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Chapter 7 Tool Kit for Stock Valuation

5 VALUING COMMON STOCKS (Section 7.5) 6 7 Stocks can be evaluated in two ways: (1) find the stock price directly by calculating the present value of the 8 expected future dividends, or (2) find the stock price indirectly by first calculating the value of the entire 9 corporation, which is the the present value of the firm's expected future free cash flows, and then subtracting the 10 value of the debt and preferred stock to find the total value of the common equity. Only the first approach (the 11 dividend model) is discussed in this chapter. The second approach (the corporate valuation model) is described 12 in Chapter 13. 13 14 THE DISCOUNTED DIVIDEND APPROACH 15 16 The value of any financial asset is the present value of the future cash flows provided by the asset. When an 17 investor buys a share of stock, he or she typically expects to receive cash in the form of dividends and then, 18 eventually, to sell the stock and to receive cash from the sale. However, the price the first investor receives is 19 dependent upon the dividends the next investor expects to earn, and so on for different generations of investors. 20 Thus, the stock's value ultimately depends on the cash dividends the company is expected to provide and the 21 discount rate used to find the present value of those dividends. 22 23 24 Here is the basic dividend valuation equation: 25 D1 D2 DN + + . . . . 26 P0 = 2 ( 1 + rs ) ( 1 + rs ) ( 1 + rs ) N 27 28 29 The dividend stream theoretically extends on out forever, i.e., to n = infinity. Obviously, it would not be feasible 30 to deal with an infinite stream of dividends, but fortunately, a relatively simple equation has been developed that 31 can be used to find the PV of the dividend stream, provided it is growing at a constant rate. 32 33 34 VALUING A CONSTANT GROWTH STOCK (Section 7.6) 35 36 In the constant growth model, we assume that the dividend and stock will grow forever at a constant growth rate. 37 Naturally, assuming a constant growth rate for the rest of eternity is a rather bold assumption. However, 38 considering the implications of imperfect information, information asymmetry, and general uncertainty, the 39 assumption of constant growth is often reasonable. It is reasonable to guess that a given stock will experience 40 ups and downs throughout its life. By assuming constant growth, we are trying to find the average of the good 41 times and the bad times, and we assume that we will see both scenarios over the firm's life. In addition to a 42 constant growth rate, we also need the estimated long-term required return for the stock, and it too must be 43 constant. If these variables are constant, our price equation for common stock simplifies to the following 44 expression:

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A 45 46 47 48 49 50 51 52 53 54 55 56 P0 =

B D1 ( rs g )

In this equation, the long-run growth rate (g) can be approximated by multiplying the firm's return on assets by the retention ratio. Generally speaking, the long-run growth rate of a firm is likely to fall between 5% and 8% a year. EXAMPLE: CONSTANT GROWTH A firm just paid a $1.15 dividend and its dividend is expected to grow at a constant rate of 8%. What is its stock price, assuming it has a required return of 13.4%?

D0 = $1.15 57 58 g= 8% rs = 13.4% 59 60 D1 D0 (1 + g) $1.2420 61 P0 = = = ( rs g ) ( rs g ) 0.0540 62 63 P0 = $23.00 64 65 66 67 How sensitive is the stock's price to changes in the dividend, the growth rate, and rs? We can construct a series 68 of data tables and a graph to examine this question. 69 70 71 Resulting Changes in Dividends, Req's Return, and Growth: Effect 72 % Change Last Price on Stock Price Stock Price in D0 Dividend, D0 $23.00 73 $100 74 -30% $0.81 $16.10 75 -15% $0.98 $19.55 $90 76 0% $1.15 $23.00 $80 77 15% $1.32 $26.45 78 30% $1.50 $29.90 $70 79 $60 80 % Change Req'd Return $23.00 81 -30% 9.38% $90.00 $50 Growth Rate 82 -15% 11.39% $36.64 $40 83 0% 13.40% $23.00 84 15% 15.41% $16.76 $30 Dividend 85 30% 17.42% $13.18 $20 86 87 $10 Required Return % Change Growth Rate $23.00 88 -30% 5.60% $15.57 $0 89 -15% 6.80% $18.61 -30% -20% -10% 0% 10% 20% 90 0% 8.00% $23.00 Percent Change from Base 91 15% 9.20% $29.90 92 30% 10.40% $42.32

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This chart shows that the stock price has a positive relationship with the dividend and the growth rate, and a negative relationship with the required return. Furthermore, we see that the dividend has a linear relationship with price, while the growth rate seems to have a quadratic relationship. The relationship between required return and stock price is not only negative, but it is a quadratic relationship with greater convexity than the growth rate. This indicates that the required return is the factor that more directly influences the stock price. In other words, required return is the value driver in this valuation technique. However, the final effects also depend on the amount of change in each of the three variables. If the required return and dividend are expected to be stable, but the dividend growth rate is expected to change significantly, then the growth rate will be the primary determinant of the stock price. DO STOCK PRICES REFLECT LONG-TERM OR SHORT-TERM CASH FLOWS? Managers often claim that stock prices are "short-term" in nature in the sense that they reflect what is happening in the near-term and ignore the long-term. We can use the results for the constant growth model to shed light on this claim. The first step is to forecast the dividends for the next 5 years. Then we find the present value of these dividends and compare that PV with the current stock price, which reflects the PV of all future dividends. P0 = D0 = g= rs = Year Dividend 0 $1.15 $23.00 $1.15 8% 13.4% 1 $1.24 2 $1.34 $4.98 $23.00 21.6% 78.4% 3 $1.45 4 $1.56 5 $1.69

