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Stock Valuation

This document discusses stock valuation methods. It provides the following key points in 3 sentences: The book value of a stock is its net assets minus liabilities and preferred shares, but this does not reflect the stock's market value which should incorporate the present value of expected future cash flows. Basic valuation methods use discounted cash flow models like the dividend discount model to calculate a stock's intrinsic value based on expected future dividends and price changes. The required rate of return, also called the market capitalization rate, represents the opportunity cost to investors and should equal the expected return in an efficient market in equilibrium.

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42 views30 pages

Stock Valuation

This document discusses stock valuation methods. It provides the following key points in 3 sentences: The book value of a stock is its net assets minus liabilities and preferred shares, but this does not reflect the stock's market value which should incorporate the present value of expected future cash flows. Basic valuation methods use discounted cash flow models like the dividend discount model to calculate a stock's intrinsic value based on expected future dividends and price changes. The required rate of return, also called the market capitalization rate, represents the opportunity cost to investors and should equal the expected return in an efficient market in equilibrium.

Uploaded by

sanchi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Stock valuation

Stock Valuation
• Law of one price – two assets with the same risk
and the same expected cash flow should trade at
the same price.
• Book value =
net assets – (liabilities + preferred shares )
value of common shares

Notice this is NOT its MARKET VALUE


• Market Value – should reflect the P. V.
of expected cash flows.

• The Book Value DOES NOT provide a floor price–


instead the floor price should be the liquidation
value. Why?
• Suppose that M.V. < Liquidation Value
You could buy a controlling interest in the firm and
liquidate it ( turn it into cash) and make a profit.

In an efficient market this would be quickly realised


and the firm’s shares would increase in value
erasing the profit possibilities.
• In economics we use Tobin’s q

q = Value of the firms (stock market)


replacement cost of capital
If q > 1 then the value of capital is more that the cost
to acquire capital. Investment will be profitable.
Basic Valuation Methods
• The holding period is always of concern!!
The Holding Period Return is the E(r).

E(r) = E(D1 ) + [ E(P1 ) –P0 ]


P0
• Where do we get the required return ? – many
estimates BUT if markets are in equilibrium it
should come from the CAPM

• In any case the required return represents the


opportunity cost investors require k.
• k -- the market consensus of k is called the
“market capitalization rate “ or the required return.

• If you think the market has mispriced an asset you


are seeking “Alpha”
example
• Risk free == 6%
• E(rm ) – rf == 5%
• Western stock Beta = 1.2

k = 6% + 1.2(5%) = 12%
• If expected dividend D1 = $4
• If Expected price = $52
• If current price =$48

• Then the E(r) = 4 + (52-48) = 16.7%


• 48
• 16.7% > the required return of 12% so the investor
would want to hold Western stock.
N>B> Intrinsic Value
• Vo = E(D1)(dividend) +E(P1)(expected price)
1+K(market capitalization)
Intrinsic value is the PDV of cash flows
Given the above values

= 4 + 52  $50
1.12
• Say today the stock is 48 –then we have positive
alpha!!– Western is undervalued.(for now)

50

48
• Why is this possible – because at any given time
different values of E(D1) or P1 or even k are being
used.

• Now suppose dividends are expected to grow.


• This is the model that is used extensively –the
dividend growth model.
Dividend Discount Model
• DDM with growth.

Vo = D1
k-g where D1 = Do(1+g)
• In equilibrium ( where we evaluate from)
P0 = V0
If dividends do not grow then this is a perpetuity

And P0 = D1
K
• If Dividends are growing then

• Po = D1
• k-g

• You Must use D1 in both cases.


• If we want to solve for expected market return

• K = D1 + g
• Po

•  this means the market will tell us how much the


stock’s price can be attributed to growth
• Now remember in equilibrium the required return
will equal the expected return.

• E(r) = k = D1/P0 + g
Stock prices and Investment
opportunities
• Suppose k= 12.5% ( market capitalization rate)
• Suppose 5$ paid out and 5$ earned.
• Then this is like a perpetuity:
D1/k = 5/.125=$40
Suppose there are investment opportunities with
return of 15%

• Inputs -- plant and equipment = 100 million all


equity financed.
• ROE = 15%
• ROE = .15 * 100 million = 15 million.
• If there are 3 million shares outstanding this
represents $5 per share in earnings.
• Capitalization rate (required return) = 12.5%
• If 60% of the 15 million is reinvested then this
represents $9 million increase in the firm’s capital.
• g = ROE x b(retention ratio) = .15 x .6 = .09
• P= D1/(k-g)  Now if 60% is retained then 40% is
paid out so dividends are now $2.

• P= 2/(.125-.09) = 57.14
example of dividend
decrease
• Now remember in equilibrium the required return
will equal the expected return.

• E(r) = k = D1/P0 + g
Stock prices and Investment
opportunities
• Suppose k= 12.5% ( market capitalization rate)
• Suppose 5$ paid out and 5$ earned.
• Then this is like a perpetuity:
D1/k = 5/.125=$40
• Exercise 1- Suppose the firm has projects that could
return 15%
• b = plowback ratio  60%
• Dividend now is .40 x $5 = $2
• Suppose the firm has $100 million of capital all
equity financed with ROE of 15%.
• Will the share price fall? (Because the dividend was
cut)– done on board as class exercise.
• Exercise 2– (another firm called Target)
• Suppose the management of Target corp. Wants to
invest 60% of earnings in projects with an ROE of
10%.
• Suppose:
K= 15% dividend expected at the end of the year is
$2 on $5 of earnings.
What will happen in this case – analyze the situation
– done in class.

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