Free Cash Flow, II.  Depreciation is key to understanding how a company can have negative earnings and positive cash flows.  Depreciation reduces earnings because it is counted as an expense (more expenses = lower taxes paid).  Most stock analysts use a simple formula to calculate Free Cash Flow, FCF: FCF = EBIT(1 − Tax Rate) + Depreciation − Capital Spending − Change in Net Working Capital  Looking at the FCF formula, you can see how Earnings, i.e., EBIT < 0 but FCF > 0  It is also possible, i.e., via a big capital expenditure, for EBIT > 0 and FCF < 0 6-35  Free Cash Flow, III.  Two companies have the same constant revenue and expenses for the next three years. Also, assume no debt (no interest expense), no taxes, no CAPEX, and no change in Working Capital. So, without depreciation, each year:  Assume depreciation chosen by each company is: 6-36  Free Cash Flow, IV.  Let’s compare Cash Flow = Net Income + Depreciation (with our assumptions):  Net income differences have nothing to do with the profitability of the companies.  Cash flows are the same; depreciation differs. 6-37  DDMs Versus FCF  The DDMs calculate a value of the equity only.  DDMs use dividends, a cash flow only to equity holders.  DDMs use the CAPM to estimate required return.  DDMs use an equity beta to account for risk.  Using the FCF model, we calculate a value for the firm.  Free cash flow can be paid to debt holders and to stockholders.  We can still calculate the value of equity using FCF:  Calculate the value of the entire firm.  Subtract out the value of debt.  We need a beta for assets, not the equity, to account for risk. 6-38  Asset Betas  Asset betas measure the risk of the company’s industry.  Firms in an industry should have about the same asset betas.  Their equity betas can be quite different.  Investors can increase portfolio risk by borrowing money.  A business can increase risk by using debt.  So, to value the company, we must “convert” reported equity betas into asset betas by adjusting for leverage.  Analysts widely use the following conversion formula: Debt BEquityBAsset[1 (1 t )] Equity tax rate. What happens when a firm has no debt? 6-39  The FCF Approach, Example  Inputs  An estimate of FCF:  Net Income  Depreciation  Capital Expenditures  The growth rate of FCF  The proper discount rate  Tax rate  Debt/Equity ratio  Equity beta  Calculate value using a modified “DDM” formula  “DDM” because we are using FCF, not dividends. 6-40  Valuing Landon Air: A New Airline  An estimate of FCF: By Using CAPM with Asset  EBIT: $45 million Beta. Assume:  Interest Expense: 6.45 million No dividends  Depreciation: $10 million Risk-free rate = 4%  No change in Net Working Capital Market risk premium =  Capital Expenditures: $3 million 7%  Growth rate of FCF: 3% The proper discount rate:  Tax rate: 21%  Debt/Equity ratio:.40 k = 4.00 + (7 × 0.912) = Put FCF into the Basic DDM formula:  Equity Beta: 1.2 10.38% Landon Air Value = = $593.62  Asset Beta: If Landon Air has $100 million in debt, the 1.2 = BAsset × [1+.4 × (1 −.21)] total equity value is $493.62 million 1.2 = BAsset × 1.32 Value per share = $4,936,200 / number of BAsset =.912 shares 6-41  Price Ratio Analysis, I.  Price-earnings ratio (P/E ratio): Current stock price per share divided by annual earnings per share (EPS)  Earnings yield: Inverse of the P/E ratio, i.e., earnings per share (EPS) divided by price per share (E/P)  High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as value stocks. 6-42  Price Ratio Analysis, II.  Price-cash flow ratio (P/CF ratio)  Current stock price divided by current cash flow per share  In this context, cash flow is usually taken to be net income plus depreciation.  Most analysts agree that in examining a company’s financial performance, cash flow can be more informative than net income.  Earnings and cash flows that are far from each other may be a signal of poor quality earnings. 6-43  Price Ratio Analysis, III.  Price-sales ratio (P/S ratio)  Current stock price divided by annual sales per share  A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales growth.  Price-book ratio (P/B ratio)  Market value of a company’s common stock divided by its book (accounting) value of equity  A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders. 6-44  Price/Earnings Analysis, Intel Corp. Intel Corp (INTC) − Earnings (P/E) Analysis 5-year average P/E ratio 15.9 Current EPS $3.22 EPS growth rate.9% Expected stock price = historical P/E ratio  projected EPS $51.66 = 15.9  ($3.22  1.009) Early-2019 INTC stock price = $47.30 6-45  Price/Cash Flow Analysis, Intel Corp. Intel Corp (INTC) − Cash Flow (P/CF) Analysis 5-year average P/CF ratio 8.8 Current CFPS $3.06 CFPS growth rate 2.2% Expected stock price = historical P/CF ratio  projected CFPS $27.52 = 8.8  ($3.06  1.022) Early-2019 stock price = $47.30 6-46  Price/Sales Analysis, Intel Corp. Intel Corp (INTC) − Sales (P/S) Analysis 5-year average P/S ratio 3.1 Current SPS $14.70 SPS growth rate 3.1% Expected stock price = historical P/S ratio  projected SPS $46.98 = 3.1  ($14.7  1.031) Early-2019 stock price = $47.30 6-47  Enterprise Value Ratios, Overview  The PE ratio is an equity ratio: numerator is price per share of stock and denominator is earnings per share of stock.  