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Stock Valuation

Stock Valuation. FIL 341 Prepared by Keldon Bauer. Introduction. The valuation of all financial securities is based on the expected PV of future cash flows. Equity Valuation.

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Stock Valuation

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  1. Stock Valuation FIL 341 Prepared by Keldon Bauer

  2. Introduction • The valuation of all financial securities is based on the expected PV of future cash flows.

  3. Equity Valuation • Because equity has no stated maturity, the value of the security can be seen as the present value of a kind of perpetuity:

  4. Equity Valuation • To use the equation above, one would have to forecast every dividend (or cash flow) forever, which is not realistic. • To estimate the equity value, simplifying assumptions can be made. • If we allow dividends (cash flows) to grow at a constant rate. • If ks is fixed over the life of the stock.

  5. [1] [2] Equity Valuation • The Gordon Constant Growth Model:

  6. Gordon Constant Growth Model • Subtracting [2] from [1]:

  7. Gordon Constant Growth Model • Solving for PV:

  8. Gordon Constant Growth Model • Assumptions: • g must be less than ks (or P0 = ¥) • ks must be fixed • Dividend growth must be smooth (constant) • Note that this model works for any growth rate less than ks - including g=0

  9. Gordon Growth Model-Example • If a share currently pays $1.50 in annual dividends, is expected to grow at a rate of 5% per year, and has a required return of 14%, what should its share price be?

  10. Equity Valuation • The Gordon Growth Model suggests that valuation is a function of: • Dividend (or free cash flow), • Growth in dividends (or free cash flows), • Discount rate. • How does current stock news affect the market’s estimates of these three measures?

  11. Equity Valuation • Some have suggested that a company should not just have one constant growth rate. • As a partial answer to that problem the same solution has been solved (virtually the same way) for a two stage growth valuation model. • The solution is as follows:

  12. Two-Stage Dividend Growth Model Where: P0 = Price of stock today. D0= Most recent dividend (or cash flow). g1 = Growth rate over the first growth period. k = Required rate of return for common equity. T = Length of time the first growth rate is expected to last. g2 = Growth rate over the second growth period.

  13. Non-Constant Growth Valuation • Since constant growth is unlikely, we will now consider how to value stock under non-constant growth. • First, project dividends (or free cash flows) as far as practical. • From there estimate a constant growth rate. • Then take the PV as in chapter 6.

  14. Non-Constant Growth - Example • If Buford’s Bulldozer is expected to pay the following dividends, and then grow indefinitely at 4.5% (assuming a discount rate of 14.50%), what would its stock value be?

  15. Non-Constant Growth - Example • First we consider the price of the stock at time five.

  16. Non-Constant Growth - Example • Next we sum all period cash flows.

  17. $ 1.09 2 3 4 5 0 1 14.5% $ 2.10 $ 1.00 $ 1.63 $1.25 $2.75 $1.50 $2.80 $36.64 $18.62 Non-Constant Growth - Example $24.44 = Present Value

  18. Non-Constant Growth Valuation • If the cash flows or dividends can be estimated for a short-term, after which a two-stage growth model is appropriate, then a similar procedure can be employed to estimate the value, only using a two-stage formula in the terminal cash flow, rather than the Gordon Growth Model.

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