Stock Valuation

Session-10 & 11
 Key Points
To understand who are stockholders and what is a share
01

02 To understand the distinction between common and preferred stockholders

03 To understand the rights and responsibilities of stockholders

04 To differentiate stock’s price and its intrinsic value

05 Stocks and the Stock Market

06 Book Values, Liquidation Values and Market Values

 Key Points
07 Understand the investor required return

08 Understand how stock prices depend on future dividends and dividend

growth

Be able to compute stock prices using the dividend growth model

09

10 Understand
. the Two stage model growth and Three stage model valuation

11 To understand the return from shares

12 To understand different stock valuation model to estimate stock price

 Shareholder’s Equity

Assets = Liabilities + Shareholder’s Equity

Stock is a share in the ownership of a company. Stock represents a claim

on the company's assets and earnings
Difference between Preferred and Common Stock
Characteristic Common Stock Preferred Stock
Ownership Yes Yes
Voting Rights Yes Generally does not
Company Liquidation Paid back investment Paid back investment
Rights after debtors and after debtors but
preferred Stockholders before common
stockholders
Return on Capital Not Guaranteed. Guranteed by fixed
Paid after preferred ratePaid before any
dividends distribution to Common
Stockholders.
 Intrinsic Value and Stock Price
 A process through which we determine the intrinsic value of per
share.
 The stock price is simply the current market price, and it is easily
observed for publicly traded companies.
 By contrast, intrinsic value, which represents the “true” value of the
company’s stock, cannot be directly observed and must instead be
estimated.
Determinants of Intrinsic Value and Stock Prices
 Why Do Investors and Companies Care
About Intrinsic Value?
• When investing in common stocks, one’s goal is to purchase stocks
that are undervalued and avoid stocks that are overvalued.
• Managers should consider carefully the decision to issue new
shares if they believe their stock is undervalued.
• Two basic models are used to estimate intrinsic values:
the discounted dividend model and the corporate valuation
model
 Stocks & Stock Market
Primary Market - Place where the sale of new stock first
occurs.
Initial Public Offering (IPO) - First offering of stock to the
general public.
Seasoned Issue - Sale of new shares by a firm that has
already been through an IPO
 Stocks & Stock Market
Common Stock - Ownership shares in a publicly held
corporation.
Secondary Market - market in which already issued
securities are traded by investors.
Dividend - Periodic cash distribution from the firm to
the shareholders.
P/E Ratio - Price per share divided by earnings per
share.
 Stocks & Stock Market
Book Value - Net worth of the firm according to the
balance sheet.
Liquidation Value - Net proceeds that would be
realized by selling the firm’s assets and paying
off its creditors.
Market Value Balance Sheet - Financial statement
that uses market value of assets and liabilities.
 Return from Shares
The value of a share of common stock depends
on the cash flows it is expected to provide,
and those flows consist of two elements:
(1) the dividends the investor receives each
year
(2) the price received when the stock is sold
 Cash Flows for Stockholders
 If you buy a share of stock, you can receive cash in two ways
 The company pays dividends
 You sell your shares, either to another investor in the market or back
to the company
 As with bonds, the price of the stock is the present value of
these expected cash flows
 The Time Line
End of Start of
second year third year
Today

t=0 t =1 t=2 t=3 t=4

Po D1 D2 D3 D4 + P4
 Important symbols
Do = Current dividend/ Just paid dividend

D1 = Dividend at year 1

D2 = Dividend at year 2

D3 = Dividend at year 3

And so on…

Po = Current price/ Intrinsic value/ fundamental value

P1 = Price at year 1 (end)

P2 = Price at year 2 (end)

And so on …
 Return from shares OR
Investor Required Return
Investor required return based on two components,
1) Dividend yield, 2) Capital gain/ growth
Expected return = The percentage yield that an investor
forecasts from a specific investment
Expected return or Required Return of Investor = r = Dividend yield+ Capital gain yield
 Investor Required Return
Q1: Waterworks has a dividend yield of 8 percent. If its dividend is expected to grow at a
constant rate of 5 percent, what must be the expected rate of return on the company’s stock?
Data

