Stock Valuation
Chapter Seven
Remaining Topics
• Where now
– Stock Valuation (Intrinsic and Relative)
– Capital Budgeting Tools (NPV, IRR, Payback, etc.)
– Capital Budgeting problems with Excel
– Return Risk and Weighted Average Cost of Capital (WACC)
• This Chapter (Stock Valuation)
– What are stocks and why should we care
– Stock Book Value vs. Market Value
– Intrinsic value price vs. actual market price
•
Dividend Discount Model of Intrinsic Valuation
– Relative Valuation Metrics
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Stock Returns
• The returns on a stock over one period (Rt) can be
divided into capital gains and dividend returns:
Pt  Pt 1 Dt
Rt 

Pt 1
Pt 1
Pt = stock price at time t
Dt = dividends paid over time t – 1 to t
(Pt – Pt – 1) / Pt – 1 = capital gain over time t – 1 to t
Dt / Pt – 1 = return from dividends paid over time t – 1 to t
Suppose an investor buys 10 shares of stock priced at $55.10 and sells the stock
one year later for $56.30 after collecting a $0.30 dividend per share. What was the
investor’s pre-tax holding period return?
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HPR 
$56.30  $55.10 $0.30

 2.18%  .54%  2.72%
$55.10
$55.10
2
Common Stock
• Common stock is the fundamental ownership claim in a
public or private corporation
• Dividends are discretionary and are thus not guaranteed
• Must own before ex-dividend date.
• Common stockholders have the lowest priority claim in the
event of bankruptcy (i.e., a residual claim)
• Limited liability implies that common stockholders can lose
no more than their original investment
• Common stockholders control the firm’s activities indirectly by
exercising their voting rights in the election of the board of
directors
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8-3
3
Stock Price Predictions……
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Market
WSJ: TODAY'S MARKETS Updated November 8, 2012, 12:52 p.m. ET
Stocks edged lower, a day after
their steepest tumble in a year for
the Dow industrials, as worries
about U.S. politicians' ability to
strike a budget deal outweighed
firm labor-market and export data.
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AB InBev, SABMiller Formalize
$108 Billion Deal
SABMiller agrees to sell stake in MillerCoors to
Molson Coors Brewing
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Today 3-3-15… In Stocks
News drives stock prices
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Lumber Liquidators (LL) Today…
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LL 3-Year Price Movement
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LL Fundamentals look good
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Today’s Market “Carpet”
11-11-15
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NYSE Trading Floor
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8-1212
Simple Facts about a
Company’s Stock…. Cont…
• Stable, sound balance sheets & Income statements typically
see less volatile stock price swings.
– Consumer Staples: McDonalds (MCD) & Proctor & Gamble (PG)
– Earnings sensitive industries generally see more volatile price
swings
•
•
Caterpillar (CAT) ---- Sensitive economic data, Capital intensive
McDonalds (MCD) and P&G ---- Less sensitive to economic data
• In the short run (under a year) stock prices (market) can
deviate from it’s true “intrinsic price”
• Prices are influenced by macroeconomic data and
microeconomic or firm data, .e.g., earnings, company news,
etc.
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Simple Facts about a Company’s Stock….
• Short term price action is dictated by market “news” surrounding the particular
company.
NETFLIX (NFLX)
Separate DVD from Streaming.
P/E = 85
Larger than expected loss of customers ~ 1M
23% better than
expected earnings.
P/E = 20
Volume of Shares
traded…
Think
Supply & Demand
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~ 66% drop in market price
14
Blue Chips (DOW)
Caterpillar (CAT)
Industrial Sector
Price: $115-$70
~ 40% move
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Johnson & Johnson (JNJ)
Health Care Sector
~ %5 – 10%
15
Small Capitalization (S-CAP)
Applied Micro (AMCC) Semiconductors
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AFFYMAX INC COM (BIO Tech Company)
16
Book Topics
• Common Stock Valuation
– Dividend Growth Model
•
•
•
No Growth
Constant Growth
Non-constant Growth
• Some Features of Common and Preferred Stocks
• Fundamental Analysis vs. Technical Analysis
– http://www.youtube.com/watch?v=kpMJEBMUWo4
• The Stock Markets
– How does the market for stocks work
– Exchanges
– Etc..