PV of dividends in Years 1 through 5 = Current stock price = Percent of current stock price due to dividends in Years 1 through 5 = Percent of current stock price due to dividends beyond Year 5 =

For most stock, the percentage of the current price that is due to long-term cash flows is over 80%.

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EXPECTED RATE OF RETURN ON A CONSTANT GROWTH STOCK (Section 7.7)

Using the constant growth equation introduced earlier, we can re-work the equation to solve for r s. In doing so, we are now solving for an expected return. The expression we are left is: rs = D1 P0 + g

This expression tells us that the expected return on a stock comprises two components. First, it consists of the expected dividend yield, which is simply the next expected dividend divided by the current price. The second component of the expected return is the expected capital gains yield. The expected capital gains yield is the expected annual price appreciation of the stock, and is given by g. This shows us the dual role of g in the constant growth rate model. Not only does g indicate expected dividend growth, but it is also the expected stock price growth rate. EXAMPLE: EXPECTED RATE OF RETURN ON A CONSTANT GROWTH STOCK You buy a stock for $23, and you expect the next annual dividend to be $1.242. Furthermore, you expect the dividend to grow at a constant rate of 8%. What is the expected rate of return on the stock, and what is the dividend yield of the stock? P0 D1 g rs Dividend yield $23.00 $1.242 8% 13.40%
Dividend Yield + Capital Gains Yield = Expected Rate of Return

5.40%

5.40% + 8% = 13.40%

EXAMPLE: EXPECTED PRICE IN THE FUTURE What is the expected price of this stock in five years? N = 5 Using the growth rate we find that: P5
=

$33.79

=B152*(1+B154)^B163

VALUING NONCONSTANT GROWTH STOCKS (Section 7.8)

For many companies, it is unreasonable to assume that they grow at a constant growth rate. Hence, valuation for these companies proves a little more complicated. The valuation process, in this case, requires us to estimate the short-run nonconstant growth rate and predict future dividends. Then, we must estimate a constant longterm growth rate at which the firm is expected to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a rather constant rate. Of course, the difficulty in this framework is estimating the shortterm growth rate, how long the short-term growth will hold, and the long-term growth rate.

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A B C D E F G H 179 Specifically, we will predict as many future dividends as we can and discount them back to the present. Then we will treat all dividends to be received after the convention of constant growth rate with the Gordon constant 180 growth model described above. The point in time when the dividend begins to grow constantly is called the 181 182 horizon date. When we calculate the constant growth dividends, we solve for a terminal value (or a continuing 183 value) as of the horizon date. The terminal value can be summarized as: 184 DN+1 DN (1 + g) 185 TVN = PN = = ( rs g ) ( rs g ) 186 187 188 This condition holds true, where N is the terminal date. The terminal value can be described as the expected 189 value of the firm in the time period corresponding to the horizon date. 190 191 EXAMPLE: NONCONSTANT GROWTH 192 193 A company's stock just paid a $1.15 dividend, which is expected to grow at 30% for the next three years. After 194 three years the dividend is expected to grow constantly at 8% forever. The stock's required return is 13.4%, what 195 is the price of the stock today? 196 D0 = $1.15 197 rs = 13.4% 198 gs = 30% Short-run g; for Years 1-3 only. 199 gL = 8% Long-run gL; for all years after Year 3. 200 201 202 Growth rate 30% 30% 30% 8% 8% Year 0 1 2 203 204 $1.15 $1.4950 $1.9435 Dividends 205 206 PV of dividends discounted at rs 207 $1.3183 208 1.5113 1.7326 209 $4.5622 = PV of nonconstant dividends 210 $34.6512 = PV of horizon value 211 3 $2.5266 4 $2.7287

$50.5310

= Horizon value =

$2.7287 5.4%

$39.2135 = P0 rs gL 212 213 214 215 PREFERRED STOCK (Section 7.11) 216 217 Consider an issue of preferred stock that pays a $10 dividend and has a required return of 10%. What is the price 218 of this preferred stock? 219 Vps = Dps rps 220 = $10.00 10.00% 221 222 = $100.00 223 224

