PowerPoint PresentationKey Concepts and SkillsChapter Outline6.1 The PV of Common StocksCase 1: Zero GrowthZero Growth ExampleCase 2: Constant GrowthConstant Growth ExampleA Word About Dividends in the Constant Growth ModelCase 3: Differential GrowthGraphic: Differential Dividend GrowthSlide 12Slide 13Slide 14Slide 15A Differential Growth ExampleWith the FormulaWith Cash Flows6.2 Estimates of ParametersWhere Does R Come From?Using the DGM to Find RExample: Using DGM to Find RTotal PayoutExample: Total Payout Valuation6.3 ComparablesPrice-Earnings RatioPE and NPVGOEnterprise Value Ratios6.5 Features of Common StockFeatures of Preferred Stock6.6 The Stock MarketsNASDAQStock Market ReportingQuick Quiz6-1STOCK VALUATIONChapter 6Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.6-2KEY CONCEPTS AND SKILLS•Comprehend that stock prices depend on future dividends and dividend growth•Compute stock prices using the dividend growth model•Understand how growth opportunities affect stock values•Appreciate the PE ratio•Know how stock markets work6-3CHAPTER OUTLINE6.1 The Present Value of Common Stocks6.2 Estimates of Parameters in the Dividend Discount Model6.3 Comparables6.4 Valuing Stocks Using Free Cash Flows6.5 Some Features of Common and Preferred Stocks6.6 The Stock Markets6-46.1 THE PV OF COMMON STOCKS•The value of any asset is the present value of its expected future cash flows.•Stock ownership produces cash flows from: •Dividends •Capital Gains•Valuation of Different Types of Stocks•Zero Growth•Constant Growth•Differential Growth6-5CASE 1: ZERO GROWTH•Assume that dividends will remain at the same level foreverRPRRRPDiv)1(Div)1(Div)1(Div03322110 321DivDivDiv-Since future cash flows are constant, the value of a zero growth stock is the present value of a perpetuity:6-6ZERO GROWTH EXAMPLE•Suppose Big Deal Company will pay an annual dividend of $2.00 per common share that will never increase or decrease. •The market rate of return is 8.5%. •What is the maximum amount you should be willing pay for a common share of Big Deal Corporation? •Formula for Zero Growth Model: P = Div / R•Solution: P = $2.00 / .085 P = $23.536-7CASE 2: CONSTANT GROWTH)1(DivDiv01gSince future cash flows grow at a constant rate forever, the value of a constant growth stock is the present value of a growing perpetuity:gRP10DivAssume that dividends will grow at a constant rate, g, forever, i.e., 2012)1(Div)1(DivDiv gg 3023)1(Div)1(DivDiv gg ...6-8CONSTANT GROWTH EXAMPLE•Suppose Big D, Inc., just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk level, how much should the stock be selling for?•P0 = .50(1+.02) / (.15 - .02) = $3.926-9A WORD ABOUT DIVIDENDS IN THE CONSTANT GROWTH MODEL•It is critical to understand that in the constant growth model, calculations are based on the next dividend•If a situation only provides information on the last dividend it must be increased by the growth rate to arrive at the next dividend•If a situation provides the value of the next dividend, then the data necessary for the calculation is known and need not be derived.•An analyst must discriminate whether they have information about the next or last dividend and proceed with calculation accordingly6-10CASE 3: DIFFERENTIAL GROWTH•Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter.•To value a Differential Growth Stock, we need to:•Estimate future dividends in the foreseeable future.•Estimate the future stock price when the stock becomes a Constant Growth Stock (case 2).•Compute the total present value of the estimated future dividends and future stock price at the appropriate discount rate.6-11GRAPHIC: DIFFERENTIAL DIVIDEND GROWTH•This graph demonstrates the dividend profile for a company with differential growth6-12CASE 3: DIFFERENTIAL GROWTH)(1DivDiv101g-Assume that dividends will grow at rate g1 for N years and grow at rate g2 thereafter. 210112)(1Div)(1DivDiv gg NNNgg )(1Div)(1DivDiv1011)(1)(1Div)(1DivDiv21021gggNNN......6-13CASE 3: DIFFERENTIAL GROWTH)(1Div10gDividends will grow at rate g1 for N years and grow at rate g2 thereafter 210)(1Div gNg )(1Div10)(1)(1Div)(1Div2102gggNN…0 1 2…N N+1…6-14CASE 3: DIFFERENTIAL GROWTHWe can value this as the sum of: a T-year annuity growing at rate g1TTARggRCP)1()1(111plus the discounted value of a perpetuity growing at rate g2 that starts in year T+1TBRgRP)1(Div21T6-15CASE 3: DIFFERENTIAL GROWTHConsolidating gives:TTTRgRRggRCP)1(Div)1()1(121T11Or, we can “cash flow” it out.6-16A DIFFERENTIAL GROWTH EXAMPLEA common stock just paid a dividend of $2. The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in perpetuity. What is the stock worth? The discount rate is 12%.6-17WITH THE FORMULA3333)12.1(04.12.)04.1()08.1(2$)12.1()08.1(108.12.)08.1(2$P  3)12.1(75.32$8966.154$ P31.23$58.5$ P89.28$P6-186-18WITH CASH FLOWS08).2(1$208).2(1$…0 1 2 3 4308).2(1$)04.1(08).2(1$316.2$33.2$0 1 2 308.62.2$52.2$ 89.28$)12.1(75.32$52.2$)12.1(33.2$12.116.2$320P75.32$08.62.2$3PThe constant growth phase beginning in year 4 can be valued as a growing perpetuity at time 3.6-196.2 ESTIMATES OF PARAMETERS•The value of a firm depends upon its growth rate, g, and its discount rate, R. •Where does g come from?g = Retention ratio × Return on retained earnings•Example: Suppose a company has a retention ratio of 70% and earns an ROE of 12%. What is the Growth Rate, g?•g = .70 X .12•g = .084 = 8.4%6-20WHERE DOES R COME FROM?•The discount rate can be broken into two parts: •The dividend yield •The growth rate (in dividends)•AKA: Capital Gains Yield•In practice, there is a great deal of estimation error involved in selecting R.•Cases calling for special skepticism:•Stocks not paying dividends•Stocks with g