Unformatted text preview: Asset Valuation: Equity
Readings: Text Ch. 10 (p. 355-368), 16 (p.614-629), 17 (p.669-673) Valuing Equity: Complications
Difficulties in valuing equity/common stock: 1. Residual claimant on firm value. 2. Each firm is unique. 3. Usually only one class of common per firm. Assumptions for the moment We can estimate expected cashflows. We have a methodology for estimating a risk-adjusted discount rate. Dividend Discount Model
Starting Point: Investors in common stock anticipate a dividend (D1) and capital appreciation (P1-P0). Today's price (P0) will be set in equilibrium such that these anticipated cash flows generate a "fair" rate of return (ks). ^ ^ D1 + P1 - P0 ^ ks = = ks P0
^ ^ D1 + P1 P0 = (1 + k s ) Dividend Discount Model (II)
What will determine the price P1 that the next investor will be willing to pay for the stock?
P0 D1, P1 D2, P2 D3, P3 ^ ^ D1 + P1 ^ P0 = (1 + k s ) ^ ^ D 2 + P2 ^ P1 = (1 + k s ) ^ ^ D 3 + P3 ^ P2 = (1 + k s ) ^ ^ ^ ^ ^ = D1 + D 2 + D 3 + P3 P0 (1 + k s ) (1 + k s ) 2 (1 + k s ) 3 (1 + k s ) 3 ^ Dt ^ P0 = t t = (1 + k s ) 1 A Practical Simplification for DDM
Assume that dividends actually grow at a constant rate g: ^ ^ Dt D1 (1 + k ) t = k - g t =1 s s Applying the DDM
Exxon-Mobil: 8/16/2007 @ 3 pm, $80 per share
Open High Low 80.85 81.93 79.02 Shares Out Market Cap 52 wk high 52 wk low Avg Volume 5.55 B 443.98 B 93.62 63.87 27.84 M P/E EPS Div Yield Ex Date 11.47 6.98 0.35 1.75 8/9/07 Assume that the growth rate (g) of Exxon's common dividend is 8% and that rE is 11%. What would be the appropriate price for Exxon common? D1 P0 = kS - g 1.40 * (1.08) P0 = = 50.40 .11 - .08 Extending the DDM When growth is varying, you can still apply the DDM as long as growth is eventually constant. Example: assume Exxon's dividend will grow at 20% for years 1,2,3 then settle down to 8%.
P0 = 1.68 2.02 2.42 + + + PV[ Remaining Dividends] 2 3 (1.11) (1.11) (1.11) 2.61 PV3 [ Remaining Dividends] = ( .11 - .08) 1.68 2.02 2.42 P0 = + + 2 (1.11) (1.11) (1.11) 3 2.61 1 + ( .11 - .08) * (1.11) 3 = 68.54 Extending the DDM (II)
Example: Assume that ABC Corp recently paid a $1 dividend and that dividends are expected to grow at 10% for the next five years after which time growth will slow to 5%. If 15% is shareholders' required rate of return, what should they be willing to pay for ABC? ^ = 1 (1.10 ) + 1 (1.10 ) + 1 (1.10 ) + 1 (1.10 ) + 1 (1.10 ) P0 (1.15) (1.15) 2 (1.15) 3 (1.15) 4 (1.15) 5
2 3 4 5 1 (1.10) 5 (1.05) 1 + (1.15) 5 ( .15 - .05) ^ P0 = .96 + .91 + .88 + .84 + .80 + 8.41 = 12.80 Estimating Dividend Growth
1. 2. Use historical growth in earnings/dividend. Use accounting data: Assume firm reinvests a fixed percentage of earnings every year: r (retention or plowback ratio). The firm maintains its current level of operating profitability. Return on Equity (ROE) stays constant. g = r * ROE. Growth Rate Example Example for Exxon Mobil: EPS = 6.98 Div = 1.40 retention ratio = (6.98-1.40)/6.98 = 0.80 ROE = 34.8% (EPS/BVPS) g = 0.8 * 34.8% = 27.8% Is All Growth Good Growth?