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A B C D E F G H 225 Some preferred stock has a maturity date. Consider a firm whose preferred stock matures in 50 years, pays a $10 annual dividend, has a par value of $100, and has a required return of 8%. What is the price of this preferred 226 stock? 227 228 Years to Maturity (N): 50 229 Annual Dividend (PMT): $10 230 Par value (FV): $100 8% 231 Required return, rd (I/YR): 232 Vps = 233 $124.47 234 235 236 STOCK MARKET EQUILIBRIUM (Section 7.12) 237 238 Changes in Equilibrium Stock Prices 239 Small changes in the market's expectations can cause large changes in stock price! 240 241 Original New Risk-free rate, rRF 8% 7% 242 Market risk premium, rM rRF 4% 3% 243 Stock is beta coefficient, bi 244 2 1 ri 245 16.00% 10.00% Stock is expected growth rate, gi 5% 6% 246 D0 247 $2.8571 $2.8571 248 Price of Stock i $27.27 $75.71 249

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5 6 alue of the 7 entire 8 subtracting the 9 approach (the 10 el) is described 11 12 13 14 15 16 t. When an 17 s and then, 18 or receives is 19 ns of investors. 20 vide and the 21 22 23 24 25 26 27 28 29 not be feasible 30 developed that 31 32 33 34 35 ant growth rate. 36 wever, 37 tainty, the 38 will experience 39 ge of the good 40 dition to a 41 oo must 42 be 43 ollowing 44

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I 45 46 47 48 on assets by 49 5% and 50 a 8% 51 52 53 hat is its stock 54 55 56

57 58 59 60 61 62 63 64 65 66 nstruct a series 67 68 69 70 71 wth: Effect 72 73 74 75 76 77 78 79 80 81 82 83 84 Dividend 85 86 87 88 89 30% 90 91 92

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I 93 94 h rate, and a 95 relationship 96 n required 97 y than the 98 stock price. In 99 ects also 100 d are expected 101 e will be the 102 103 104 105 106 at is happening 107 to shed light on 108 109 110 111 hese dividends 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 %. 130 131

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132 133 134 s. In doing so, 135 136 137 138 139 consists of the 140 The second 141 yield is142 the f g in the 143 expected stock 144 145 146 147 expect148 the hat is the 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 ce, valuation for 172 us to estimate 173 nstant long174 point of time, all 175 ing the short176 177 178

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I resent.179 Then we Gordon 180 constant ntly is called the 181 (or a continuing 182 183 summarized as: 184

185 186 187 he expected 188 189 190 191 192 years. 193 After n is 13.4%, what 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211

212 213 214 215 216 What is the price 217 218 219 220 221 222 223 224

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I 225 ears, pays a $10 s preferred 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249

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SECTION 7.5
SOLUTIONS TO SELF-TEST If D1 = $3.00, P0 = $50, and the expected P at t=1 is equal to $52, what are the stocks expected dividend yield, capital gains yield, and total return for the coming year? D1 P0 Expected P1 Exp. dividend yield Exp. capital gains yield Exp. total return $3.00 $50.00 $52.00 6.0% =B6/B7 4.0% =(B8-B7)/B7 10.0% =C10+C11

pected dividend yield, capital

0.06 $0.04 $0.10

SECTION 7.6
SOLUTIONS TO SELF-TEST

A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is r s = 12%. What would stocks price be if the growth rate were 4%? D1 g rs Stock price $2.00 4% 12% $25.00 25

A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is r s = 12%. What would stocks price be if the growth rate were 0%? D1 g rs Stock price $2.00 0% 12% $16.67 16.66666667

f return is r s = 12%. What would the

f return is r s = 12%. What would the

SECTION 7.7
SOLUTIONS TO SELF-TEST If D0 = $4.00, rs = 9%, and g = 5% for a constant growth stock, what are the stocks expected dividend yield and capital gains yield for the coming year? D0 g rs $4.00 5% 9%

Expected D1 Stock price Expected dividend yield Expected capital gains yield

$4.20 $105.00 4.00% 5.00%

4.2 105 0.04 0.05

Alternatively, you know that the capital gains yield is equal to the growth rate. Expected capital gains yield = growth rate = 5.00%

Because the total return is rs, the dividend yield is rs minus the capital gains yield: Expected dividend yield 4.00%

SECTION 7.8
SOLUTIONS TO SELF-TEST Suppose D0 = $5.00 and rs = 10%. The expected growth rate from Year 0 to Year 1 (g0 to 1) = 20%, the expected growth rate from Year 1 to Year 2 (g1 to 2) = 10%, and the constant rate beyond Year 2 is gn = 5%. What are the expected dividends for Year 1 and Year 2? What is the expected horizon value price at Year 2? What is the expected P0? D0 g0 to 1 g1 to 2 gn rs $5.00 20% 10% 5% 10% Year 1 D1 Expected dividends Expected P2 PV of expected dividends PV of expected P2 Expected P0 $10.91 $114.55 $125.45 $6.00 2 D2 $6.60 $138.60 D1 6 138.6 $10.91 $114.55 $125.45 D2 $6.60

constant rate beyond he expected horizon

D3 6.93

SECTION 7.11
SOLUTIONS TO SELF-TEST A preferred stock has an annual dividend of $5. The required return is 8%. What is the Vps? Dps rps Vps $5.00 8% $62.50 $62.50

he Vps?