Stocks and their valuation

common stock

represents ownership

common stock

ownership implies control

common stock

stockholders elect directors

common stock

directors elect management

management’s goal common stock

maximize the shareholder value

outside investors, corporate insiders, and analysts use a variety of approaches to estimate

a stock’s intrinsic value (P0)

in equilibrium we assume that a stock’s price equals

its intrinsic value

outsiders estimate intrinsic value to help determine

which stocks are attractive to buy and/or sell

stocks with a price below its intrinsic value are

undervalued

stocks with a price above its intrinsic value are

overvalued

valuation approach

discount cash flow valuation

valuation approach

relative valuation (valuation using multiples of comparable firms)

type of discount cash flow valuation

discount dividend model (DDM)

type of discount cash flow valuation

free cash flow model = corporate valuation model

the value of any asset is

the present value of future cash flows generated by the asset

discounted cash flow valuation key principal

asset is valuable only to the extent it generates cash flows

discounted cash flow valuation key principal

the timing of cash flows matters (cash received sooner is better)

discounted cash flow valuation key principal

investors are risk averse and therefore require premium for risk

when valuing firms, in most cases one is interested in the value of equity. there are two ways to find it

discount dividend model and free cash flow model

first way to find value of equity

find cash flow to equity holders and discount them at the cost of equity (DDM)

second way to find value of equity

find cash flows to entire firm (both equity and debt holders) and discount them at the WACC. subtract the value of debt to get the value of equity (free cash flow model)

discount dividend model cash flows to equity holders:

dividends (ALL: both current & future) and price investors receive when they sell the stock

Rs (= rate of return on stock i = cost of equity)

required rate of return calculated using capital asset pricing model (CAPM)

RPM

market risk premia

RM

rate of return on the market

RM - rRF

market risk premia

if dividends grow at a constant rate g

then the formula has a very simple closed form mathematical solution

if the markets are in equilibrium, required rate of return (rs) is equal to

the expected rate of return (r^ s)

expected dividend yield

D1/P0

expected growth rate or capital gains yield

g

problem with constant growth model

only applicable to established, stable companies which pay dividends (like GE), some companies don’t pay dividends at all (Microsoft)

problem with constant growth model

only works if assumption of constant growth is reasonable, again, better suited to mature companies

discount dividend model non-constant growth

most firms, especially start-ups, do not grow at a constant growth rate

discount dividend model non-constant growth, for each company

it is realistic to assume that it will grow at a constant growth rate at some point in time N, assumption allows us to use constant growth formula to find the value of the tail of the timeline (terminal value)

terminal value is

only way to deal with infinity in general formula

what is terminal value

the stock price at time N, when the constant growth starts

how to estimate growth rate

estimate past growth rate in dividend and make necessary assumptions about projecting it into the future, can you expect same (better/worse) performance

how to estimate growth rate

use analyst estimate of the future growth rate (Bloomberg, Value Line, Morning Star, Thompson One, Yahoo)

how to estimate growth rate

use a formula g=ROE*retention ratio

constant growth rate can not be

higher than the expected growth rate of the economy

high growth firms

low dividend payout ratio

high growth firms

beta greater than one

high growth firms

high net capital expenditures

high growth firms

low leverage

high growth firms

high return on capital

stable growth firms

high dividend payout ratio

stable growth firms

average beta

stable growth firms

low net capital expenditures

stable growth firms

high leverage

stable growth firms

low return on capital (close to cost of capital)

how long will high growth persist? answer will depend on

size of the company, larger firms will have shorter high growth period

how long will high growth persist? answer will depend on

current growth rate, higher current growth rate - longer projected high growth period

how long will high growth persist? answer will depend on

competitive advantage, patterns, brand recognition and other differentiation, barrier to entry

preferred stock

hybrid security

preferred stock

like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders

preferred stock

companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy

Vp

what dividend sells for

rp

preferred stock expected return

DDM calculation example Harley-Davidson step 1

calculate expected growth rate using payout ratio

DDM calculation example Harley-Davidson step 2

calculate cost of equity using CAPM to estimate cost of capital

DDM calculation example Harley-Davidson step 3

use dividend at end of 5 years for terminal value, use growth rate that drops to after g in formula

DDM calculation example Harley-Davidson step 4

calculate stock price

DDM calculation example Harley-Davidson step 5

add stock price and terminal value to find what stock traded at

why is our estimate so far off?

estimation is not a science, different assumptions will yield different results, you need to conduct as much research as possible to justify your assumptions

calculating numbers for terminal value

previous dividend * (1 + growth rate)