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Common Stock Valuation

6. Common Stock Valuation. Learning Objectives. Separate yourself from the commoners by having a good Understanding of these security valuation methods: 1. The basic dividend discount model. 2. The two-stage dividend growth model. 3. The residual income model.

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Common Stock Valuation

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  1. 6 Common Stock Valuation

  2. Learning Objectives Separate yourself from the commoners by having a good Understanding of these security valuation methods: 1. The basic dividend discount model. 2. The two-stage dividend growth model. 3. The residual income model. 4. Price ratio analysis.

  3. Common Stock Valuation • Our goal in this chapter is to examine the methods commonly used by financial analysts to assess the economic value of common stocks. • These methods are grouped into three categories: • Dividend discount models • Residual Income models • Price ratio models

  4. Security Analysis: Be Careful Out There • Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock. • The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell. • In practice however, such stocks may in fact be correctly priced for reasons not immediately apparent to the analyst.

  5. The Dividend Discount Model • The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by discounting all expected future dividend payments. The basic DDM equation is: • In the DDM equation: • P0 = the present value of all future dividends • Dt = the dividend to be paid t years from now • k = the appropriate risk-adjusted discount rate

  6. Example: The Dividend Discount Model • Suppose that a stock will pay three annual dividends of $200 per year, and the appropriate risk-adjusted discount rate, k, is 8%. • In this case, what is the value of the stock today?

  7. The Dividend Discount Model: the Constant Growth Rate Model • Assume that the dividends will grow at a constant growth rate g. The dividend next period (t + 1) is: • For constant dividend growth for “T” years, the DDM formula becomes:

  8. Example: The Constant Growth Rate Model • Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly dividends, and the appropriate discount rate is 8%. • What is the value of the stock, based on the constant growth rate model?

  9. The Dividend Discount Model:the Constant Perpetual Growth Model. • Assuming that the dividends will growforever at a constant growth rate g. • For constant perpetual dividend growth, the DDM formula becomes:

  10. Example:Constant Perpetual Growth Model • Think about the electric utility industry. • In 2007, the dividend paid by the utility company, DTE Energy Co. (DTE), was $2.12. • Using D0 =$2.12, k = 6.7%, and g = 2%, calculate an estimated value for DTE. Note: the actual mid-2007 stock price of DTE was $47.81. What are the possible explanations for the difference?

  11. The Dividend Discount Model:Estimating the Growth Rate • The growth rate in dividends (g) can be estimated in a number of ways: • Using the company’s historical average growth rate. • Using an industry median or average growth rate. • Using the sustainable growth rate.

  12. The Historical Average Growth Rate • Suppose the Broadway Joe Company paid the following dividends: • 2002: $1.50 2005: $1.80 • 2003: $1.70 2006: $2.00 • 2004: $1.75 2007: $2.20 • The spreadsheet below shows how to estimate historical average growth rates, using arithmetic and geometric averages.

  13. The Sustainable Growth Rate • Return on Equity (ROE) = Net Income / Equity • Payout Ratio = Proportion of earnings paid out as dividends • Retention Ratio = Proportion of earnings retained for investment

  14. Example: Calculating and Using the Sustainable Growth Rate • In 2007, American Electric Power (AEP) had an ROE of 10.17%, projected earnings per share of $2.25, and a per-share dividend of $1.56. What was AEP’s: • Retention rate? • Sustainable growth rate? • Payout ratio = $1.56 / $2.25 = .693 • So, retention ratio = 1 – .693 = .307 or 30.7% • Therefore, AEP’s sustainable growth rate = .1017  .307 = .03122, or 3.122%

  15. Example: Calculating and Using the Sustainable Growth Rate, Cont. • What is the value of AEP stock, using the perpetual growth model, and a discount rate of 6.7%? • The actual mid-2007 stock price of AEP was $45.41. • In this case, using the sustainable growth rate to value the stock gives a reasonably accurate estimate. • What can we say about g and k in this example?

