4 1 B40 2302 Class 2 BM6 chapters 4 5 6 Based on slides created by Matthew Will Modified 9 18 2001 by Jeffrey Wurgler Irwin McGraw Hill The McGraw Hill Companies Inc 200 Principles of Corporate Finance Brealey and Myers Sixth Edition The Value of Common Stocks Slides by Matthew Will Jeffrey Wurgler Irwin McGraw Hill Chapter 4 The McGraw Hill Companies Inc 200 4 3 Topics Covered How To Value Common Stock Capitalization Rates Stock Prices and EPS Cash Flows and the Value of a Business Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 4 Stocks Stock Market Common Stock Ownership shares in a publicly held corporation Secondary Market Market in which previously issued securities are traded Dividend Periodic cash distribution from the firm to the shareholders P E Ratio Price per share divided by earnings per share Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 5 Stocks Stock Market Book Value Net worth of the firm according to the balance sheet Liquidation Value Net proceeds that would be realized by selling liquidating all assets and paying off all creditors Market Value Balance Sheet Balance sheet that uses market value of assets and liabilities instead of the usual accounting value Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 6 Valuing Common Stocks Expected Return The percentage gain that an investor forecasts from a specific investment over a set period of time Sometimes called the market capitalization rate Div1 P1 P0 Expected Return r P0 Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 7 Valuing Common Stocks Expected return can be broken into two parts Dividend Yield Capital Appreciation Div1 P1 P0 Expected Return r P0 P0 Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 8 Valuing Common Stocks Dividend Discount Model Model of today s stock price which states that share value equals the present value of all expected future dividends Div1 Div2 Div H PH P0 1 2 H 1 r 1 r 1 r H Time horizon for your investment Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 9 Valuing Common Stocks Example Current forecasts are for XYZ Company to pay annual cash dividends of 3 3 24 and 3 50 per share over the next three years respectively At the end of three years you expect to sell your share at a market price of 94 48 What should be the price of a share today with a 12 expected return 3 00 3 24 3 50 94 48 PV 1 2 3 1 12 1 12 1 12 PV 75 00 P0 Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 10 Valuing Common Stocks No Growth DDM If we forecast no growth and plan to hold our stock indefinitely then we can value the stock as a perpetuity Div1 EPS1 Perpetuity PV P0 or r r Assumes all earnings are paid to shareholders So Div EPS each year No retentions no growth Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 11 Valuing Common Stocks Constant Growth DDM A version of the dividend growth model in which dividends grow at a constant rate g Div1 P0 r g When you use the growing perpetuity formula to value a stock you are using the Gordon Growth Model Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 12 Valuing Common Stocks Example If a stock is selling for 100 in the stock market what might the market be assuming about the growth rate of dividends 3 00 100 12 g g 09 Irwin McGraw Hill Answer The market is assuming the dividend will grow at 9 per year indefinitely The McGraw Hill Companies Inc 200 4 13 Valuing Common Stocks Example continued Suppose in the same example you knew g was 9 per year but didn t know r What is the market s estimate of r 3 00 100 r 09 r 12 Irwin McGraw Hill Answer The market has set r at 12 per year The McGraw Hill Companies Inc 200 4 14 Valuing Common Stocks If the board elects to pay a lower dividend and reinvest the remainder the stock price may increase because future dividends may be higher Payout Ratio Fraction of earnings paid out as dividends Plowback Ratio Fraction of earnings retained or plowed back into the firm Payout Ratio Plowback Ratio 1 Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 15 Valuing Common Stocks An accounting return measurement Return on Equity ROE EPS ROE Book Equity Per Share Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 16 Valuing Common Stocks Instead of asking an analyst growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations g Plowback Ratio x ROE Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 17 Valuing Common Stocks Example We forecast a 5 00 dividend next year which represents 100 of earnings This will provide investors with a 12 expected return Instead we decide to plow back 40 of the earnings at the firm s current accounting return on equity of 20 What is the value of the stock before and after the plowback decision No Growth Div EPS 5 P0 41 67 12 Irwin McGraw Hill With Growth Div EPS g 40 20 08 1 40 5 P0 75 00 12 08 The McGraw Hill Companies Inc 200 4 18 Valuing Common Stocks Example continued With the no growth policy the stock price is 41 67 With the plowback growth policy the price rose to 75 00 The difference between these two numbers 75 0041 67 33 33 is called the Present Value of Growth Opportunities PVGO Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 19 Valuing Common Stocks Present Value of Growth Opportunities PVGO Net present value of a firm s future investments Sustainable Growth Rate Steady rate at which a firm can grow without new external capital ROE x Plowback Ratio Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 20 EPS P E and share price Under a no growth policy Div EPS so EPS P0 r In general share price capitalized value of average earnings under no growth policy plus PVGO EPS P0 PVGO r Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 21 EPS P E and share price Rearranging EPS PVGO r 1 P0 P0 EPS P ratio underestimates r if PVGO 0 Growth stocks sell at high P E ratios because PVGO is high Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 22 FCF and PV Free Cash Flows FCF are the theoretical basis for all PV calculations FCF is more relevant than EPS FCFt cash inflowst cash outflowst PV firm PV FCF Irwin McGraw Hill The McGraw Hill Companies Inc 200 4 23 FCF and PV Valuing a Business The value of a business is often computed as the present value of FCF out to a valuation horizon H The value at H is sometimes called the terminal value or horizon value FCF1 FCF2 FCFH PVH PV 1 2 …