Stock Valuation
Stock Valuation
Stock Valuation
Classes of Stock
Preferred Stock
Cumulative versus Non-Cumulative Preferred Stock
Preferred Stock: Equity or Debt?
Price and Dividends
Common Stocks and Dividends
Earnings are distributed to shareholders through dividends.
Market price of a stock reflects the value the market has placed
on the right to receive future dividends.
Payment of dividends is not assured, and dividend policy varies
between firms.
Dividends - In the U.S. generally paid quarterly
Cash flow and earnings are not the same thing.
Stock Price Quote
The Dividend-Discount Model
A One-Year Investor
Two Potential Sources of Cash Flows from Stock
The firm might pay out cash to its shareholders in the form of a
dividend
The investor might generate cash by selling the shares at some future
date
0 1
-P0 Div1+P1
Div1 + P1
P0 =
1 + rE
If the current price is less than P0, investing into the stock has
a positive NPV, so investors will demand more and driving
up the price.
If the current price is more than P0, (short) selling the stock
has a positive NPV, driving down the stock price.
The Dividend-Discount Model
rE can also be interpreted as the total expected return of
investing this stock.
Note rE has two components:
Div1 + P1 Div1 P1 − P0
=rE = −1 +
P0 P0 P0
Dividend Yield Capital Gain Rate
The Dividend-Discount Model
Dividend Yield: expected annual dividend of the stock
divided by its current price.
Capital Gain: amount the investor will earn on the stock,
difference between the expected sale price and the original
purchase price for the stock .
Total Return: The expected total return of the stock
should equal the expected return of other investments
available in the market with equivalent risk.
The Dividend-Discount Model
Example:
Suppose you expect Longs Drug Stores to pay an annual
dividend of $.56 per share in the coming year and to trade
$45.50 per share at the end of the year. If investments with
equivalent risk to Longs’ stock have an expected return of
6.80%, what is the most you would pay today for Longs’
stock? What dividend yield and capital gain rate would you
expect at this price?
The Dividend-Discount Model
Solution:
Div1 Div2 + P2
=P0 +
1 + rE (1 + rE )
2
In words, the price of a stock is equal to the present value of all of the
expected future dividends it will pay. So stock is a claim to all future
dividends.
Estimating Dividends in DD model
Constant Dividend Model
If we assume that expected dividends never change (i.e. no
growth) then the valuation formula is simply a perpetuity.
DIV1
P0 =
r
But in reality, both dividend and price of stocks increases over
time on average. So we need a better model.
Estimating Dividends in DD model
Constant Dividend-Growth Model
If we assume the growth rate of dividend growth rate g, then the
valuation formula is a growing perpetuity.
Div1
P0 =
rE − g
The value of the firm depends on the dividend level of next year,
divided by the equity cost of capital adjusted by the growth rate.
Estimating Dividends in DD model
Note that we can rearrange it as follows:
Div1
= rE +g
P0
Compare it with previous formula
Div1 + P1 Div1 P − P0
=rE = −1 + 1
P0 P0 P0
Dividend Yield Capital Gain Rate
Div1 $4.50
=P0 = = $64.29
rE − g 0.10 − 0.03
Div1 $4.50
= P0 = = $56.25
rE − g .10 − .02
Investing into the “bad” project (low rI ) actually decrease the
firm value and the stock price.
Estimating Dividends in DD model
In summary, the previous examples show that: Cutting
dividend to increase investment will raise the stock price if,
and only if, the new investment have a higher expected
return(rI) than the equity’s cost of equity(rE).
Another way to say the statement after “if and only if ” above
is: the new investment have a positive NPV, hence add value
to the company.
Estimating Dividends in DD model
Link to Growth and Value stocks
Growth firms have good projects to invest, so they retain most or all
of the earnings, and focus primarily on capital gains. (e.g. Technology
Stocks).
