Stocks & Valuation

Facts about common stock

Represents ownership.

Ownership implies control.

Stockholders elect directors.

Directors hire management.

Since managers are agents of
shareholders, their goal should be:
Maximize stock price.
Social/Ethical Question

Should management be equally concerned

about employees, customers, suppliers,
and the public, or just the stockholders?

In an enterprise economy, management
should work for stockholders subject to
constraints (environmental, fair hiring, etc.)
and competition.
Types of stock market
transactions

Secondary market

Primary market

Initial public offering market (going
public)
Different approaches for
valuing common stock

Dividend growth model

Using the multiples of comparable firms

Corporate Valuation Model
 Dividend growth model

Value of a stock is the present value of the
future dividends expected to be generated by
the stock.

^ D1 D2 D3 D
P0 = 1
+ 2
+ 3
+ ... +
(1 + rs ) (1 + rs ) (1 + rs ) (1 + rs )
 Constant growth stock

A stock whose dividends are expected to
grow forever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

If g is constant, the dividend growth formula
converges to: ^ D 0 (1 + g) D1
P0 = =
rs - g rs - g

Estimating growth:

g = (retention rate)(return on equity)

g = (1-payout rate)(ROE)
Future dividends and their
present values

$ Dt = D0 ( 1 + g ) t

Dt
PVD t = t
(1+ r )

P0 = PVDt

0 Years (t)
Non-constant growth stock
^ D1 D2 DN PN
P0 = + + ... + +
(1 + rs )1 (1 + rs ) 2 (1 + rs ) N (1 + rs ) N

^ D1 D2 DN ((DN+1) /(rs - g))

P0 = 1
+ 2
+ ...+ N
+
(1+ rs ) (1+ rs ) (1+ rs ) (1+ rs )N

Zero growth stock

^ D
P0 =
rs
Sample Problem
ABC Inc is assumed to grow at the rate of 10%
a year. This high growth is expected to
continue until year-5. Starting year-6 growth is
expected to be reduced to 5% indefinitely.
If ABCs cost of equity is 12% and current
(year-0) dividend is $2.00, whats the stock
price?
 Sample Problem - Answer
D0 2.00
rs 12.00%
g 10.00%
g6 5.00%

0 1 2 3 4 5 6
Dividen 2.00 2.20 2.42 2.66 2.93 3.22 3.38
Price at 5 48.32
CF 2.00 2.20 2.42 2.66 2.93 51.54
PV 1.96 1.93 1.89 1.86 29.24
Sum PV 36.89
Market Multiple Analysis

Analysts often use the following multiples

to value stocks.

P/E

Stock price = EPS P/E ratio

P / CF
Market price of common stock
P/CF ratio =
Cash flow per share

P / Sales
Market price of common stock
P/S ratio =
Sales per share
Using Stock Price Multiples to
Estimate Stock Price

Analysts often use the P/E multiple (the

price per share divided by the earnings per
share).

Example:

Estimate the average P/E ratio of comparable
firms. This is the P/E multiple.

Multiply this average P/E ratio by the expected
earnings of the company to estimate its stock
price.

13
Using Entity Multiples

The entity value (V) is:

the market value of equity (# shares of stock
multiplied by the price per share)

plus the value of debt.

Pick a measure, such as EBITDA, Sales,
Customers, etc.

Calculate the average entity ratio for a sample of
comparable firms. For example,

V/EBITDA

V/Customers

14
Using Entity Multiples
(Continued)

Find the entity value of the firm in question. For

example,

Multiply the firms sales by the V/Sales multiple.

Multiply the firms # of customers by the V/Customers
ratio

The result is the firms total value.

Subtract the firms debt to get the total value of its
equity.

Divide by the number of shares to calculate the
price per share.
15
Problems with Market Multiple
Methods

It is often hard to find comparable firms.

The average ratio for the sample of
comparable firms often has a wide range.

For example, the average P/E ratio might be 20,
but the range could be from 10 to 50. How do
you know whether your firm should be compared
to the low, average, or high performers?

16
Corporate Valuation Model

Forecasting Pro Forma Financial Statements,
determining Free Cash Flow

Determine Total Corporate Value (V)

Less value of debt (D) & preferred stocks (P):
value of common equity (E)

FCFt
V = t
t =1 (1 + WACC )
Claims on Corporate Value

Debtholders have first claim. (D)

Preferred stockholders have the next claim.
(P)

Any remaining value belongs to stockholders.
(E)
V=D+P+E
E=V-DP
Stockprice = E / # shares
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.
Dp
V0 =
rp
Why are stock prices volatile?

^ D1
P0 =
rs g

rs = rRF + (RPM)bi could change.

Inflation expectations

Risk aversion

Company risk

g could change.
20
Consider the following
situation.

D1 = $2, rs = 10%, and g = 5%:

P0 = D1/(rs g) = $2/(0.10 0.05) = $40.

What happens if rs or g changes?

21
Stock Prices vs. Changes in rs
and g

g
rs 4% 5% 6%
9% $40.00 $50.00 $66.67
10% $33.33 $40.00 $50.00

11% $28.57 $33.33 $40.00

22
Volatile stock prices and rational
pricing

Small changes in expected g and rs

cause large changes in stock prices.

As new information arrives, investors
continually update their estimates of g
and rs.

23