Practitioners often use ratios involving both debt and equity.  Perhaps the most common one is the enterprise value (EV) to EBITDA ratio.  Enterprise value is equal to the market value of the firm’s equity plus the market value of the firm’s debt minus cash.  EBITDA stands for earnings before interest, taxes, 6-48  Enterprise Value Ratios, Example  Kourtney’s Kayaks has equity worth $800 million, debt worth $300 million, and cash of $100 million.  The enterprise value is $1 billion (= 800 + 300 − 100).  Suppose Kourtney’s Kayaks’ income statement is: Any income statement item below EBITDA is not included in the EV to EBITDA ratio.  The EV to EBITDA ratio is 5 (= $1 billion / $200 million). 6-49  Using Enterprise Value Ratio to Estimate Stock Price  Analysts often assume that similar firms have similar EV/EBITDA ratios (and similar PE ratio, too).  Suppose the average EV/EBITDA ratio in an industry is 6.  Qwerty Corporation, a firm in the industry, has EBITDA of $50 million.  If Qwerty Corporation is judged to be similar to the rest of the industry, its enterprise value is estimated at $300 million (= 6 × $50 million).  If Qwerty Corporation has $75 million of debt and $25 million of cash, the EV estimate provides an estimate of it stockConsult value, $250 million (= the textbook: $300 There − four are $75 + $25). important questions concerning enterprise value ratios. 6-50  An Analysis of the CVS Health Corporation The next few slides contain a financial analysis of CVS Health Corporation, using data from the Value Line Investment Survey. 6-51  Using the Dividend Discount Model to Value CVS  Here’s a summary quote from Yahoo! Finance:  Our first task is to estimate a discount rate for CVS. We see that CVS’s beta is 1.03.  Using a Treasury bill rate of 3.0 percent and a stock market risk premium of 7 percent, we obtain a CAPM discount rate estimate for CVS of 3.0% +1.03 × 7% = 10.21%. 6-52  Next Task: Calculate a Sustainable Growth Rate  From the Summary Quote, we see CVS’s most recent earnings per share (annualized) are $3.04, and the annualized dividends per share is $2.00—implying a retention ratio of: 1 − $2.00/$3.04 = 0.342.  We need an ROE. We found financial highlights at finance.yahoo.com. The ROE is 8.71 percent, which yields a sustainable growth rate of: 0.342 × 8.71% = 2.98%. 6-53  Dividend Discount Model: CVS  Based on the CAPM, k = 3.0% +1.03 × 7% = 10.21%.  Retention ratio = 1 − $2.00/$3.04 = 0.342.  Sustainable g = 0.342 × 8.71% = 2.98%.  Using the constant dividend growth rate model, we get: = $28.49  The current stock price, from the Current Quote, is $66.82. We better try something else. 6-54  CVS, Estimated Stock Price and Method Valuation Method Price DDM, with calculated sustainable $28.49 growth rate DDM, with analyst forecasted growth $54.37 rate DDM, two-stage model $32.83 RIM, with calculated sustainable $28.49 growth rate RIM, with analyst forecasted growth $24.74 rate FCF, with historical growth rate $82.34 Price-Earnings Model $63.43 Price-Cash You should beFlow Model able to verify all our$48.91 numbers. (BeingModel Price-Sales a stock analyst is work!) $118.43 6-55  Final Thoughts: CVS  Notice the wide range of share values we obtained by the various models.  This result is common in security analysis—it shows how hard a task security analysts face.  We don’t care which model yields a value closest to the current price.  Our goal is to find a model about which we are confident.  Some models provide estimates that are higher than the current du Pont price.  Some models provide estimates that are lower than the current du Pont price.  Lesson One: There is much subjectivity in the valuation process, even though we have objective financial data.  This fact is why analysts using the same financial information provide different values.  In its premium section, Morningstar provides a fair value estimate for CVS of $96, but it provides a range of possible values of $67.20 to $129.60.  Lesson Two: Even experts have a hard time determining an exact value! 6-56  Chapter Review, I.  Security Analysis: Be Careful Out There  The Dividend Discount Model  Constant Dividend Growth Rate Model  Constant Perpetual Growth  Applications of the Constant Perpetual Growth Model  The Sustainable Growth Rate  The Two-Stage Dividend Growth Model  Discount Rates for Dividend Discount Models  Observations on Dividend Discount Models 6-57  Chapter Review, II.  Residual Income Model (RIM)  Free Cash Flow Model  Price Ratio Analysis  Price-Earnings Ratios  Price-Cash Flow Ratios  Price-Sales Ratios  Price-Book Ratios  Applications of Price Ratio Analysis  An Analysis of CVS Health Corporation 6-58