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Main Formulas for Stocks
(Dividend Discount Model)
Table 7.1
Page 217
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Characteristics of Common
Stock
• Common Stock can last for ever
• No maturity date as with bonds
• You can still loose all of you investment however, e.g.,
Bear Sterns Example
• Factors that affect Stock Prices
– Firm Specific Unsystematic: Earnings, growth rates, cost of
capital (WACC)
– Market Specific Systematic: competition, geo-political,
Economic, market interest rates
• These variables are captured in the firms financial
statements and through stock valuation metrics
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More on Stock Price Movers
• Almost everything…. can impact or not impact the price….
• Earnings Events or Outside impacts to Earnings
– Earnings growth rates or changes in growth rates
– Positive or negative impacts to future earnings
• M & A, disasters, product launches, financial leverage (gearing), CEO
comments,
• Sector sell-offs, tactical reallocation, Hedge fund redemptions,
• Macro-economic indicators (GDP, unemployment), interest rates, firmspecific indicators.
• Liquidity of the stock (velocity of change ….)
– Microsoft is more liquid than Fuqi
– Fuqi vs. MS or Google
• Basically, any type of fear and uncertainty can cause prices to
change
(short term events…… or noise)
• Eventually, prices will regress to their intrinsic value however
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S & P 500 moving towards
historical P/E Ratios
Historical
(median)
P/E Ratio
close to
15
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PE Ratio and Dividend Yield
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Historical P/E (S&P 500) and
Interest Rates
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Cash Flow Model
(Intrinsic Value…)
Cash Flow to Creditors
The cash flow identity
Cash Flow from Assets = Cash flow to creditors + Cash
flow to owners
Cash flow to creditors = Interest – net new debt
= Interest – (Ending LTD – Beg LTD)
1. Cash Flow of Assets (Firm)
Cash flow from Assets = OCF – NCS – change NWC
Cash Flow to Stockholders (owners)
OCF = EBIT + Depreciation – tax
Cash to owners = Dividends – net new equity
(includes common stock and paid in capital)
NCS = Ending NFA – Beg NFA + Depreciation
Change NWC = Ending NWC – Beg NWC
Retained Earnings
Plowback
$
OCF – change NWC
True Cash Flow
From Operations
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$
Assets
(Firm)
$
NCS
Creditors
CFFA
(Free Cash Flow)
Investments &
Other non-operating
Income
Stockholders
(Owners)
24
Industry Lifecycle
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The Crossover Point
Applied Material,
Chipotle
or
Allergan
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P0 
D 0 (1  g)
D1

R -g
R -g
Apple
ATT, Johnson &
Johnson, P&G,
Colgate,
PepsiCo, YUM
Kodak
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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
through a buy-back of shares by the company
• As with bonds, the price of the stock is the present value
of these expected cash flows
• Cash flow from Stock Dividends & capital appreciation of stock
P0 = D1/(1+r)1 + D2/(1+r)2 + …Dt/(1+r)t + (Pt)/(1+r)t
Where D1, D2, Dn are dividend cash flows, t = number of periods
and r = discount rate. Pt = future value of stock at period t.
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Developing The Model
• You could continue to push back when you would sell
the stock
• You would find that the price of the stock is really just
the present value of all expected future dividends
• So, how can we estimate all future dividend payments?
• There are basically three different models for valuing
stocks….
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Estimating Dividends:
Special Cases
• Constant dividend (No Growth..)
– The firm will pay a constant dividend forever
– This is like preferred stock
– The price is computed using the perpetuity formula
• Constant dividend growth
– The firm will increase the dividend by a constant percent every period
– Diversified company with constant and steady increases in profit: Proctor
and Gamble
• Supernormal (non-constant) growth
– Dividend growth is not consistent initially, but settles down to constant
growth eventually
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One Period Example
• Suppose you are thinking of purchasing the stock of Moore Oil, Inc.
and you expect it to pay a $2 dividend in one year and you believe
that you can sell the stock for $14 at that time. If you require a return
of 20% on investments of this risk, what is the maximum you would
be willing to pay?
Pt = $14
r = 20%
D = $2.00
– Compute the PV of the expected cash flows
– FV = Div in one year plus the Capital appreciation
– Price = FV/(1+r)t = (14 + 2) / (1 + .2)1 = $13.33
Calculator
– FV = 16; I/Y = 20; N = 1; PV = -13.33
Very similar to PV
of a Bond
P0 = D1/(1+r)1 + D2/(1+r)2 + …Dt/(1+r)t + Pt / (1+r)t
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Two Period Example
• Now what if you decide to hold the stock for two years? In
addition to the dividend in one year, you expect a dividend of
$2.10 in and a stock price of $14.70 at the end of year 2. Now how
much would you be willing to pay?
