Stocks and their valuation

1

• Stocks and their valuation
• (chapter 12)

2
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 its intrinsic value are
  undervalued
• Buy or Sell?
• Stocks with a price above its intrinsic value are
  overvalued
• Buy or Sell?

3
Dividend growth model

• Value of a stock is the present value of the
  future dividends expected to be generated by the
  stock.
• r s is the required rate of return (think the
  one from CAPM)

4
Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• If g is constant, the dividend growth formula
  converges to

5
What happens if g gt rs?

• If g gt rs, the constant growth formula leads to a
  negative stock price, which does not make sense.
• The constant growth model can only be used if
• rs gt g
• g is expected to be constant forever

6
If rRF 7, rM 12, and ß 1.2, what is the
required rate of return on the firms stock?

• Use the SML to calculate the required rate of
  return (rs)
• rs rRF (rM rRF)ß
• 7 (12 - 7)1.2
• 13

7
If D0 2 and g is a constant 6, What is the
stocks market value?

• Using the constant growth model

8
What is the expected dividend yield, capital
gains yield, and total return during the first
year?

• Dividend yield
• D1 / P0 2.12 / 30.29 7.0
• Capital gains yield
• (P1 P0) / P0
• (32.10 - 30.29) / 30.29 6.0
• Total return (rs)
• Dividend Yield Capital Gains Yield
• 7.0 6.0 13.0

9
Supernormal growthWhat if g 30 for 3 years
before achieving long-run growth of 6?

• Can no longer use just the constant growth model
  to find stock value.
• However, the growth does become constant after 3
  years.

10
Valuing common stock with nonconstant growth
2.6/(10.13) 2.301
2.647
3.045

P
66.54/(10.13)3 46.114

54.107 P0
11
Calculations D1 D0(1g1) 2x(10.3) 2.6 D2
D1(1g1) 2.6x(10.3) 3.38 D3 D2(1g1)
3.38x(10.3) 4.394 D4 D3(1g2)
4.394x(10.06) 4.658 Present Value of D1
2.6/(10.13) 2.301 Present Value of D2
3.38/(10.13)2 2.647 Present Value of D3
4.394/(10.13)3 3.045
12
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.
• FCF NOPAT Net capital investment
• 1. Find the market value (MV) of the firm.
• Find PV of firms future FCFs
• 2. Subtract MV of firms debt and preferred stock
  to get MV of common stock.
• MV of MV of MV of debt andcommon
  stock firm preferred
• 3. Divide MV of common stock by the number of
  shares outstanding to get intrinsic stock price
  (value).
• P0 MV of common stock / of shares

13
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.

14
Given the long-run gFCF 6, and WACC of 10,
use the corporate value model to find the firms
intrinsic value.
15
Calculations Present Value of CF1 -5/(10.1)
-4.545 Present Value of CF2 10/(10.1)2
8.264 Present Value of CF3 20/(10.1)3
15.026 CF 4 CF3(1g)20(10.06)
21.2 Present Value of Terminal Value in 3 years
(at time 3) 530/(10.1)3 388.197
16
If the firm has 40 million in debt and has 10
million shares of stock, what is the firms
intrinsic value per share?

• MV of equity MV of firm MV of debt
• 416.94m - 40m
• 376.94 million
• Value per share MV of equity / of shares
• 376.94m / 10m
• 37.69