Chapter 9

Stocks and Their Valuation

Topics Covered
Common and Preferred Stock Properties Valuing Preferred Stocks Valuing Common Stocks - the Dividend Growth Model
No growth Constant growth Non-constant or supernormal growth

Valuing the Entire Corporation Free Cash Flow Approach Stock Market Equilibrium

Facts about common stock

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Managements goal: Maximize the stock price

Preferred Stock Characteristics

Unlike common stock, no ownership interest Second to debt holders on claim on companys assets in the event of bankruptcy. Annual dividend yield as a percentage of par value Preferred dividends must be paid before common dividends If cumulative preferred, all missed past dividends must be paid before common dividends can be paid.

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 (above) its intrinsic value are undervalued (overvalued).

Preferred Stock Valuation

Promises to pay the same dividend year after year forever, never matures. A perpetuity. VP = DP/rP Expected Return: rP = DP/P0 Example: GM preferred stock has a $25 par value with a 8% dividend yield. What price would you pay if your required return is 7%?

What do investors in common stock want?

Periodic cash flows: dividends, and To sell the stock in the future at a higher price Management to maximize their wealth

Stock Valuation: Dividend Growth Model

Stock Value = PV of Future Expected Dividends

D3 D1 D2 D P0 ... 1 2 3 1 r 1 r 1 r 1 r

Stock Valuation: Dividend Patterns

For Valuation: we will assume stocks fall into one of the following dividend growth patterns.
Constant growth rate in dividends Zero growth rate in dividends, like preferred stock Variable (non-constant) growth rate in dividends

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Stock Valuation Case Study: Doh! Doughnuts

We have found the following information for Doh! Doughnuts: current dividend = $2.00 = Div0 The current T-bill rate is 5% and investors demand an 9% market risk premium. Doh!s beta = 1.2.

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Analysts Estimates for Doh! Doughnuts

NEDFlanders predicts a constant annual growth rate in dividends and earnings of zero percent (0%) Barton Kruston Simpson predicts a constant annual growth rate in dividends and earnings of 10 percent (9%). Homer Co. expects a dramatic growth phase of 30% annually for each of the next 3 years followed by a constant 10% growth rate in year 4 and beyond.

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Our Task: Valuation Estimates

What should be each analysts estimated value of Doh! Doughnuts?

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Valuing Common Stocks: No Growth

If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

Div1 EPS1 Perpetuity P0 or r r

Assumes all earnings are paid to shareholders.

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Ned Flanders Valuation

D0 = $2.00, rS = 15.8% or 0.158, g = 0%

Constant Growth Valuation Model

Assumes dividends will grow at a constant rate (g) that is less than the required return (rS ) If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next years dividend as D1:

D (1 + g ) = D P = r -g r -g
0 1 0 S S

Commonly called the Gordon growth model

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Barton Kruston Simpsons Valuation

D0 = $2.00, g = 9%, rS = 15.8%

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Expected Return of Constant Growth Stocks

Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains Yield D1/P0 = Expected Dividend Yield g = Expected Capital Gains Yield r = (D1/P0) + g = (D0(1+g)/P0) + g

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Example
Burns Internationals stock sells for $80 and their expected dividend is $4. The market expects a return of 15%. What constant growth rate is the market expecting for Burns International?

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Variable Growth Stock Valuation

Framework: Assume Stock has period of nonconstant growth in dividends and earnings and then eventually settles into a normal constant growth pattern (gc). 0 g1 1 g2 2 g3 3 gc 4 gc 5 gc ...

D1

D2

D3 Constant Growth

Non-constant Growth Period

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Todays agenda
Supernormal (non-constant) dividend growth valuation Corporate value approach to stock valuation Stock Market Equilibrium

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Homer Co. Valuation

Variable (non-constant) growth Years 1-3 expect 30% growth After year 3: constant growth of 10%

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Variable Growth Valuation Process

3 Step Process Estimate Dividends during non-constant growth period. Estimate Price, which is the PV of the constant growth dividends, at the end of non-constant growth period which is also the beginning of the constant growth period. This is called the horizon or terminal value. Find the PV of non-constant dividends and horizon value. The total of these PVs = Todays estimated stock value.

