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o NPVGO model
o Comparables
o DCF model
9-1
Cash Flows to Stockholders
o If you buy a share of stock, you can receive
cash in two ways
n The company pays dividends
n You sell your shares, either to another investor in
the market or back to the company
9-3
Two Period Example
Now what if you decide to hold the stock for two years? In
addition to the dividend in one year, you expect a dividend of
2.10 in and a stock price of 14.70 at the end of year 2. Now
how much would you be willing to pay?
9-4
Three Period Example
Finally, what if you decide to hold the stock for three
periods? In addition to the dividends at the end of years 1 and
2, you expect to receive a dividend of 2.205 at the end of year
3 and a stock price of 15.435. Now how much would you be
willing to pay?
9-5
The PV of Common Stocks
o The value of any asset is the present value of its
expected future cash flows.
9-6
Developing The Model
o You could continue to push back when you
would sell the stock
o You would find that the price of the stock is
really just the present value of all expected
future dividends
o So, how can we estimate all future dividend
payments?
9-7
Dividend discount model
H
Divt PH
P0 = ∑ t
+
t =1 (1 + R ) (1 + R) H
9-8
Dividend discount model
Example
Fledgling Electronics is forecasted to pay a Rs.5.00 dividend
at the end of year one and a Rs.5.50 dividend at the end of
year two. At the end of the second year the stock will be sold
for Rs.121. If the discount rate is 15%, what is the price of
the stock?
9-9
Dividend discount model
Example
Fledgling Electronics is forecasted to pay a Rs.5.00 dividend
at the end of year one and a Rs.5.50 dividend at the end of
year two. At the end of the second year the stock will be sold
for Rs.121. If the discount rate is 15%, what is the price of
the stock?
5.00 5.50 + 121
PV = 1
+
(1 + .15) (1 + .15) 2
PV = Rs.100.00
9-10
Dividend discount model
9-11
Dividend discount model
9-12
How Common Stocks Are Valued
9-13
Stock perpetuity, R=15%, g=5%
Expected Future Values Present Values
Price Cumulative
Horizon Period (H) Dividend (DIVt ) Future Price Total
(Pt ) Dividends
9-14
Valuation of different types of stocks
n Zero Growth
n Constant Growth
n Differential Growth
9-15
Case 1: Zero Growth
o Assume that dividends will remain at the same level
forever
Div 1 = Div 2 = Div 3 = !
• Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:
9-18
Case 3: Differential Growth
o Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
o To value a Differential Growth Stock, we need
to:
n Estimate future dividends in the foreseeable future.
n Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
n Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate. 9-19
PV of a stock
DivH +1
PH =
R−g
9-20
PV of a stock
9-21
PV of a stock
= 9.13
9-22
Can be treated as growing annuity too…..
• Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.
Div 1 = Div 0 (1 + g1 )
Div 2 = Div 1 (1 + g 1 ) = Div 0 (1 + g 1 ) 2
..
.
Div N = Div N −1 (1 + g 1 ) = Div 0 (1 + g 1 ) N
Div 0 (1 + g 1 ) Div 0 (1 + g 1 ) 2
…
0 1 2
Div N (1 + g 2 )
Div 0 (1 + g 1 ) N = Div 0 (1 + g1 ) N (1 + g 2 )
… …
N N+1 9-24
Case 3: Differential Growth
We can value this as the sum of:
§ a T-year annuity growing at rate g1
T
C ⎡ (1 + g1 ) ⎤
PA = ⎢1 − T ⎥
R − g1 ⎣ (1 + R ) ⎦
§ plus the discounted value of a perpetuity growing at
rate g2 that starts in year T+1
⎛ Div T +1 ⎞
⎜⎜ ⎟⎟
⎝ R − g2 ⎠
PB = T
(1 + R ) 9-25
Case 3: Differential Growth
Consolidating gives:
⎛ Div T +1 ⎞
⎜ ⎟
C ⎡ (1 + g1 )T ⎤ ⎜⎝ R − g 2 ⎟⎠
P= ⎢1 − T ⎥
+ T
R − g1 ⎣ (1 + R ) ⎦ (1 + R )
9-26
A Differential Growth Example
A 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%.
