Unformatted text preview: Stock Valuation Stock Mind Map Mind
s Why?: Common stock (aka common equity) represents ownership in a firm. As such, common stock holders have a residual claim on the earnings and assets of the firm. In this section, we discuss the basic models used to value equity. This is sometimes difficult given the uncertainty associated with equity cash flows. Mind Map Mind
s Learning objective:
– Calculate the value of common and preferred Calculate stock with the basic valuation models, including: including:
» Singleperiod model » Constant growth model » Twostage model Twostage Mind Map Mind
s Key words/concepts:
– – – – – Preferred stock Common stock Dividend discount model Constant growth model (aka Gordon Growth) Twostage model Twostage Stock Valuation Stock
s The intrinsic value of an asset = the The intrinsic present value of the stream of present expected cash flows discounted at an appropriate required rate of return. required
s Does this sound familiar? (Recall Does our discussion of bond valuation) our Preferred Stock Preferred
s A hybrid security: s it’s like common stock  no fixed maturity. maturity technically, it’s part of equity capital. technically, s it’s like debt  preferred dividends are fixed. fixed  missing a preferred dividend does not constitute default, but preferred dividends are usually cumulative. cumulative Preferred Stock
s Usually sold for $25, $50, or $100 per Usually share par value. share s Dividends are often quoted as a Dividends percentage of par. Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. preferred s $4.125 is the fixed, annual dividend $4.125 per share (i.e., $50 x .0825). per Preferred Stock
s Is usually nonvoting, and nonIs nonvoting and non participating.
s Priority: lower than debt, higher lower than common stock. than HOW DO YOU VALUE UNENDING CASH FLOWS? UNENDING
This is an unending (i.e., infinite This maturity) annuity. maturity) s What do you know?
s – – – Payment Discount rate maturity? Preferred Stock Valuation Preferred
Preferred stocks can usually be valued Preferred like a perpetuity: like Vps = D k ps Example:
Xerox preferred pays $4.125 dividend per year. Suppose our required rate of return on Xerox preferred is 9.5% preferred Example:
Xerox preferred that pays $4.125 dividend per year. Suppose our required rate of return on Xerox preferred is 9.5% preferred Vps = 4.125 .095 = $43.42 Common Stock Common
s is a variableincome security. is variableincome  dividends may be increased or dividends decreased at management’s discretion. discretion. s represents equity (or ownership). represents equity s includes voting rights. includes voting s Priority: Lowest (lower than Lowest everybody i.e, debt, preferred). Common Stock Valuation (Single Holding Period)
s You expect XYZ stock to pay a $5.50 dividend You $5.50 at the end of the year. The stock price is expected to be $120 at that time. If you require $120 a 15% rate of return, what would you pay for 15% the stock now? the Common Stock Valuation (Single Holding Period)
s You expect XYZ stock to pay a $5.50 dividend You $5.50 at the end of the year. The stock price is expected to be $120 at that time. If you require $120 a 15% rate of return, what’s the most you would 15% pay for the stock now? pay ? 0 5.50 + 120 1 Common Stock Valuation Common (Single Holding Period) Financial Calculator solution: P/Y =1, I = 15, n=1, FV= 125.50 solve: PV = 109.13 The Financial Pages: The Common Stocks (Old Data)
52 weeks Yld Vol Net 52 Hi Lo Sym Div % PE 100s Hi Lo Close Chg 106 45 IBM .80 .8 18 54970 107 103 1051/8 +2 151 54 MSFT … 54 119822 147 141 1417/16 2 The Financial Pages: The Today’s Quotes
52 weeks Yld Vol 52 Hi Lo Sym Div % PE 100s 130 69 IBM 2.00 2.2 9.9 10316 130 Hi Lo Close 87.6 89.1 87.77 15.9 54 MSFT .52 3.2 8.6 804,735 16.7 32.1 15.9 Thought for the Day: Thought GoalSetting
s s s s Elder Ballard: “I am so thoroughly convinced Elder that if we don’t set goals in our life and learn how to master the technique of living to reach our goals, we can reach a ripe old age and look back on our life only to see that we reached but a small part of our full potential.” small What are the basic principles of goalsetting? Are you’re goals meaningful? Do you have any BHAG’s? Common Stock Valuation Common
(Multiple Holding Periods)
s Constant Growth Model Assumes common stock dividends will Assumes grow at a constant rate into the future. grow s Can we value a perpetuity that grows Can at a constant rate?? at
s Common Stock Valuation Common
(Multiple Holding Periods)
s Constant Growth Model Assumes common stock dividends will Assumes grow at a constant rate into the future. grow s aka Gordon Growth Model or GGM aka
s Vcs0 = D1 k cs  g s
s Constant Growth Model
Assumes common stock dividends will grow at a Assumes constant rate into the future. constant Vcs0 =
s s s D1 k cs  g D1 = the dividend at the end of period 1. kcs = the required return on the common stock. the g = the constant, annual dividend growth rate
– Remember: sustainable growth = g* = ROE x b Example Example
XYZ stock recently paid a $5.00 XYZ $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. 10% What would we be willing to pay if our required return on XYZ stock is 15%? 15%
s Example Example
XYZ stock recently paid a $5.00 XYZ dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%? 15%?