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Back to Homer Cos Valuation: Step 1

D0 = $2.00, g = 30% or 0.3 for next 3 years

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Homer Cos Valuation: Step 2

Find Horizon Value which is the constant growth stock value at the end of year 3.

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Homer Cos Valuation: Step 3

0 r = 15.8% 1 s
g = 30% g = 30%

2
g = 30%

3
gc = 10%

...

PV(CF)
2.245 2.521 56.495 $61.26
^

2.600

3.380

4.394 +83.334 87.728

= P0

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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. Remember, free cash flow is the firms after-tax operating income less the net capital investment
FCF = NOPAT Net capital investment

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Applying the corporate value model

Find the market value (MV) of the firm, by finding the PV of the firms future FCFs at the companys weighted average cost of capital, WACC. Subtract MV of firms 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).

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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.

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An Example: Advanced Micro Devices AMDs debt market value is $692 (AMD) million.
AMD
No preferred stock 486 million shares outstanding Current free cash flow is $286 million.

Assume that AMD will experience 21% year 1, 19% year 2 and 18% FCF growth in year 3 and 11% constant annual growth thereafter. AMDs WACC is approximately 17%.

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An Example: AMD Projected FCFs($millions)

End of Year Growth Status
1 2 3 4 Variable Variable Variable Constant

Growth Rate (%)

21 19 18 11

FCF Calculation

$286(1.21) = $346.1 $346.1 x (1.19) = $411.8 $411.8 x (1.18) = $485.9 $485.9 x (1.11) = $539.4

Use non-constant growth to estimate AMDs corporate value.

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AMDs FCF Corporate Valuation ($millions)

0 WACC=17% 1 2 3
gc = 11%

...

346.1
295.8 300.8 303.4 5613.0

411.8

485.9

539.4

$ TV3
= Firm Value
^

539.4 0.17 - 0.11

8989.8

6513.0

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AMDs Stock Value per share

MV of firm = $6513 million MV of debt = $692 million MV of equity (stock) = $6513 - $692 = $5821 million 486 million shares outstanding P0 = MV of equity/shares = $5821/486 = $11.98 Recent price = $13.50

Stock Market Equilibrium

In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. In equilibrium, two conditions hold:
The current market stock price equals its intrinsic value (P0 = P0). Expected returns must equal required returns.

D1 rs g P0
^

rs rRF (rM - rRF )b

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How is market equilibrium established?

If price is below intrinsic value

The current price (P0) is too low and offers a bargain. Buy orders will be greater than sell orders. P0 will be bid up until expected return equals required return.

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Doh! In equilibrium?
Doh! Doughnuts current stock price is $30. Required return = 5% + 9%(1.2) = 15.8% Lets assume the 2nd analyst is correct and Doh! Has a constant growth rate of 9% and its current dividend is $2. Is Doh! Doughnuts current stock price in equilibrium?

Expected Return of Constant Growth Stocks

Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains Yield D1/P0 = D0(1+g)/P0 = Expected Dividend Yield g = Expected Capital Gains Yield From our example, D1=$2(1.09) = $2.18, P0=$30, g = 9% or 0.09

D1 $2.18 rs g 9% 7.3% 10% 17.3% P0 $30

^

DOH! Doh! Doughnuts

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The Effect On the Stock Price

20% 15% 10% 5% 0% 0 0.2 0.4 0.6 0.8 1 1.2 1.4

Expected Return needs to fall to the required return of 15.8%. This means the stock price must rise to the equilibrium price that yields the required return of 15.8% New Price = D1/(rs- g)=$2.18/(.158 - .09)= $32.06
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Stock Valuation Summary

Looked at Dividend Discount Model: Value = PV of future expected dividends. All else equal:
Higher interest rates (rs) yields lower stock prices (inverse relationship) Higher growth rate yields higher stock price.

Other Stock Valuation Methods

Multiples Method: P/E, P/CF, P/S For example: Price Estimate = PE Ratio x expected EPS