Valuation of Stocks

1
Valuation of Stocks
2
Asset Valuation

• Asset Value as Present Value of the Cash Flows it
  will produce

3
Stocks Features

• Represents (residual) ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors elect management.
• Managements goal Maximize stock price.
• Stocks certificate represent proportional
  ownership.
• Stocks certificate entitle its holders to
  proportional distributions (mainly dividend), if
  there are any.

4
The Discounted Dividend Model

• A discounted dividend model is any model that
  computes the value of a share of a stock as the
  present value of the expected future cash
  dividends
• Using (1) above Let P0 be the present stock
  price, Dt - Cash dividend per share at time
  t r discount rate

5
The Discounted Dividend Model

• Alternative view of the Model.
• Assume a risk less environment
• Every investor takes a position in a stock for
  one period only.
• P1 -the price the next investor will pay for the
  stock in period 1, after dividend in that period
  is paid
• Repeated substitution will result in (2)

6
The Dividend Model

• Case 1 Constant DividendWhen all dividends are
  the sameD0 D1 D2 .
• The dividend stream is treated as a perpetuity

7
Dividend Growth Model

• Case 2 Constant Growth Dividend
• When dividend grow at constant growth rate g from
  D1 and on and gltr (normal growth)
• D2 D1(1g)D3 D2(1g) D1(1g)2
• The dividend stream is treated as a constant
  growth perpetuity

8
Dividend Growth Model

• Case 3 Limited abnormal growth continued by
  Constant Growth Dividend
• Let dividend grow at g1gt r rate for t periods,
  and from t1 grow forever at a constant growth
  rate g2lt r .
• Compute (6.1) Dt1 Dt (1 g2) D0(1
  g1)t (1 g2)

9
Dividend Growth Model

• Which can be substituted with a growing annuity

10
Where is Growth Coming from ?

• ReviewNet Income Retained earning Dividend
• Retained earning are additions to equity,
  therefore, next period the increase in NI ROE
  Retained earning
• Therefore, growth (7) g ROE(Retention
  Ratio)

11
Price and Investment Opportunities

• The price of a stock that pays out 100 of its
  earning
• If the firm decides to retain earning and invest
  in new project, its value will increase by
  exactly the projects NPV.