– PV = 2 / (1.2)1 + (2.10 + 14.70) / (1.2)2 = 13.33
Dividend + Stock Price
on
final year
Calculator
– CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1;
NPV;
I = 20;
CPT NPV = 13.33
P0 = D1/(1+r)1 + D2/(1+r)2 + …Dt/(1+r)t + Pt/(1+r)t
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Three Period Example
• Finally, what if you decide to hold the stock for three periods? In addition
to the dividends at the end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and a stock price of $15.435. Now
how much would you be willing to pay?
– PV = 2 / (1.2)1 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33
Last year considers
Dividend and Capital
Calculator
– CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 =
1; NPV; I = 20;
CPT NPV = 13.33
P0 = D1/(1+r)1 + D2/(1+r)2 + …Dt/(1+r)t + Pt/(1+r)t
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Zero Growth Dividend
• If dividends are expected at regular intervals forever,
then this is like preferred stock and is valued as a
perpetuity
• P0 = D / R
where D = dividend & R = discount rate
• Suppose stock is expected to pay a $0.50 dividend
every quarter and the required return is 10% with
quarterly compounding. What is the price?
– P0 = .50 / (10% / 4) = $20
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Dividend Growth Model
(Constant Growth)
• Dividends are expected to grow at a constant percent
per period.
– P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
– P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + …
•
Where g = growth rate
• With a little algebra, this reduces to:
D0 (1  g)
D1
P0 

R -g
R -g
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DGM – Example 1 (Constant Growth Dividend)
• Suppose Big D, Inc. just paid a dividend of $.50. 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?
• D0 = $.50, g=2%, R=15%
• P0 = D0(1+g) / (R - g)
• P0 = .50(1+.02) / (.15 - .02) = $3.92
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DGM – Example 2
• Suppose TB Pirates, Inc. is expected to pay a $2 dividend in one
year. If the dividend is expected to grow at 5% per year and the
required return is 20%, what is the price.
Constant Growth Formula
– P0 = D1 / (R- g)
– P0 = 2 / (.2 - .05) = $13.33
P0 
D0 (1  g)
D
 1
R -g
R -g
– Why isn’t the $2 in the numerator multiplied by (1.05) in this
example?
•
•
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Because D1 is the next dividend one year later, not the current
dividend
D1 = D0(1+g)
36
Stock Prices are sensitive to
Earnings
P0 
D0 (1  g)
D
 1
R -g
R -g
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Growth Stocks with volatile
Earnings can be risky…
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Stock Price Sensitivity to
Dividend Growth, g
250
D1 = $2; R = 20%
Stock Price
200
Price volatility accompanies
high growth rates
150
100
50
0
0
0.05
0.1
0.15
0.2
Growth Rate
D0 (1  g)
D1
P0 

R -g
R -g
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As g gets larger the denominator gets
smaller
(as long as g < R)
39
Blue Nile Growth Warning…
•
October 12, 2007, 2:44PM EST text size: TT
• CITIGROUP CUTS BLUE NILE TO SELL FROM HOLD
•
Citigroup analyst Mark Mahaney downgraded Blue Nile (NILE) on
his belief that near-term market expectations have gotten ahead
of fundamentals. Proprietary Web Traffic Conversion Tracking
suggests third quarter units could be 30,000-34,000 vs. his 35,000
estimate. He notes he has very limited visibility into average
order size, but sensitivity analysis indicates in-line revenue
quarter at best; He thinks the Street's $0.16 EPS is intact.
•
Mahaney says his $88 target remains based on U.S. specialty
retailer average 3.7% 2008 free cash flow yield, which implies
10% downside from current price levels (pre-open). He notes that
Blue Nile shares are up 19% since its major second quarter beat,
implying expectations for another very strong quarter. He keeps
$0.99 2007, $1.35 2008 EPS estimates.
D0 (1  g)
D1
P0 

R -g
R -g
http://www.bluenile.com
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Stock Price Sensitivity to
Required Return, R
250
D1 = $2; g = 5%
Stock Price
200
150
100
P0 
50
D0 (1  g)
D
 1
R -g
R -g
0
0
0.05
0.1
0.15
0.2
0.25
0.3
Required Return
WSJ Prime Rate
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This week
Month ago
Year ago
3.25
3.25
3.25
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Example 8.3 Gordon Growth Company - I
• Gordon Growth Company is expected to pay a dividend of
$4 next period and dividends are expected to grow at 6%
per year. The required return is 16%.
