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FINE 3010-01 Financial Management

FINE 3010-01 Financial Management. Instructor: Rogério Mazali Lecture 08: 10/19/2011. FINE 3010-01 Instructor: Rogério Mazali. Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin. Chapter 7: Valuing Stocks (continued).

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FINE 3010-01 Financial Management

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  1. FINE 3010-01Financial Management Instructor: RogérioMazali Lecture 08: 10/19/2011

  2. FINE 3010-01Instructor:RogérioMazali Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin Chapter 7: Valuing Stocks (continued)

  3. Agenda • Dividend Discount Model • Case 1: Zero Growth - The Firm does not experience any growth (Constant Dividend) • Case 2: Constant Growth – The Firm experiences a constant growth rate forever • Case 3: Differential Growth - The Firm has a growth rate that is changing with time • Calculating growth rates from accounting data • Payout ratios • Sustainable Growth Ratios

  4. Simplifying the Dividend Discount Model • Not all companies are valued the same • Growth firms vs. income firms • Example 7.1 (p. 189): Amazon.com vs. Consolidated Edison • Amazon.com • 2007 profits of $476 million • Investors paid 76 x that amount, $36.5 billion • Value came from firm’s market position, distribution system and new related products • Investors paid 30.5 times book value for shares • Consolidated Edison (Con Ed) • Electric utility company servicing NYC area • Market is limited, capacity expansion at deliberate pace • Electricity is a regulated utility, firm’s future revenues are constrained • Firms revenues are generated by existing assets. • Investors paid only 1.5 times book value for shares

  5. Dividend Discount Model with no Growth • Consider a firm that has just paid this period’s dividends: • If firm has no growth, then: • Therefore, our formula becomes:

  6. Example • What is the value of a share of a firm that is expected to pay constant dividend of $2 per share forever, starting from next year? The required rate of return is 10%

  7. Dividend Discount Model with no Growth • If the firm has not yet paid its dividends in the current period, then: • If firm has no growth, then: • Therefore, our formula becomes:

  8. Example 2 • What is the value of a share of a firm that is expected to pay constant dividend of $2 per share forever, starting this year? The required rate of return is 10%

  9. Dividend Discount Model With No Growth • Also, since firm does not grow, there are no new investments and, thus, all its earnings will be distributed to shareholders as dividends • Thus,

  10. Example 3 • What is the value of a share of a firm that is not expected to grow, has 2 million shares outstanding, and had $60 million in net income last year? The required rate of return is 20%

  11. The Constant- Growth Dividend Discount Model (Gordon Growth Model) • Suppose our dividends grow at a constant rate g indefinitely. Thus, • We have seen that: • Thus,

  12. Example • What is the value of a share of a firm that paid a dividend of $2 per share this year, and is expected to grow at 5%, starting from next year? The required rate of return is 10%

  13. Estimating Expected Rates of Return • We have that: • Rearranging terms: • This is also the rate of return that must be offered by other, equally risky stocks

  14. Example • Company X has just paid a $2 dividend per share. X’s dividends are expected to grow at 5% a year. What is the rate of return of X’s stock if it is currently being traded on the market at $42?

  15. Example 2 • Blue Skies, Inc. stocks are expected to pay a $3.00/share dividend next year, and then increase the dividend at a rate of 8% per year, indefinitely. Assume a 12% expected return. What should Blue Skies stock price be?

  16. Example 2 (continued) • If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?

  17. Non-Constant Growth • Companies don’t usually grow at constant rates • Usually, there is a period of rapid growth and then, once the industry reaches maturity, company grows at a lower, somewhat constant rate • We have seen that: • Last term is known as terminal value.

  18. Non-Constant Growth • Example 7.5 (p. 199): Estimating the Value of PepsiCo Stock • Step 1: Value Pepsi’s dividends over the period of rapid growth • Step 2: Estimate Pepsi’s stock price at the horizon year, when growth should have settled down • Step 3: Calculate the PV of Pepsi stock by summing the PV of dividends and the PV of the stock at the horizon.

  19. Non-Constant Growth • Step 1: Market analysts have estimated Pepsi’s growth in earnings to be around 11.4%. If Pepsi’s dividends keep pace with the growth in earnings: • PV of dividends years 1 to 5:

  20. Non-Constant Growth • Step 2: at the horizon year, we will assume that Pepsi’s growth rate falls immediately to 6%

  21. Non-Constant Growth • Step 3: Sum up the parts

  22. Calculating Growth Rate Estimates • What determines the dividend growth? • If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher. • Suppose Blue Skies starts year 1 with BE/share = $25 and ROE = 20%/year. • Earnings per share = (BE/share) × ROE = = $25 × 0.20 = $5

  23. Calculating Growth Rate Estimates • Definitions: • Payout Ratio: Fraction of earnings paid out as dividends • Plowback Ratio: Fraction of earnings retained by the firm • Sustainable Growth Rate: Steady rate at which firm can grow without recurring to external financing.

  24. Calculating Growth Rate Estimates • Blue Skies’ BEPS at the start of year 1: $25 • Blue Skies’ earnings per share: $5 • Blue Skies proposes to pay dividends of $3/share in year 1 (payout ratio = $3/$5 = 60%). • $2/share are to be plowed back in new plant and equipment (plowback ratio = $2/$5 = 40%).

  25. Calculating Growth Rate Estimates • Blue Skies start year 2 with additional equity per share: = EPS during year 1 × plowback ratio = $5 × .40 = $2 = BEPS in the end of year 0 × ROE × plowback ratio = $25 × .20 × .40 = $2 • Since it started with BE of $25/share, its growth rate was $2/$25 = 0.08 = 8%.

  26. Calculating Growth Rate Estimates • Sustainable Growth Ratio: • Remember Blue Skies, Inc.: • We can recalculate P0 with g = 0 and Div1 = EPS1 = $5

  27. Calculating Growth Rate Estimates

  28. Calculating Growth Rate Estimates • Alternative Formulae for the sustainable growth rate: gt = (Earningst - Earningst-1)/ Earningst-1 gt = (Increase in Earnings)t / Earningst-1 gt = (Retained Earningst-1 * Ret on Inv ) / Earningst-1 gt = Retained Earningst-1 * ROE / Earningst-1 gt = (Retained Earningst-1 / Earningst-1 )* ROE gt = Plowback ratiot-1 * ROE gt = (1 – Payout Ratiot-1) * ROE

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