If you have good projects where ROE > ks, then increasing the plowback ratio to increase investment (and cutting current dividends) is value-increasing. If you have poor projects where ROE < ks, then decreasing the plowback ratio to reduce investment (and increasing current dividends) is value-increasing. Facts About Dividends
1. Dividends and Stock Repurchases are very similar.
Assets Cash $2m PP & E $10m Total $12m Liabilities Debt $2m Equity $10m Total $12m Case 1: $1m dividend
Assets Cash $1m PP & E $10m Total $11m Liabilities Debt $2m Equity $9m Total $11m Case 2: $1m repurchase
Assets Cash $1m PP & E $10m Total $11m Liabilities Debt $2m Equity $9m Total $11m Price per share: $18 Transaction: Price per share =$20 (.5 x)*price = 9 # shares = 450,000 x * price = 1 Facts About Dividends (II)
1. Propensity to pay dividends has declined significantly over time but aggregate real dividends have actually increased.
1978 % of Payers Aggregate Div. Ratio 67% 36.9% 2000 19.3% 39.3% 1. Repurchases have become much more important
1978 Aggregate Rep. Ratio 4.0% 1998 48.4% 1. Cash M&A accounts for significant payouts.
1978 Cash Mergers Dividends Repurchases $8.1Bn $40.1Bn $4.3Bn 1998 $410.6Bn $174.1Bn $175.5Bn Facts About Dividends (III)
1. Recent dividend-friendly tax law changes have increased propensity to pay dividends and slightly reduced repurchases.
REDMOND, Wash., Jan. 16, 2003 -- Microsoft Corp. today announced that its Board of Directors declared an annual dividend and approved a two-for-one split on Microsoft common stock. The annual dividend of $0.16 per share presplit ($0.08 post-split) is payable March 7, 2003, to shareholders of record at the close of business on Feb. 21, 2003. As a result of the stock split, shareholders will receive one additional common share for every share held on the record date of Jan. 27, 2003. Facts about Dividends (IV)
1. When firm announce a dividend or a dividend increase, there is usually an immediate jump in the stock price. Conversely, a dividend cut results in a stock price drop. 9/26/2003: Investors, many of whom had thought that Kodak's $1.80 annual dividend was sacrosanct, reacted with fury, sending Kodak shares down $4.84, or 18 percent, to $22.15. Although there had been widespread speculation that a lower dividend was in the offing, the size of the cut -- to 50 cents -- came as a shock. What do CFOs Say? Survey of ~350 CFOs in 2003:
Policy Statement % who agree or strongly agree 1. We try to avoid reducing dividends per share 93.8% 2. We try to maintain a smooth dividend from year to year 89.6% 3. We are reluctant to make dividend changes that might 77.9% might have to be reversed in the future 4. We pay dividends to attract institutional investors 41.7% (subject to prudent man investment restrictions) Using Multiples Instead of DDM
Analysts often make "back of the envelope" estimates of a stock's value by taking an accounting item and multiplying by the average ratio of price relative to that item for the industry. Potential Multiples: Price/Earnings (P/E) Market/Book Price/Sales Price/Installed Base Price/Earnings Multiples
Industry Average P/E multiple MicroComputers 25.3 Canned Foods 20.7 Oil 11.8
Trailing Earnings Hewlett Packard 2.30 Campbell 2.08 Exxon-Mobil 6.98 Firm Actual "Multiple" Price Price 44.76 35.37 80.00 Benefits of Multiples Analysis Quick. Does not require estimates of g or ke . Easier to do for a non-dividend paying firm. Easy to sell. DDM, ratio/multiple analysis and industry knowledge are all used in the art of equity valuation. Summary
A stock's price should equal the present value of expected future cash flows: ^ D1 ^ P = 0 k s -g Holding period is irrelevant. Model can be adjusted to incorporate more info. Results are sensitive to estimates. Ratio analysis is a useful back-up ...
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