• What is the current price?
– Given: D1 = $4, g = 6%, R = 16%
– P0 = D1 / (R-g)
– P0 = 4 / (.16 - .06) = $40
– Remember that we already have the dividend expected next
year, so we don’t multiply the dividend by 1+g
or ….. D1 = D0(1+g)
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Example 8.3 – Gordon Growth
Company - II
• What is the price expected to be in year 4?
– P4 = D4(1 + g) / (R – g) = D5 / (R – g)
– P4 = 4(1+.06)4 / (.16 - .06) = 50.50
Constant Growth….
D0 (1  g)
D1
P0 

R -g
R -g
• What is the implied return given the change
in price during the four year period?
– 50.50 = PV(1+R) 4 = 40(1+R)4; R = 6%
– PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
• The price grows at the same rate as the
dividends
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Non-constant Growth Problem
Statement
• Suppose a firm is expected to increase dividends by 20%
in one year and by 15% in two years. After that dividends
will increase at a rate of 5% per year indefinitely. If the last
dividend was $1 and the required return is 20%, what is
the price of the stock?
• Remember that we have to find the PV of all expected
future dividends.
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Nonconstant Growth –
Example Solution
G1 = 20%
G2 = 15%
G3 = 5%
• Compute the dividends until growth levels off
– D1 = 1(1.2) = $1.20
– D2 = 1.20(1.15) = $1.38
– D3 = 1.38(1.05) = $1.449
• Find the expected future price
(price at year 3)
– P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
• Find the present value of the expected future cash flows
– P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
P0 = D1/(1+r)1 + D2/(1+r)2 + …Dt/(1+r)t + Pt/(1+r)t
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Problems
• What is the value of a stock that is expected to pay a constant
dividend of $2 per year if the required return is 15%?
– This is a zero-growth dividend stock
– P0 = D / R = 2/.15 = $13.3
• What if the company starts increasing dividends by 3% per
year, beginning with the next dividend? The required return
stays at 15%.
– Constant Growth Dividend stock
– P0 = D0(1+g) / (R-g) = 2(1+.03) / (.15-.03) = $17.17
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Using the DGM to Find R
• Start with the DGM:
D 0 (1  g)
D1
P0 

R -g
R -g
rearrange and solve for R
D 0 (1  g)
D1
R
g
g
P0
P0
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Finding the Required Return
- Example
• Suppose a firm’s stock is selling for $10.50. They just
paid a $1 dividend and dividends are expected to
grow at 5% per year. What is the required return?
– R = [D0(1+g) / P0] + g
– R = [1(1.05)/10.50] + .05 = 15%
• What is the dividend yield?
– 1(1.05) / 10.50 = 10%
• What is the capital gains yield?
– g =5%
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Table 8.1 - Summary of Stock
Valuation
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US Car Industry…..
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GM Stock Price….
As of
4-16-09
Price
of
$1.9/Share
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Earnings and Growth in
Earnings
Dividend = 0
Growth Rate < 0
Debt/Asset Ratio
~ 1.45
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Features of Common Stock
• Voting Rights
– Usually one share one vote
– Straight voting (Directors are elected one at a time)
•
Share holders with large ownerships (50% or more) of the corporation virtually controls the vote
– Cumulative Voting (All directors are determined during a single vote and not individually at a time; allows
for minority representation on the board, i.e., one person can’t control all elected board members.)
• Proxy voting
– Allows someone to vote for another person
– Mutual Funds do this all the time (i.e., since you will not be voting at the annual meeting)
– Carl Ichan uses this method to change or replace company management (Green Card)
• Classes of stock
–
–
–
–
Class B
Class C (possibly a non-voting class, etc.)
Etc…
Examples:
•
Class B gets dividend distributions before class C, etc.
•
Stocks used for specific purposes (FCB family classes for example)
•
Set for specific purposes by the board, e.g., M&A would be one example
• Separate class for voting (owners maintain control) and a separate class for raising equity capital
• Other Rights of Stock holders
– Share proportionally in declared dividends
– Share proportionally in remaining assets during liquidation
– Preemptive right – first shot at new stock issue to maintain proportional ownership if desired
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See Notes Page…
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Rights Offering
Dividend Characteristics
• Dividends are not a liability of the firm until a dividend has been
declared by the Board
• Consequently, a firm cannot go bankrupt for not declaring dividends
• Dividends and Taxes
– Dividend payments are not considered a business expense,
therefore, they are not tax deductible (after Net Income)
– Dividends received by individuals are taxed as ordinary income
(1099-DIV….)……. Declaring dividends can have tax consequences
for stock holders…
– Dividends received by corporations have a minimum 70%
exclusion from taxable income (i.e., they are taxed on only the
remaining 30%.)