Value firms have few good projects, so they pay most of the earnings
as dividends (e.g. Utility Stocks)
DIVt +1
where Pt =
r−g
Estimating Dividends in DD model
Example
Small Fry, Inc., has just invented a potato chip that looks and tastes like a
french fry. Given the phenomenal market response to this product,
Small Fry is reinvesting all of its earnings to expand its operations.
Earnings were $2 per share this past year and are expected to grow at a
rate of 20% per year until the end of year 4. At that point, other
companies are likely to bring out competing products. Analysts project
that at the end of year 4, Small Fry will cut its investment and begin
paying 60% of its earnings and dividends. Its growth will also slow to a
long-run rate of 4%. If Small Fry’s equity cost of capital is 8%, what is
the value of a share today?
Estimating Dividends in DD model
Solution
Div4 $2.49
=P3 = = $62.25
rE − g 0.08 − 0.04
Div1 Div2 Div3 P3 $62.25
P0 = + + + = =
$49.42
1 + rE (1 + rE ) 2
(1 + rE ) (1 + rE ) (1.08)
3 3 3
Estimating Dividends in DD model
Limitations of Dividend-Discount Model
Forecasting actual dividends is difficult.
Dividend payout policies change over time.
Earnings depend on interest which varies with debt.
Shares are issued and repurchased over time.
These decisions are subject to management’s discretion so
valuation methods that are focused more on the fundamental
aspects of a firm’s cash flows are useful.
Total Payout Model
Share Repurchases are equivalent to Dividends.
Rather than focusing on Dividends per Share to calculate the
price of an individual shares, this approach looks at aggregate
payments to shareholders.
When a firm uses share repurchases this method is more
reliable and easy to apply
$3 billion
PV(Total Payout) = = $157.89 billion
0.10 - 0.081
Its stock price is
$157.89 billion
P0 = = $552
286 million
Free Cash Flow Valuation Model
This model starts estimating the enterprise value – the value of
the firm’s business .
Like the capital budgeting process, we estimate the firm’s
enterprise value as the present value of the free cash flows.
Unlevered Net Income
Free Cash=Flow (Revenues − Costs − Depreciation) × (1 − tax rate)
+ Depreciation
Note V is the enterprise value. − CapEx − Change in NWC
0
=
Enterprise Value Market Value of Equity + Debt − Cash
V0 + Cash 0 − Debt 0
P0 =
Shares Outstasnding 0
Note: when we calculate PV(Free CFs), the discount rate here is not rE,
because the existence of both equity and debt will affect the risk of the
business. Here we use weighted average cost of capital (WACC) rWACC ,
which we will come back to on Chapter 12.
Valuing Nike, Inc., Stock Using Free
Cash Flow
Problem:
Nike had sales of $25.3billion in 2009. Suppose you expect its
sales to grow at a rate of 10% in 2013, but then slow by 1% per
year to the long-run growth rate that is characteristic of the
apparel industry—5%—by 2018. Based on Nike’s past
profitability an investment needs, you expect EBIT to be 10% of
sales, increases in net working capital requirements to be 10% of
any increase in sales, and capital expenditures to equal
depreciation expenses. If Nike has $3.3 billion in cash, $1.2 billion
in debt, 893.6 million shares outstanding, a tax rate of 24%, and a
weighted average cost of capital of 10%, what is your estimate of
the value of Nike’s stock in early 2013?
Valuing Nike, Inc., Stock Using Free
Cash Flow
Solution:
Plan:
We can estimate Nike’s future free cash flow by
constructing a pro forma statement. The only difference
is that the pro forma statement is for the whole
company, rather than just one project. Further, we need
to calculate a terminal (or continuation) value for Nike
at the end of our explicit projections.
Valuing Nike, Inc., Stock Using Free
Cash Flow
Plan (cont’d):
Because we expect Nike’s free cash flow to grow at a
constant rate after 2015, we can compute a terminal
enterprise value. The present value of the free cash flows
during the years 2013–2018 and the terminal value will
be the total enterprise value for Nike. Using that value,
we can subtract the debt, add the cash, and divide by the
number of shares outstanding to compute the price per
share.
