Stocks and Their Valuation

1
Chapter 9

• Stocks and Their Valuation

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Topics Covered

• Common and Preferred Stock Properties
• Valuing Preferred Stocks
• Valuing Common Stocks - the Dividend Growth Model
• No growth
• Constant growth
• Non-constant or supernormal growth
• Valuing the Entire Corporation Free Cash Flow
  Approach
• Stock Market Equilibrium

3
Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Managements goal Maximize the stock price

4
Preferred Stock Characteristics

• Unlike common stock, no ownership interest
• Second to debt holders on claim on companys
  assets in the event of bankruptcy.
• Annual dividend yield as a percentage of par
  value
• Preferred dividends must be paid before common
  dividends
• If cumulative preferred, all missed past
  dividends must be paid before common dividends
  can be paid.

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Intrinsic Value and Stock Price

• Outside investors, corporate insiders, and
  analysts use a variety of approaches to estimate
  a stocks intrinsic value (P0).
• In equilibrium we assume that a stocks 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).

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Preferred Stock Valuation

• Promises to pay the same dividend year after year
  forever, never matures.
• A perpetuity.
• VP DP/rP
• Expected Return rP DP/P0
• Example GM preferred stock has a 25 par value
  with a 8 dividend yield. What price would you
  pay if your required return is 7?

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What do investors in common stock want?

• Periodic cash flows dividends, and
• To sell the stock in the future at a higher price
• Management to maximize their wealth

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Stock Valuation Dividend Growth Model

• Stock Value PV of Future Expected Dividends

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Stock Valuation Dividend Patterns

• For Valuation we will assume stocks fall into
  one of the following dividend growth patterns.
• Constant growth rate in dividends
• Zero growth rate in dividends, like preferred
  stock
• Variable (non-constant) growth rate in dividends

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Stock Valuation Case Study Doh! Doughnuts

• We have found the following information for Doh!
  Doughnuts
• current dividend 2.00 Div0
• The current T-bill rate is 5 and investors
  demand an 9 market risk premium.
• Doh!s beta 1.2.

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Analysts Estimates for Doh! Doughnuts

• NEDFlanders predicts a constant annual growth
  rate in dividends and earnings of zero percent
  (0)
• Barton Kruston Simpson predicts a constant annual
  growth rate in dividends and earnings of 10
  percent (9).
• Homer Co. expects a dramatic growth phase of 30
  annually for each of the next 3 years followed by
  a constant 10 growth rate in year 4 and beyond.

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Our Task Valuation Estimates

• What should be each analysts estimated value of
  Doh! Doughnuts?

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Valuing Common Stocks No Growth

• If we forecast no growth, and plan to hold out
  stock indefinitely, we will then value the stock
  as a PERPETUITY.

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Ned Flanders Valuation

• D0 2.00, rS 15.8 or 0.158, g 0

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Constant Growth Valuation Model

• Assumes dividends will grow at a constant rate
  (g) that is less than the required return (rS )
• If dividends grow at a constant rate forever, you
  can value stock as a growing perpetuity, denoting
  next years dividend as D1

Commonly called the Gordon growth model
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Barton Kruston Simpsons Valuation

• D0 2.00, g 9, rS 15.8

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Expected Return of Constant Growth Stocks

• Expected Rate of Return Expected Dividend Yield
  Expected Capital Gains Yield
• D1/P0 Expected Dividend Yield
• g Expected Capital Gains Yield
• r (D1/P0) g (D0(1g)/P0) g

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Example

• Burns Internationals stock sells for 80 and
  their expected dividend is 4. The market expects
  a return of 15.
• What constant growth rate is the market expecting
  for Burns International?

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Variable Growth Stock Valuation

• Framework Assume Stock has period of
  non-constant growth in dividends and earnings and
  then eventually settles into a normal constant
  growth pattern (gc).
• 0 g1 1 g2 2 g3 3 gc 4
  gc 5 gc ...

D1 D2 D3
Non-constant Growth Period Constant
Growth
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Todays agenda

• Supernormal (non-constant) dividend growth
  valuation
• Corporate value approach to stock valuation
• Stock Market Equilibrium

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Homer Co. Valuation

• Variable (non-constant) growth
• Years 1-3 expect 30 growth
• After year 3 constant growth of 10

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Variable Growth Valuation Process

• 3 Step Process
• Estimate Dividends during non-constant growth
  period.
• Estimate Price, which is the PV of the constant
  growth dividends, at the end of non-constant
  growth period which is also the beginning of the
  constant growth period. This is called the
  horizon or terminal value.
• Find the PV of non-constant dividends and horizon
  value. The total of these PVs Todays
  estimated stock value.

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Back to Homer Cos Valuation Step 1

• D0 2.00, g 30 or 0.3 for next 3 years

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Homer Cos Valuation Step 2

• Find Horizon Value which is the constant growth
  stock value at the end of year 3.

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Homer Cos Valuation Step 3
83.334 87.728

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Corporate value model

• Also called the free cash flow method. Suggests
  the value of the entire firm equals the present
  value of the firms free cash flows.
• Remember, free cash flow is the firms after-tax
  operating income less the net capital investment
• FCF NOPAT Net capital investment

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Applying the corporate value model

• Find the market value (MV) of the firm, by
  finding the PV of the firms future FCFs at the
  companys weighted average cost of capital, WACC.
• Subtract MV of firms 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).

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Issues regarding the corporate value model

• Often preferred to the dividend growth model,
  especially when considering number of firms that
  dont 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.

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An Example Advanced Micro Devices (AMD)
Assume that AMD will experience 21 year 1, 19
year 2 and 18 FCF growth in year 3 and 11
constant annual growth thereafter.
AMDs WACC is approximately 17.
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An Example AMD Projected FCFs(millions)
Use non-constant growth to estimate AMDs
corporate value.
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AMDs FCF Corporate Valuation (millions)

TV

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AMDs Stock Value per share

• MV of firm 6513 million
• MV of debt 692 million
• MV of equity (stock) 6513 - 692 5821
  million
• 486 million shares outstanding
• P0 MV of equity/shares 5821/486 11.98
• Recent price 13.50

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Stock 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.

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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.

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Doh! In equilibrium?

• Doh! Doughnuts current stock price is 30.
• Required return 5 9(1.2) 15.8
• Lets assume the 2nd analyst is correct and Doh!
  Has a constant growth rate of 9 and its current
  dividend is 2.
• Is Doh! Doughnuts current stock price in
  equilibrium?

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Expected Return of Constant Growth Stocks

• Expected Rate of Return Expected Dividend Yield
  Expected Capital Gains Yield
• D1/P0 D0(1g)/P0 Expected Dividend Yield
• g Expected Capital Gains Yield
• From our example, D12(1.09) 2.18, P030, g
  9 or 0.09

DOH! Doh! Doughnuts
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The Effect On the Stock Price

• Expected Return needs to fall to the required
  return of 15.8. This means the stock price must
  rise to the equilibrium price that yields the
  required return of 15.8
• New Price D1/(rs- g)2.18/(.158 - .09) 32.06

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Stock Valuation Summary

• Looked at Dividend Discount Model Value PV of
  future expected dividends. All else equal
• Higher interest rates (rs) yields lower stock
  prices (inverse relationship)
• Higher growth rate yields higher stock price.
• Other Stock Valuation Methods
• Multiples Method P/E, P/CF, P/S
• For example Price Estimate PE Ratio x expected
  EPS