Dividend Yield = 8% DY CG
Capital Growth = 5%

Required Return of Investor 8% + 5%

Required Return of
Investor
13%
 Example-Return from Shares
• XYZ Corporation current stock price is 25 and if you
hold it for 1 year, you will receive a dividend of $2. You
can sell the stock at the end of year for $27.
 Example-Return from Shares
Current price of stock is $20 and expected price after one year
is 22.5. If investor required return is 18%. What percentage of
dividend should company pay?

Data
Po = $20
P1 = $22.5
Ri = 18%
DY = ?
Stock Price Valuation Concept

Zero Growth Constant Super Normal Growth Model

Model Growth Model

When companies at its Companies are growing at Companies having multi growth
peek and no further a constant growth rate, stage
growth intact going denoted with g
forward.
 Zero Growth Model
Q1: You own a stock that will start paying $0.50 annually at the end of the year. It has zero growth in
future. If the required rate of return is 14%, what should you pay per share?

Data

D1 = $0.50
P0 = ?
Ri = 14%
Q2: You own a stock that will start paying $3 annually at the end of the year. It has zero
growth in future. If the current price of share $50, then what will be the implied required
return of investor?

Data

D1 = $3
P0 = 50
Ri = ?
Q3: You bought a stock today at $40 per share while implied required return of
investor 12%, then what dividend you will receive from this stock?

Data

D1 = ?
P0 = $40
Ri = 12%
 Constant Growth Model
Below given formula we use to calculate the intrinsic value per share in
constant growth model

For Intrinsic Value

D 0 (1  g) D1
P0  
R -g R -g
For Required Return of
investor

D 0 (1  g) D
R g  1 g
P0 P0
Q1: Suppose Big D, Inc., just paid a dividend of $0.50 per share. It is expected to increase its
dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much
should the stock be selling for?

Data D 0 (1  g) D1
P0  
D0 =$0.5 R -g R -g
R = 15%
g = 2%
Po = ?
0.5(1  2%)
P0 
15% - 2%

P0 3.92
Q2: EXON company just paid a dividend of $2 while analyst project constant growth rate around 5% and stock
currently trading at $21, what is the implied required return investor will get from this investment?

Data D 0 (1  g) D1
R g  g
D0 =$2 P0 P0
R=?
g = 5%
2(1  5%)
Po = $21 R  5%
21

R 15%
Q3: XYZ company expected to pay year end dividend $3, stock currently trades at $40, Investor required
return from this investment is 15%, while this stock is being considered as a growth stock. What is the
implied growth rate?

D 0 (1  g) D1
Data
R g  g
D1 =$3 P0 P0
R = 15%
g=?
3
Po = $40
15%   g
40

g 7.5%
Q4: XYZ company expected to pay year end dividend $3, stock currently trades at $40,
Investor required return from this investment is 15%, while this stock is being considered as a
growth stock. What is the implied growth rate?

D 0 (1  g) D1
Data
R g  g
D1 =$3 P0 P0
R = 15%
g=5
3
Po = ?
Po 
15% - 5%

Po $30
 Dividend Discount Model
 Value of a stock is the present value of the
future dividends expected to be generated by
the stock
 This model is also known as Dividend Discount
Model (DDM)
^ D1 D2 D3 D
P0  1
 2
 3
 ... 
(1  rs ) (1  rs ) (1  rs ) (1  rs )
When an investor plans to invest in
a stock for ‘N’ years then
 Dividend Discount Model-Example
Current forecasts are for XYZ Company to pay dividends of
$3, $3.24 and $ 3.50 over the next three years,
respectively. At the end of the three years you anticpate
selling your stock at a market price of 94.48. What is the
price of the stock given a 12% expected return?
Solution
 Corporate value model
 Also called the free cash flow method.
 Free cash flow is the cash generated before any payments are
made to any investors; so it must be used to compensate
common stockholders, preferred stockholders, and
bondholders
 Suggests the value of the entire firm equals the present value
of the firm’s free cash flows.
 Horizon Value
• FCFs are generally forecasted for 5 to 10 years, after which
it is assumed that the forecasted FCF will grow at some
long-run constant rate
• We can use the following formula to calculate the market
value of the company as of that date
Applying the corporate value model
 Find the market value (MV) of the firm, by finding the PV
of the firm’s future FCFs.
 Subtract MV of firm’s 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).
Given the long-run g= 6% after year 3, and r of 10%, use
the corporate value model to find the firm’s intrinsic value