Valuing Nike, Inc., Stock Using Free
Cash Flow
Execute:
The spreadsheet below presents a simplified pro forma for Nike based on the
information we have:
Less: Income Tax (24%) 667.9 728.0 786.3 841.3 891.8 936.4
Plus: Depreciation
Less: Capital Expenditures
Less: Increase in NWC (10%
Δ Sales) 253.0 250.5 242.7 229.3 210.3 185.8
Price P P D1 1
= = = × Payout Rate
EPS E D1 E rE − g
Valuation Multiples
Enterprise value multiples use a measure of earnings before
interest payments are made
FCF1
V0 rwacc − g FCF FCF1 / EBITDA1
= =
EBITDA1 EBITDA1 rwacc − g FCF
Weaknesses of Comparable Valuation
Although valuation multiples are simple to use, they rely on
some very strong assumptions about the similarity of the
comparable firms to the firm you are valuing.
It is important to consider these assumptions are likely to be
reasonable—and thus to hold—in each case.
It only tells you the relative price compared to some
“comparable” stocks, not the absolute price.
Stock Prices and Multiples for the Footwear
Industry (excluding Nike), July 2013
Valuation Based on Comparable Firms
Comparison with Discounted Cash Flow Methods
Valuation multiple does not take into account
material differences between firms
Talented managers
More efficient manufacturing processes
Patents on new technology
Valuation Based on Comparable Firms
Comparison with Discounted Cash Flow Methods
Discounted cash flow methods allow us to incorporate
specific information about cost of capital or future
growth
Potential to be more accurate
Valuation Based on Comparable Firms
Stock Valuation Techniques: The Final Word
No single technique provides a final answer
regarding a stock’s true value
Practitioners use a combination of these
approaches
Confidence comes from consistent results from
a variety of these methods
Information, Competition and Stock
Prices
Efficient markets hypothesis: The idea that competition
among investors works to eliminate all positive-NPV trading
opportunities. It implies that securities will be fairly priced,
based on their future cash flows, given all information that
is available to investors.
Public, Easily Available Information: Information
available to all investors includes information in news reports,
financial statements, corporate press releases, or other public
data sources.
Private or Difficult-to-Interpret Information
Information, Competition, and Stock
Prices
Information, Competition and Stock
Prices
Example
Myox Labs announces that it is pulling one of its leading
drugs from the market, owing to the potential side effects
associated with the drug. As a result, its future expected free
cash flow will decline by $85 million per year for the next 10
years. Myox has 50 million shares outstanding, no debt, and
an equity cost of capital of 8%. If this news came as a
complete surprise to investors, what should happen to
Myox’s stock price upon the announcement?
Information, Competition and Stock
Prices
The decline in expected free cash flow will reduce
Myox’s enterprise value by
1 1
$8.5 million × 1 − 10
= $570 million
1.08 1.08
Since this is a public information, the share price should
fall by $570/50 = $11.40 immediately.
Information, Competition, and Stock
Prices
Private or Difficult-to-Interpret Information
Example: Phenyx Pharmaceuticals had just announced the
development of a new drug for which the company is seeking
approval from the FDA
If the drug is approved future profits will increase Phenyx’s
market value by $15 per share
Suppose the announcement comes as a surprise to investors,
and average likelihood of FDA approval is 10%
The announcement should lead to a 10% × $15.00=
$1.50 per share immediate stock price increase
Information, Competition, and Stock
Prices
Over time, investors will make their own
assessments of the probable efficacy of the drug
If they conclude that the drug looks more (less)
promising than average, they will buy (sell) the
stock and the price will drift higher (lower)
over time
At the time of the announcement, uninformed
investors do not know which way it will go
Information, Competition and Stock
Prices