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# Chapter 4

STOCKS

## Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
4-2 HOW COMMON STOCKS ARE VALUED
Book Value
Net worth of firm according to balance sheet
Dividend
Periodic cash distribution from firm to the
shareholders
P/E Ratio
Price per share divided by earnings per share
Market Value Balance Sheet
Financial statement that uses market value of
assets and liabilities
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4-2 HOW COMMON STOCKS ARE VALUED

## Discounted Cash Flow (DCF) Formula

Value of a stock = present value of future cash
flows, i.e. dividends

## PV(stock) PV(expecte d future dividends)

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4-2 HOW COMMON STOCKS ARE VALUED

Expected Return
Percentage yield forecast from specific
investment over time period
Sometimes called market capitalization rate

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4-2 HOW COMMON STOCKS ARE VALUED

Example
Fledgling Electronics sells for \$100 per share
today; they are expected to sell for \$110 in one
year. What is expected return if dividend in one
year is forecasted to be \$5.00?

5 110 100
Expected return .15
100

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4-2 HOW COMMON STOCKS ARE VALUED

## Price of share of stock is present value of

future cash flows
For a stock, future cash flows are dividends
and ultimate sales price

Div1 P1
Price P0
1 r

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4-2 HOW COMMON STOCKS ARE VALUED

Example
Fledgling Electronics price

5 110
Price P0 100
1.15

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4-2 HOW COMMON STOCKS ARE VALUED

## Market Capitalization Rate

Estimated using perpetuity formula
Also called cost of equity capital

Div 1
Capitaliza tion rate P0
rg
Div 1
r g
P0
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4-2 HOW COMMON STOCKS ARE VALUED

## Dividend Discount Model

Computation of todays stock price: share value
equals present value of all expected future
dividends
H: Time horizon for investment

## Div1 Div 2 Div H PH

P0 ...
(1 r ) (1 r )
1 2
(1 r ) H

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4-2 HOW COMMON STOCKS ARE VALUED

Example
Fledgling Electronics forecasted to pay \$5.00
dividend at end of year 1 and \$5.50 dividend at
end of year 2. End-of-second-year stock will be
sold for \$121. Discount rate is 15%. What is the
price of stock?

## 5.00 5.50 121

PV
(1 .15)1
(1 .15) 2

PV \$100.00
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4-2 HOW COMMON STOCKS ARE VALUED

Example
XYZ Company will pay dividends of \$3, \$3.24,
and \$3.50 over next three years. After three
years, stock sells for \$94.48. What is the price
of stock given 12% expected return?

## 3.00 3.24 3.50 94.48

PV
(1 .12) (1 .12)
1 2
(1 .12) 3

PV \$75.00
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4-3 ESTIMATING COST OF EQUITY CAPITAL

Dividend Yield
Expected return on stock investment plus
expected dividend growth
Similar to capitalization rate
Div1
Price P0
rg
Div1
Dividend yield r g
P0
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4-3 ESTIMATING COST OF EQUITY CAPITAL

Example
Northwest Natural Gas shares sold for \$47.30
at start of 2012. Dividend payments for 2013
were \$1.86 a share with no growth. What is
dividend yield?
Dividend Yield r
1.86
r
47.30
r .039
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4-3 ESTIMATING COST OF EQUITY CAPITAL

Example
Northwest Natural Gas shares sold for \$47.30 at
start of 2012. Dividend payments for 2013 were
\$1.86 a share with 4.6% growth. What is dividend
yield?
Dividend yield r
1.86
r .046
47.30
r .085

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4-3 ESTIMATING COST OF EQUITY CAPITAL

Return Measurements

Div1
Dividend yield
P0

## Return on Equity ROE

EPS
ROE
Book equity per share

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4-3 ESTIMATING COST OF EQUITY CAPITAL

## Dividend Growth Rate

Derived by applying return on equity to
percentage of earnings reinvested in operations
g = return on equity plowback ratio

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4-3 ESTIMATING COST OF EQUITY CAPITAL

## Div1 Div 2 Div H PH

PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H

Div H 1
PH
rg

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4-3 ESTIMATING COST OF EQUITY CAPITAL

Example
Phoenix pays dividends in three consecutive
years of 0, .31, and .65. Year-4 dividend is
estimated at .67 with perpetuity growth at 4%.
With 10% discount rate, what is stock price?

## 0 .31 .65 1 .67

PV
3

(1 .1) (1 .1) (1 .1) (1 .1) (.10 .04)
1 2 3

9.13

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4-4 STOCK PRICE AND EARNINGS PER SHARE

## If firm pays lower dividend and reinvests

funds, stock price may increase due to
higher future dividends
Payout Ratio
Fraction of earnings paid out as dividends
Plowback Ratio
Fraction of earnings retained by firm

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4-4 STOCK PRICE AND EARNINGS PER SHARE

Example
Company plans \$8.33 dividend next year (100%
of earnings). Investors required return is 15%.
Then the company decides to plow back 40% of
earnings at firms current ROE of 25%. What is
the stock value before and after plowback
decision?

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4-4 STOCK PRICE AND EARNINGS PER SHARE

Example, continued
No Growth

8.33
P0 \$55.56
.15
With Growth

## g .25 .40 .10

5.00
P0 \$100.00
.15 .10

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4-4 STOCK PRICE AND EARNINGS PER SHARE

Example, continued
Stock price remains at \$55.56 with no earnings
plowed back
With plowback, price is \$100.00
Difference is called present value of growth
opportunities (PVGO)

## PVGO 100.00 55.56 \$44.44

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4-4 STOCK PRICE AND EARNINGS PER SHARE

## Present Value of Growth Opportunities

(PVGO) is the net present value of firms
future investments
Sustainable Growth Rate is the steady rate
at which firm can grow: plowback ratio x
return on equity

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4-5 VALUING A BUSINESS

## Valuing a Business or Project

Usually computed as discounted value of FCF
to valuation horizon (H)
Valuation horizon sometimes called terminal
value and calculated like PVGO

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4-5 VALUING A BUSINESS

PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H

## PV (free cash flows) PV (horizon value)

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4-5 VALUING A BUSINESS

Example
Given cash flows for Concatenator
Manufacturing Division, calculate PV of near-
term cash flows, PV (horizon value), and total
value of firm; r = 10% and g = 6%

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4-5 VALUING A BUSINESS

Example, Continued
.80 .96 1.15 1.39 .20 .23
PV(FCF)
1.1 1.12 1.13 1.14 1.15 1.16
3.6

1 1.59
PV(horizon value) 6 22.4
1.1 .10 .06
PV(busines s) PV(FCF) PV(horizon value)
-3.6 22.4
\$18.8
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