•
Dividends from stock the corporation owns….
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Features of Preferred Stock
• Dividends
– Stated dividend that must be paid before dividends can be
paid to common stockholders
– Dividends are not a liability of the firm and preferred dividends
can be deferred indefinitely
•
Dividends paid in arrears
– Most preferred dividends are cumulative – any missed
preferred dividends have to be paid before common dividends
can be paid
• Preferred stock generally will not carry voting rights
• Unlike debt, preferred dividends do not have to be paid
out.
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Stock Market
• Dealers vs. Brokers
– Dealer: maintains an inventory and stands ready to trade at quoted bid (price at which they
will buy) and ask (price at which they will sell) prices. Make their profit from the difference
between the bid and ask prices, called the bid-ask spread. The smaller the spread the more
competition and the more liquid the stock. The move to decimalization allows for a smaller bidask spread. There will be more discussion of this later.
– Broker matches buyers and sellers. They perform the search function for a fee (commission).
They do not hold an inventory of securities.
• New York Stock Exchange (NYSE)
– Largest stock market in the world
– Members
•
Own seats (before 2006) on the exchange. NYSE is now public and owners purchase
annual license (~$55,000 per year)
•
Specialists
•
Floor brokers
•
Floor traders
– Operations
– Floor activity
– NYSE on YouTube
Look at your Book for a host of stories and examples…..
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Liquid vs.
Illiquid Stocks
Stock Price is sensitive to the
number of shares transacted or
the daily volume.
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NASDAQ
• Not a physical exchange – computer based quotation system
• Multiple market makers
• Electronic Communications Networks
– EDI
• Three levels of information
– Level 1 – median quotes, registered representatives
– Level 2 – view quotes, brokers & dealers
– Level 3 – view and update quotes, dealers only
• Large portion of technology stocks
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NASDAQ Level I and II Quotes
(Shows the Market Makers…. Ask and Bid entity)
This is what a level II quote
looks like:
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US Stock Exchanges (BATS)
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Bulletin Board and Pink
Sheet Stocks
• Bulletin Board: Stocks that do not meet the filing
requirements for the NASDAQ or other major exchanges.
– Penny Stocks
– http://www.otcbb.com/
• Pink Sheets
– http://www.otcmarkets.com/otc-pink/home
• Both OTCBB and OTC Pink (Pink sheets) should be
considered risky companies as each have minimal listing
requirements. OTCBB must file statements and report to
the SEC, but Pink sheet companies do not.
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Reading Stock Quotes
• Sample Quote
52 wk hi lo
Comp
sym
33.25 20.75 Harris HRS
P/E Yield volume
87 .7% 3358
last trade price change
29.60
+0.50
• What information is provided in the stock quote?
• Click on the web surfer to go to CNBC for current
stock quotes.
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International Stock Exchanges
• Americas
– E.g., Toronto, Montreal, Winnipeg
– E.g., NYSE, NASDAQ, American (now owned by NYSE)
– E.g., Mexico, Brazil, Chile, Argentina
• Europe
– London Stock Exchange
– German Stock Exchange (DAX)
– http://www.site-by-site.com/exchanges_europe.htm
• Asia/Pacific
– Tokyo, Australian, Hong Kong, Taiwan, Bombay, Korea,
Singapore,
• Africa/Near East
– Johannesburg Stock Exchange,
Others:
http://dir.yahoo.com/Business_and_Economy/Business_to_Business/Financial_Services/Exchanges/Stock_Exchanges/?b=0
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World Markets as of 2-3-15
12:05pm (US Eastern Standard)
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Example of the DAX
Index
that follows
The German Stock
Exchange
or shares trading
on that exchange
Many companies
Will list outside their
Home country by issuing
ADR’s or American
Depository Receipts
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Professional Trading Tools
• Bloomberg Terminal (Macro, micro and firm specific Indicators and lots…
more…)
• S&P Compustat (Fundamental Data)
• Morningstar Direct (Mutual Funds, ETF’s, hedge funds, etc.)
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Bloomberg Terminal
(Professionals)
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