STOCK-VALUATION-PPT.pdf

Stocks and Their Valuation ◼ Features of common stock ◼ Determining common stock values ◼ Preferred stock 9-1 Facts about common stock ◼ Represents ownership ◼ Ownership implies control ◼ Stockholders elect directors ◼ Directors elect management...

Stocks and Their Valuation ◼ Features of common stock ◼ Determining common stock values ◼ Preferred stock 9-1 Facts about common stock ◼ Represents ownership ◼ Ownership implies control ◼ Stockholders elect directors ◼ Directors elect management ◼ Management’s goal: Maximize the stock price 9-2  Intrinsic Value and Stock Price ◼ Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s intrinsic value (P0). ◼ In equilibrium we assume that a stock’s price equals its intrinsic value. ◼ Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or sell. ◼ Stocks with a price below (above) its intrinsic value are undervalued (overvalued). 9-3 Determinants of Intrinsic Value and Stock Prices (Figure 1-1) 9-4 Determinants of Intrinsic Value and Stock Prices (Figure 1-1) 9-5 Investors’ goal: ◼ Purchased undervalued stocks/ avoid overvalued stocks Manager’s goal: ◼ Review how alternative actions will affect stock prices; consider price vs intrinsic values before issuing new shares 9-6 Different approaches for estimating the intrinsic value of a common stock ◼ Discounted dividend model ◼ Discounted cash flow model ◼ Corporate valuation model ◼ P/E multiple approach ◼ EVA approach 9-7 Dividend Discount Model ◼ The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of two elements: ◼ 1. the dividends the investor receives each year while he/she holds the stock ◼ 2. the price received when the stock is sold 9-8 Dividend Discount Model 1. Valuing Constant Growth Stocks 2. Valuing Common Stocks with Non-Constant Growth 9-9  Dividend growth model ◼ Value of a stock is the present value of the future dividends expected to be generated by the stock. ^ D1 D2 D3 D P0 = + + +... + (1 + rs )1 (1 + rs ) 2 (1 + rs ) 3 (1 + rs )  9-10 Constant growth stock ◼ A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t ◼ If g is constant, the dividend growth formula converges to: ^ D 0 (1 + g) D1 P0 = = rs - g rs - g 9-11 Constant Growth Stocks 9-12  Constant Growth Stocks Example 1: ◼ Firm A is expected to pay a dividend of $1.00 at the end of the year. The required rate of return is rs = 11%. Other things held constant, what would the stock’s price be if the growth rate was 5%? What if g was 0%? 9-13  Constant Growth Stocks Example 2: ◼ Firm B has 12% ROE. Other things held constant, what would its expected growth rate be if it paid out 25% of its earnings as dividend? 75%? 9-14  Constant Growth Stocks Example 3: ◼ If firm B had a 75% payout ratio but then lowered it to 25%, causing its growth rate to rise from 3% to 9%, would that action necessarily increase the price of its stocks? Why or why not? 9-15  Constant Growth Stocks Conditions 1. The required rate of return, rs , must be greater than the long run growth rate, g. If the equation is used in situations where g is greater than rs , the result will be wrong, meaningless and misleading. 2. Model is not appropriate unless a company’s growth rate is expected to remain constant in the future. This condition almost never holds for new start-up firms, but it does exist for many mature companies. 3. Most firms, even rapidly growing start-ups and others that pay no dividends at present, can be expected to pay dividends at some point in the future. 9-16  Non- Constant Growth Stocks Conditions Supernormal (Nonconstant) Growth -the part of the firm’s life cycle in which it grows faster than the economy as a whole. Horizon Terminal (Date)- the date when the growth rate becomes constant. At this date, it is no longer necessary to forecast the individual dividends. Horizon (Continuing) Value- the value at the horizon date of all dividends expected thereafter. 9-17 Non- Constant Growth Stocks Conditions 9-18  Non- Constant Growth Stocks Examples Suppose Firm M’s stockholders’ required rate of return is 9% and the years of non-constant growth is 3. What is the value of Firm M’s stocks if rate of growth for both earnings and dividends during non-constant growth period is 10%, while growth rate becomes 4% after the horizon date. Assume last dividend paid by the company is $1. 