  16. The Two-Stage Dividend Growth Model • The two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T years, and thereafter grow at a rate g2 < k during a perpetual second stage of growth. • The Two-Stage Dividend Growth Model formula is:

  17. Using the Two-Stage Dividend Growth Model, I. • Although the formula looks complicated, think of it as two parts: • Part 1 is the present value of the first T dividends (it is the same formula we used for the constant growth model). • Part 2 is the present value of all subsequent dividends. • So, suppose MissMolly.com has a current dividend of D0 = $5, which is expected to shrink at the rate, g1 = 10% for 5 years, but grow at the rate, g2 = 4% forever. • With a discount rate of k = 10%, what is the present value of the stock?

  18. Using the Two-Stage Dividend Growth Model, II. • The total value of $46.03 is the sum of a $14.25 present value of the first five dividends, plus a $31.78 present value of all subsequent dividends.

  19. Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth, I. • Chain Reaction, Inc., has been growing at a phenomenal rate of 30% per year. • You believe that this rate will last for only three more years. • Then, you think the rate will drop to 10% per year. • Total dividends just paid were $5 million. • The required rate of return is 20%. • What is the total value of Chain Reaction, Inc.?

  20. Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth, II. • First, calculate the total dividends over the “supernormal” growth period: • Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as: P3 = [D3 x (1 + g)] / (k – g) P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835

  21. Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth, III. • Therefore, to determine the present value of the firm today, we need the present value of $120.835 and the present value of the dividends paid in the first 3 years:

  22. Discount Rates for Dividend Discount Models • The discount rate for a stock can be estimated using the capital asset pricing model (CAPM). • We will discuss the CAPM in a later chapter. • However, we can estimate the discount rate for a stock using this formula: Discount rate = time value of money + risk premium = U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium)

  23. Observations on Dividend Discount Models, I. Constant Perpetual Growth Model: • Simple to compute • Not usable for firms that do not pay dividends • Not usable when g > k • Is sensitive to the choice of g and k • k and g may be difficult to estimate accurately. • Constant perpetual growth is often an unrealistic assumption.

  24. Observations on Dividend Discount Models, II. Two-Stage Dividend Growth Model: • More realistic in that it accounts for two stages of growth • Usable when g > k in the first stage • Not usable for firms that do not pay dividends • Is sensitive to the choice of g and k • k and g may be difficult to estimate accurately.

  25. Residual Income Model (RIM), I. • We have valued only companies that pay dividends. • But, there are many companies that do not pay dividends. • What about them? • It turns out that there is an elegant way to value these companies, too. • The model is called the Residual Income Model (RIM). • Major Assumption (known as the Clean Surplus Relationship, or CSR): The change in book value per share is equal to earnings per share minus dividends.

  26. Residual Income Model (RIM), II. • Inputs needed: • Earnings per share at time 0, EPS0 • Book value per share at time 0, B0 • Earnings growth rate, g • Discount rate, k • There are two equivalent formulas for the Residual Income Model: BTW, it turns out that the RIM is mathematically the same as the constant perpetual growth model.

  27. Using the Residual Income Model. • Superior Offshore International, Inc. (DEEP) • It is July 1, 2007—shares are selling in the market for $10.94. • Using the RIM: • EPS0 = $1.20 • DIV = 0 • B0 = $5.886 • g = 0.09 • k = .13 • What can we sayabout the marketprice of DEEP?

  28. DEEP Growth • Using the information from the previous slide, what growth rate results in a DEEP price of $10.94?

  29. Price Ratio Analysis, I. • Price-earnings ratio (P/E ratio) • Current stock price divided by annual earnings per share (EPS) • Earnings yield • Inverse of the P/E ratio: earnings divided by price (E/P) • High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as value stocks.

  30. Price Ratio Analysis, II. • Price-cash flow ratio (P/CF ratio) • Current stock price divided by current cash flow per share • In this context, cash flow is usually taken to be net income plus depreciation. • Most analysts agree that in examining a company’s financial performance, cash flow can be more informative than net income. • Earnings and cash flows that are far from each other may be a signal of poor quality earnings.