s D0 = $5, so D1 = 5 (1.10) = $5.50 Example Example
XYZ stock recently paid a $5.00 XYZ $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. 10% What would we be willing to pay if our required return on XYZ stock is 15%? 15%?
s Vcs = D1
k cs  g = 5.50
.15  .10 = $110 THE WAY IT’S DONE TWO STAGE GROWTH TWO
Can Google grow at it’s current rate Can forever? forever? s Estimate cash flows for two different Estimate growth stages: growth
s – Stage 1: dividends growing above average (i.e., the “supernormal” period). – Stage 2: dividends grow at the industry average after stage 1. after THE WAY IT’S DONE TWO STAGE GROWTH TWO
Value = Stage 1 + Stage 2 s Stage 1: PV of the supernormal Stage dividends (“estimation period”) dividends
s – calculate and find the PV of each supernormal dividend
s Stage 2: PV of normal dividends Stage
– a growing perpetuity starting after the growing supernormal period supernormal – Formula: PVgp = Div / (rgs) THE WAY IT’S DONE TWO STAGE GROWTH TWO
s Information needed: Information
– – – – – 1)growth rate during supernormal period, 1)growth 2)industry average growth rate, 2)industry 3)length of supernormal period, 3)length 4) required return, 4) 5) recent dividend. TWO STAGE GROWTHTWO MAKEAFRIEND MAKEAFRIEND EXAMPLE EXAMPLE
Due to a recent patent approval, earnings Due and dividends in Alpha Inc. are expected to grow at a rate of 15% for the next 3 rate years. After this period, the firm is years After expected to grow at the industry average rate of 5% forever. The firm recently rate paid a dividend of $1 and the required dividend return is 10%. return s What is the most you should pay for What Alpha? Alpha?
s Value Stage 1 Cash Flows Value
s Find present value of earning for first Find three years (discount rate =10%): three
Year 1 Future value $1.15 Present value $1.05* $1.14 $1.14 Year 2 $1.32 $1.09 Year 3 $1.52 Value of stage 1 dividends = $3.28 Value Stage 2 Cash Flows (1 of 2) (1
s “Capitalize” terminal earnings with the Capitalize” Constant (or Gordon) growth model Constant – GGM denominator (cap rate) = kg = .1.05 GGM = .05 .05 – Year 4 dividend = $1.60 (= 1.52 x 1.053 div 1.05) Yr – Capitalized value = $32 (= $1.60/.05) (= s Where on the time line does this $32 fall? Where Value of excess earnings from time 4 through infinity!! through Value Stage 2 Excess Earnings (2 of 2) (2
s This is a Time 3 value s Therefore, we must calculate the Therefore, present value of stage 2 today present s Present value of stage 2 = $24.04 Present
(calculator: 32 FV, 10 I/Y, 3 N; cpt cpt PV) PV) Calculate the Value of the Stock Calculate
s The value of the stock is simply the The value of Stage 1 cash flows plus Stage 2 cash flows, or: cash value = Stage 1 + Stage 2 = $3.28 + $24.04 =$27.32 $3.28 Two Stage Valuation: Review Two
s A picture is worth… Today 1=1.15 PV of Stage 1 =$3.28 2=1.32 3 = 1.52 Discounted Div Model: A Review Discounted
s A picture is worth…
Today 4 = 1.60 PV of Stage 2 = $24.04 Cap Yr 4 = 32 Time 3 value!! LOS 1.A.m / Book 4, p. 105 Core Material and LOS Equity Valuation DDM: Constant Growth (Gordon)
Strengths: Use for mature, stable, dividend paying firms Supplements other methods Weaknesses: Very sensitive to estimates of g Difficult to use with nondividendpaying stocks Not useful for acquisition valuation because doesn’t take control perspective
36 LOS 1.A.n / Book 4, p. 106 Core Material and LOS Equity Valuation DDM: MultiStage Models Constant growth is not realistic for most firms Twostage assumes a “dropoff” in growth Link to growth duration model in SS 13 (solve for length of stage 1, given other variables)
37 LOS 1.A.n / Book 4, p. 106 Core Material and LOS Equity Valuation DDM: MultiStage Models The Hmodel assumes a gradual change Reflects “regression to the mean” of profit margins and growth rates as industry matures
38 LOS 1.B.k / Book 4, p. 150 Core Material and LOS Equity Valuation TwoStage Example
SuperNormal Growth Normal 0 1 2 3 4 5 6 10.00 10.90 11.88 12.95 14.12 15.39 16.00 PV of normal growth at end of year 5 $160.00 PV of years 15 today $43.79 PV of normal growth today +$83.11 Total value of equity $126.90
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 Winter '11
 JimBrau
 Finance, Stock Valuation, Valuation, Gordon model

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