Analysis of Common Stocks

1. Analysis of Common Stocks Investments and Portfolio Management (MB 72)

2. Outline • Process of Valuation of a Financial Asset • Process of Valuation of Common Stocks • Determining parameters of models • How to determine the growth rate? • Length of growth period • How to determine the required rate of return • Models for Stock Valuation • Dividend Discount Models • Price-Earnings Models • Free Cash Flow to Equity Valuation Models

3. Valuation of Financial Assets • Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows • Three step process: • Estimate the expected cash flows • Determine the appropriate interest rate or interest rates to discount the cash flows • Compute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2

4. Estimating Cash Flows • Holding aside the risk of bankruptcy, the cash flows of a common stock are: • Payment of dividend so long as we hold the stock • Sale price of common stock when we sell the stock • Is it difficult to estimate the cash flows of a common stock?

5. Value of a Common Stock • Fair Market Value of a common stock depends on • PV of cash flows from a stock • PV of an infinite dividend stream OR • PV of a finite dividend stream plus PV of the sale price of the stock

6. Discounted Cash Flow Valuation • Value of any asset—a function of 3 variables • How it generates its cash flows? • When these cash flows are expected to occur? • Uncertainty of these cash flows t=n CFt • Value =  ---------- t=1 (1+r)t

7. Dividend Discount Model (DDM) • Value of a share of common stock is the present value of all future dividends n DPSt • Value per share of stock=  ---------- t=1 (1+r)t • What if the stock is not held for an infinite period? • One year holding period • Multiple year holding periods

8. Dividend Discount Model • Two types of cash flows • Dividends during the holding period • Expected price at the end of holding period—this itself is dependent on future dividends • How to determine the value of a share of common stock?

9. Infinite Holding Period • What will be the value of a share of common stock? • Present value of an infinite stream of anticipated dividends • Simplified assumptions to simply valuation model • Zero Growth Model • Constant Growth Model • Two-stage growth model • Three-stage growth model

10. Zero Growth Model • Dividend every year will be the same • Investor anticipates to receive the same amount dividend per year forever DPS • V = ------------- rcs

11. Constant Growth Model • Assume that firm grows at a stable growth rate of g per year forever DPS1 V = --------- r - g

12. Two-Stage DDM • In general version of the model, two stages of growth • An initial period of extraordinary growth • After initial period, a period of stable growth nDPSt Pn • P0=  ---------- + --------- t=1 (1+r)t (1 + r)n DPSn+1 Where Pn = ----------------- (r – gn)

13. Three-stage growth model

14. Four Basic Inputs • Length of high growth period • Dividends per share each period • Required rate of return by stockholders each period • Terminal price at the end of high growth period

15. High Growth Rate and Stable Growth Rate • Stable Growth Rate? • Growth rate expected to last forever • Firm’s other measures of performance including can be expected to grow at the same rate • What growth rate is reasonable as a “stable” growth rate? • A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy • Length of High Growth Period? • How much is the current growth rate? • Source of high growth?

16. High Growth Period • The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth period • The larger the current size of the firm, the shorter the high-growth period.

17. Guide to Length of High-Growth Period Current Growth Length of High Rate Growth Period • 1% higher than stable No high growth 1 – 10% higher than stable 5 years > 10% higher than stable 10 years

18. How do we Estimate Growth Rate? • g = b[ROA+D/E(ROA-I (1-t))] • Where b refers to the retention ratio • ROA is the return on assets • D/E is the debt to equity ratio in book value terms • i = interest expense/book value of debt

19. FCFE Valuation Model • The cash flow that the firm can afford as dividends and contrasted with actual dividends—may not payout as dividends • The residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and create new assets for future growth.

20. FCFE = Net Income + Depreciation – Capital Spending - Working Capital – Principal Repayments + New Debt Issues If there is a target debt ratio,  FCFE = Net Income - (1 - )(Capital Expenditure – Depreciation) - ( 1- ) Working Capital

21. FCFE Model n FCFEt Pn • P0=  ---------- + --------- t=1 (1+r)t (1 + r)n FCFEn+1 Where Pn = ----------------- (r – gn)