9-19 Non- Constant Growth Stocks Examples 9-20 Discounted Cash Flow Model ◼ This method is suitable for companies that do not make regular dividend payments to its shareholders. The method uses the discounted future cash flow of the company to calculate its market value. The method is applicable for companies that pay a dividend or do not pay a dividend to their shareholders. ◼ It evaluates investment by discounting the estimated future cash flows. ◼ A project or investment is profitable if it is DCF is higher than the initial cost ◼ Future cash flows, the terminal value, and the discount rate should be reasonably estimated conduct DCF analysis. 9-21 Discounted Cash Flow Model ◼ The DCF is often compared with the initial investment. If the DCF is greater than the present cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash. 9-22 Discounted Cash Flow Model ◼ DCF- discounted cash flow ◼ Cfi = cash flow period i ◼ r = interest rate ◼ n = time in years before the future cash flow occurs NET PRESENT VALUE= Total DCF- Initial investments 9-23 Problem: A company requires a $150,000 initial investment for a project that is expected to generate cash inflows for the next five years. It will generate $10,000 in the first two years, $15,000 in the third year, $25,000 in the fourth year, and $20,000 with a terminal value of $100,000 in the fifth year. Assuming the cost of capital is 5%, and no further investment is required during the term, compute for the DCF and net present value. Is this project financially viable or not? 9-24 Corporate valuation model 9-25 Corporate valuation model ◼ The firm finances with debt, preferred stock, and common equity. The WACC is the weighted average of these three types of capital. ◼ Free cash flow is the cash generated before any payments are made to any investors, so it must be used to compensate common stockholders, preferred stockholders, and bondholders. Moreover, each type of investor has a required rate of return, and the weighted average of those returns is the WACC, which is used to discount the free cash flow. 9-26  Applying the corporate value model ◼ Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs. ◼ Subtract MV of firm’s debt and preferred stock to get MV of common stock. ◼ Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value). 9-27 Issues regarding the corporate value model ◼ Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast. ◼ Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. ◼ Terminal value (TVN) represents value of firm at the point that growth becomes constant. 9-28  Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value. 0 r = 10% 1 2 3 4... g = 6% -5 10 20 21.20 -4.545 8.264 15.026 21.20 398.197 530 = = TV3 0.10 - 0.06 416.942 9-29 If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share? ◼ MV of equity = MV of firm – MV of debt = $416.94 - $40 = $376.94 million ◼ Value per share = MV of equity / # of shares = $376.94 / 10 = $37.69 9-30 Firm multiples method ◼ Analysts often use the following multiples to value stocks. ◼ P/E ◼ P / CF ◼ P / Sales ◼ EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. 9-31 What is market equilibrium? ◼ In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. ◼ In equilibrium, two conditions hold: ◼ The current market stock price equals its ^ intrinsic value (P0 = P0). ◼ Expected returns must equal required returns. ^ D1 rs = +g = rs = rRF + (rM − rRF )b P0 9-32 Market equilibrium ◼ Expected returns are determined by estimating dividends and expected capital gains. ◼ Required returns are determined by estimating risk and applying the CAPM. 9-33 How is market equilibrium established? ◼ If price is below intrinsic value … ◼ The current price (P0) is “too low” and offers a bargain. ◼ Buy orders will be greater than sell orders. ◼ P0 will be bid up until expected return equals required return. 9-34 How are the equilibrium values determined? ◼ Are the equilibrium intrinsic value and expected return estimated by managers or are they determined by something else? ◼ Equilibrium levels are based on the market’s estimate of intrinsic value and the market’s required rate of return, which are both dependent upon the attitudes of the marginal investor. 9-35 Preferred stock ◼ Hybrid security. ◼ Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. ◼ However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy. 9-36 If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? Vp = D / rp $50 = $5 / rp ^r = $5 / $50 p = 0.10 = 10% 9-37 Problem MR food has no preferred stocks outstanding, but discussions about such an issue suggested that its preferred stocks should pay a dividend of $10 per year. If its required return was 10.3%, what is the preferred stocks value? 9-38