0 1 2 3 4
...
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = = TV3
0.10 - 0.06
416.942
Example Continued
If the firm has $40 million in debt and has 10 million shares
of stock, what is the firm’s intrinsic value per share?

MV of equity= MV of firm – MV of debt

= $416.94 - $40
= $376.94 million
Value per share= MV of equity / # of shares
= $376.94 / 10
= $37.69
 Super Normal Growth Model
Below given formula we use to calculate the intrinsic value per share by using “Super Normal Growth
Model”

Present Values Dividend payments and price at the of

horizon period

To find out the growth

g = ROE x (1 – DPS)

ROE = Return on equity, (1 - DPS) = Retention ratio, DPS = Dividend per share
Q1: XYZ company paid last year $2 as dividend, further investors expected dividend
growth 20% for next two years and then 10% next 3 years and 5% forever thereafter.
Calculate future dividend payments?

t=0 t =1 t=2 t=3 t=4 t=5 t=6

Do D1 D2 D3 D4 D5 D6

Do 2
2 2.4 2.88 3.17 3.48 3.83 4.02
D1 2(1  20%) 2.4
D2 2.4(1  20%) 2.88
D3 2.88(1  10%) 3.17
D4 3.17(1  10%) 3.48
D5 3.48(1  10%) 3.83
D6 3.83(1  5%) 4.02
Q1: SMR Inc. last year paid dividend of $1 and investors believe that dividend would grow by
15% for next 2 years and in the 3 year company will pay 10%, while after third year dividend
would grow by 5% thereafter. What is the maximum value investor can pay for this stock if the
required rate of return 15%?

Using CGM
D0 = 1 P3 = 15.30
D1 = 1*(1+15%) = 1.15 1.45 * (1  5%)
D2 = 1.15*(1+15%) = 1.32
P3 
(15%  5%)
D3 = 1.32*(1+10%) = 1.45
D4 = 1.45*(1+5%) = 1.53

1.15 1.32 1.45  15.30

Po   
(1  15%)^1 (1  15%)^ 2 (1  15%)^3
Po 13.01
Q1: Assume a company has earnings per share of $5 and pays out 40% in dividends. The earnings
growth rate for the next 3 years will be 20%. At the end of the third year the company will start paying out
100% of earnings in dividends and earnings will increase at an annual rate of 5% thereafter. If a 12% rate
of return required then what will be the value of the company stock?
Formula used to calculate dividends
Dividend = Earnings x Payout ratio
E0 = 5 D1 = 6*40% = 2.4
E1 = 5*(1+20%) = 6 D2 = 7.2*40% = 2.88
E2 = 6*(1+20%) = 7.2 D3 = 8.64*100% = 8.64
E3 = 7.2*(1+20%) = P3 = 129.60 Using CGM
8.64= 8.64*(1+5%) = 9.07
E4 8.64 * (1  5%)
P3 
(12%  5%)
2 .4 2.88 8.64  129.60
Po   
(1  12%)^1 (1  12%)^ 2 (1  12%)^3
Po 105.24
 References
1.Financial Management Theory and Practice by
BE [Brigham, E. F., & Ehrhardt, M. C.] (Chapter
8)
2.Fundamentals of financial management by BH
[Brigham, E. F., & Houston, J. F.] (Chapter 9)
Thank you