CHAPTER 9 Stocks and Their Valuation

1. CHAPTER 9Stocks and Their Valuation Features of common stock Determining common stock values Preferred stock

2. Facts about common stock • Represents ownership • Ownership implies control • Stockholders elect directors • Directors elect management

3. Corporate Organization 1-3

4. Intrinsic Value and Stock Price • corporate insiders, and analysts use a variety of approaches to estimate a stock’s intrinsic value (P0). • In equilibrium we assume that a stock’s price equals its intrinsic value. • Investors 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).

5. Different approaches for estimating the intrinsic value of a common stock • Dividend growth model • Corporate value model

6. Dividend growth model • Value of a stock is the present value of the future dividends expected to be generated by the stock.

7. Div 1 Common Stock Valuation Div 2 Div 3 Div ∞ k% k% k% k%

8. Pmt 1 Bond Valuation: (a comparison) Pmt 2 Pmt 3 Pmt 20 + k% k% k% k%

9. Constant growth stock • A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0 (1+g)1 D2 = D1 (1+g)1 D3 = D2 (1+g)1

10. 0 1 2 3 g = 6% 2.12A 2.247B 2.382C D0 = 2.00 1.8761 rs = 13% 1.7599 1.6509 If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs (assume rs = 13%. ∞ Div ∞ rs% A, D1= D0(1+g)1 = 2.00 (1+0.06) = 2.12 B, D2= D1(1+g)1 = 2.12(1+0.06) = 2.247 C, D3= D2(1+g)1 = 2.247 (1+0.06)1 = 2.382

11. Constant growth stock • A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0 (1+g)1 D2 = D1 (1+g)1 D3 = D2 (1+g)1 • If g is constant, the dividend growth formula converges to:

12. What is the stock’s intrinsic value? • Using the constant growth model: A , D0 (1+g) = 2.0 (1+0.06) = 2.12

13. 0 1 2 3 rs = 13% ... 2.00 2.00 2.00 What would the expected price today be, if g = 0? • The dividend stream would be a perpetuity. * * P0 = D rs-g If g = 0

14. Supernormal growth:What if g = 30% for 3 years before achieving long-run growth of 6%? • Can no longer use just the constant growth model to find stock value. • However, the growth does become constant after 3 years.

15. D1 Common Stock Valuation g= 30% ∞ g= 6% D∞ D2 D3 D4 rs% rs% rs% P3; Present value of all future cash flows to be received beyond Yr 3 rs% P3= D4 rs-g = D3 (1+6%) rs-g

16. 0 1 2 3 4 rs = 13% ... g = 30% g = 30% g = 30% g = 6% D0 = 2.00 2.600 3.380 4.394 4.658 2.301 2.647 3.045 4.658A = = $66.54 46.114B 3 - 0.13 0.06 54.107 = P0 Valuing common stock with nonconstant growthp: (example 1) rs=13%, n=1 rs=13%, n=2 A= D3 (1+g) = 4.394(1+6%) = 4658 rs=13%, n=3 $ rs=13%, n=3 P ^ B: FV=66.54, n=3, I/yr=13%, PV=?

17. 0 1 2 3 4 rs = 13% ... g = 0% g = 0% g = 0% g = 6% D0 = 2.00 2.00 2.00 2.00 2.12 1.77 1.57 1.39 2.12 $ P = = $30.29 20.99 3 - 0.13 0.06 ^ 25.72 = P0 Nonconstant growth: (example 2)What if g = 0% for 3 years before long-run growth of 6%? rs=13%, n=1 rs=13%, n=2 rs=13%, n=3 rs=13%, n=3

18. D1 Super normal growth (example 3):G= 40% for 5 years before achieving L-r growth of 7% G= 40% G= 7% D∞ D2 D3 D4 D5 D6 P5; Present value of all future cash flows to be received beyond Yr 5 P5= D6 rs-g = D5 (1+7%) rs-g

19. What are the expected dividend yield, capital gains yield, and total return during the first year(assume D1 = 2.12, P1 = 32.10 & P0 = 30.29)? • Dividend yield = D1 / P0 = $2.12 / $30.29 = 7.0% • Capital gains yield = (P1 – P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0% • Total return (rs) = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

20. Preferred stock • Hybrid security. • Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. • However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

21. Preferred stock Valuation If a preferred stock pays an annual dividend of RM5 a share and market interest rate is 10%, what is the preferred stock’s current price? Vp = D/rp D= 5 rp=10% , Vp= RM5/ 10% Vp = RM50

22. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? Vp = D / rp $50 = $5 / rp rp = $5 / $50 = 0.10 = 10% ^

23. What would be the intrinsic price for this stock, one year from now (assume long-run growth of x% until )? ∞ D∞ D0 D1 D2 One year from now- to determine the intrinsic value(p1) Today If today: P0 = D1 rs - g If one year: P1 = D2 from now rs - g

24. What is the expected market price of the stock, one year from now(p1)? • Assume D0 = 2, g= 6%, rs = 13% • P1 is the present value (as of year 1) of D2, D3, D4, etc. • Could also find expected P1 as: * *D2= D1 (1+g) = 2.12 (1+0.06) = 2.247 *D1= D0 (1+g) = 2.00 (1+0.06) = 2.12

25. Corporate value model • Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. • Remember, free cash flow is the firm’s after-tax operating income less the net capital investment • FCF = NOPAT – Net capital investment

26. FCF= NOPAT – Net capital invest FCF = [EBIT(1-T) + Depreciation exp] - [ capital exp + working capital]

27. Applying the corporate value model • Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs. • Subtract MV of firm’s 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).

28. 0 1 2 3 4 r = 10% ... g = 6% -5 10 20 21.20 -4.545 8.264 15.026 21.20 398.197 530 = = TV3 0.10 - 0.06 416.942 Given the long-run beyond yr 3 is gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value. * FCF Y1= -5 Y2= 10 Y3= 20

29. If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share? • MV of equity = MV of firm – MV of debt = $416.94 - $40 = $376.94 million • Value per share = MV of equity / # of shares = $376.94 / 10 = $37.69

30. How is market equilibrium established? • If price is below intrinsic value … • The current price (P0) is “too low. • If price is above intrinsic value… • The current price (P0) is “too high”