  31. Price Ratio Analysis, III. • Price-sales ratio (P/S ratio) • Current stock price divided by annual sales per share • A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales growth. • Price-book ratio (P/B ratio) • Market value of a company’s common stock divided by its book (accounting) value of equity • A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders.

  32. Price/Earnings Analysis, Intel Corp. Intel Corp (INTC) - Earnings (P/E) Analysis 5-year average P/E ratio 27.30 Current EPS$.86 EPS growth rate 8.5% Expected stock price = historical P/E ratio  projected EPS $25.47 = 27.30  ($.86  1.085) Mid-2007 stock price = $24.27

  33. Price/Cash Flow Analysis, Intel Corp. Intel Corp (INTC) - Cash Flow (P/CF) Analysis 5-year average P/CF ratio 14.04 Current CFPS $1.68 CFPS growth rate 7.5% Expected stock price = historical P/CF ratio  projected CFPS $25.36 = 14.04  ($1.68  1.075) Mid-2007 stock price = $24.27

  34. Price/Sales Analysis, Intel Corp. Intel Corp (INTC) - Sales (P/S) Analysis 5-year average P/S ratio 4.51 Current SPS $6.14 SPS growth rate 7% Expected stock price = historical P/S ratio  projected SPS $29.63 = 4.51  ($6.14  1.07) Mid-2007 stock price = $24.27

  35. An Analysis of theMcGraw-Hill Company The next few slides contain a financial analysis of the McGraw-Hill Company, using data from the Value Line Investment Survey.

  36. The McGraw-Hill Company Analysis, I.

  37. The McGraw-Hill Company Analysis, II.

  38. The McGraw-Hill Company Analysis, III. • Based on the CAPM, k = 3.1% + (.80  9%) = 10.3% • Retention ratio = 1 – $.66/$2.65 = .751 • Sustainable g = .751  23% = 17.27% • Because g > k, the constant growth rate model cannot be used. (We would get a value of -$11.10 per share)

  39. The McGraw-Hill Company Analysis (Using the Residual Income Model, I) • Let’s assume that “today” is January 1, 2008, g = 7.5%, and k = 12.6%. • Using the Value Line Investment Survey (VL), we can fill in column two (VL) of the table below. • We use column one and our growth assumption for column three (CSR) of the table below.

  40. The McGraw-Hill Company Analysis (Using the Residual Income Model, II) • Using the CSR assumption: • Using Value Line numbers for EPS1=$3.45, B1=$9.25B0=$6.50; and using the actual change in book value instead of an estimate of the new book value, (i.e., B1-B0 is = B0 x k) Stock price at the time = $57.27.What can we say?

  41. The McGraw-Hill Company Analysis, IV.

  42. Useful Internet Sites • www.nyssa.org (the New York Society of Security Analysts) • www.aaii.com (the American Association of Individual Investors) • www.eva.com(Economic Value Added) • www.valueline.com (the home of the Value Line Investment Survey) • Websites for some companies analyzed in this chapter: • www.aep.com • www.americanexpress.com • www.pepsico.com • www.intel.com • www.corporate.disney.go.com • www.mcgraw-hill.com

  43. Chapter Review, I. • Security Analysis: Be Careful Out There • The Dividend Discount Model • Constant Dividend Growth Rate Model • Constant Perpetual Growth • Applications of the Constant Perpetual Growth Model • The Sustainable Growth Rate

  44. Chapter Review, II. • The Two-Stage Dividend Growth Model • Discount Rates for Dividend Discount Models • Observations on Dividend Discount Models • Residual Income Model (RIM) • Price Ratio Analysis • Price-Earnings Ratios • Price-Cash Flow Ratios • Price-Sales Ratios • Price-Book Ratios • Applications of Price Ratio Analysis • An Analysis of the McGraw-Hill Company

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