Chapter 8

Stock Valuation
Valuing a Company and Its Future
 The single most important issue in the stock
valuation process is what a stock will do in
the future
 Value of a stock depends upon its future returns
from dividends and capital gains/losses
 We use historical data to gain insight into the
future direction of a company and its profitability
 Past results are not a guarantee of future results
Using Stock Valuation
 Once we have an estimated future stock
price, we can compare it to the current
market price to see if it may be a good
investment candidate:
current price < estimated price undervalued
current price = estimated price fairly valued
current price > estimated price overvalued
The Valuation Process
 Valuation is a process by which an
investor uses risk and return concepts to
determine the worth of a security.
 Valuation models help determine what a stock
ought to be worth
 If expected rate of return equals or exceeds
our target yield, the stock could be a
worthwhile investment candidate
 There is no assurance that actual outcome will
match
expected outcome
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.
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:

D1 D2 D3 DT
P0    
1 k  1 k  1 k 
2 3
1 k T
 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
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?

D1 D2 D3
P0   
1  k  1  k 2 1  k 3

$200 $200 $200

P0     $515.42
1  0.08  1  0.08  1  0.08 
2 3
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:
D t 1  D t  1  g

So, D 2  D1  (1  g)  D 0  (1  g)  (1  g)

 For constant dividend growth for “T”

years, the DDM formula becomes:
D1 (1  g)   1 g  
T

P0  1     if k  g
k  g   1  k  

P0  T  D 0 if k  g
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?
D 0 (1  g)   1 g  
T

P0  1    
kg    1  k  

$10  1.10   
20
 1.10 
P0  1      $243.86
.08  .10    1.08  

The Dividend Discount Model:
the Constant Perpetual Growth Model

 Assuming that the dividends will grow

forever at a constant growth rate g.

 For constant perpetual dividend growth,

the DDM formula becomes:

D 0  1  g D1
P0   (Important : g  k)
kg kg
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.

$2.12  1.02 
P0   $46.01
.067  .02

Note: the actual mid-2007 stock price of DTE was

$47.81.

What are the possible explanations for the difference?

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.

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.

Year: Dividend: Pct. Chg:

2007 $2.20 10.00%
2006 $2.00 11.11%
2005 $1.80 2.86% Grown at
2004 $1.75 2.94% Year: 7.96%:
2003 $1.70 13.33% 2002 $1.50
2002 $1.50 2003 $1.62
2004 $1.75
Arithmetic Average: 8.05% 2005 $1.89
2006 $2.04
Geometric Average: 7.96% 2007 $2.20
The Sustainable Growth Rate
Sustainabl e Growth Rate  ROE  Retention Ratio

 ROE  (1 - Payout Ratio)

 Return on Equity (ROE) = Net Income /

Equity
 Payout Ratio = Proportion of earnings paid
out as dividends
 Retention Ratio = Proportion of earnings
retained for investment
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%
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%?

$1.56  1.03122 
P0   $44.96
.067  .03122
 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.
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:
D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2
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?
Using the Two-Stage
Dividend Growth Model, II.
D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2

$5.00(0.90 )   0.90    0.90  $5.00(1  0.04)

5 5

P0  1     
0.10  ( 0.10)   1  0.10    1  0.10  0.10  0.04

 $14.25  $31.78

 $46.03.

 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.
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.?

Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, II.
 First, calculate the total dividends over the “supernormal”
growth period:

Year Total Dividend: (in $millions)

1 $5.00 x 1.30 = $6.50
2 $6.50 x 1.30 = $8.45
3 $8.45 x 1.30 = $10.985

 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

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:

D1 D2 D3 P3
P0    
1  k  1  k 2 1  k 3 1  k 3

$6.50 $8.45 $10.985 $120.835

P0    
1  0.20  1  0.20 2 1  0.20 3 1  0.20 3

 $5.42  $5.87  $6.36  $69.93

 $87.58 million.
Discount Rates for
Dividend Discount Models
 The discount rate for a stock can be estimated using the capital
asset pricing model (CAPM ).
 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)

T-bill Rate: return on 90-day U.S. T-bills

Stock Beta: risk relative to an average stock
Stock Market Risk risk premium for an average
Premium: stock
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.
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.
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.
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:

EPS 0 (1  g)  B 0  k
P0  B 0 
kg

or

EPS1  B 0  g
P0 
kg
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
EPS0  (1  g)  B 0  k
 g = 0.09 P0  B 0 
kg
 k = .13
$1.20  (1  .09)  $5.886  .13
P0  $5.886 
.13  .09

$1.308  $.7652
P0  $5.886   $19.46.
.04
DEEP Growth
 Using the information from the previous slide,
what growth rate results in a DEEP price of
$10.94?
EPS0  (1  g)  B 0  k
P0  B 0 
kg

$1.20  (1  g)  $5.886  .13

$10.94  $5.886 
.13  g

$5.054  (.13  g)  1.20  1.20g  .7652

$.6570  5.054g  1.20g  .4348

.2222  6.254g

g  .0355 or 3.55%.
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.
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.
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.
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

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

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

The McGraw-Hill Company Analysis, I.
The McGraw-Hill Company Analysis, II.
The McGraw-Hill Company
Analysis, III.
 Based on the CAPM, k = 4.5% + (.90  9%) =
12.6%

 Retention ratio = 1 – $.82/$3.45 = .762

 Sustainable g = .762  38.5% = 29.34%

 Because g > k, the constant growth rate model

cannot be used. (We would get a value of -$6.34
per share)
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.
End of 2007 2008 (VL) 2008
(CSR)
Beginning BV per NA $6.50 $6.50
share
EPS $3.05 $3.45 $3.2788
DIV $.82 $.82 $2.7913
Ending BV per $6.50 $9.25 $6.9875
share
The McGraw-Hill Company Analysis
(Using the Residual Income Model, II)
EPS0  (1  g)  B 0  k
P0  B 0 
 Using the CSR assumption: kg

$3.05  (1  .075)  $6.50  .126

P0  $6.50 
Stock price at the time = $57.27. .126  .075
What can we say?
P0  $54.73.

 Using Value Line numbers for

EPS1=$3.45, B1=$9.25 EPS0  (1  g)  B 0  k
P0  B 0 
B0=$6.50; and using the actual kg
change in book value instead of
an estimate of the new book
value, (i.e., B1-B0 is = B0 x k) $3.45  ($9.25 - 6.50)
P0  $6.50 
.126  .075

P0  $20.23
The McGraw-Hill Company
Analysis, IV.