9-27
With the Formula
⎛ $2(1.08) 3 (1.04) ⎞
⎜ ⎟
$2 × (1.08) ⎡ (1.08) 3 ⎤ ⎜⎝ .12 − .04 ⎟
⎠
P= ⎢1 − 3⎥
+ 3
.12 − .08 ⎣ (1.12) ⎦ (1.12)
P = $54 × [1 − .8966 ] +
($32.75 )
3
(1.12)
P = $ 5 . 58 + $ 23 . 31 P = $ 28 .89
9-28
With Cash Flows
$ 2(1 .08) $ 2(1 .08) 2 $ 2(1 .08) 3 $ 2(1 .08) 3 (1 .04 )
…
0 1 2 3 4
$2.62 The constant
$ 2 .16 $ 2 .33 $2.52 + growth phase
.12 − .04 beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$2 .16 $ 2.33 $ 2.52 + $ 32 .75
P0 = + 2
+ 3
= $28 .89
1.12 (1 .12 ) (1 .12 ) $2 .62
P3 = = $32 .75
.08 9-29
To summarize
9-30
Estimates of Parameters
o The value of a firm depends upon its growth
rate, g, and its discount rate, R.
n Wheredoes g come from?
g = Retention ratio × Return on retained earnings
9-31
‘g’
o Stable growth rate – This is a growth rate that a
and cashflows.
D1 = $2; R= 20%
9-33
Stock Price Sensitivity to Required Return, R
250
D1 = $2; g = 5%
200
Stock Price
150
100
50
0
0 0.05 0.1 0.15 0.2 0.25 0.3
r
9-34
Where does R come from
D 0 (1 + g) D1
P0 = =
R -g R -g
Rearrange and solve for R:
D 0 (1 + g) D1
R= +g= +g
P0 P0
9-35
Hence……
o The discount rate can be broken into two parts.
9-38
NPVGO model contd…
o Suppose the firm invest in positive NPV projects.
9-40
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a Rs.8.33
dividend next year, which represents 100%
of its earnings. This will provide investors
with a 15% expected return. Instead, we
decide to plowback 40% of the earnings at
the firm’s current return on equity of 25%.
What is the value of the stock before and
after the plowback decision?
9-41
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a Rs.8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plowback 40% of the
earnings at the firm’s current return on equity of 25%. What is the
value of the stock before and after the plowback decision?
9-42
Stock Price and Earnings Per Share
Example - continued
If the company did not plowback some earnings, the stock
price would remain at Rs.55.56. With the plowback, the
price rose to Rs.100.00.
9-43
Intrinsic Value and Market Price
o Intrinsic Value
n Self assigned Value
n Variety of models are used for estimation
o Market Price
n Consensus value of all potential traders
o Trading Signal
n IV > MP Buy
n IV < MP Sell or Short Sell
n IV = MP Hold or Fairly Priced
9-44
Comparing the Valuation Models
o In practice
n Values from various models may differ
n Analysts are always forced to make
simplifying assumptions
9-45
Comparables
o Comparables are used to value companies based
primarily on multiples.
o Common multiples include:
§ Price-to-Earnings
§ Price to Book Value
9-46
Price-Earnings Ratio
o The price-earnings ratio is calculated as the current
stock price divided by annual EPS.
9-47
PE and NPVGO
EPS
o Recall, P= + NPVGO
R
o Dividing every term by EPS provides the following description
of the PE ratio:
1 NPVGO
PE = +
R EPS
o So, a firm’s PE ratio is positively related to growth
opportunities and negatively related to risk (R)
9-48
Price Earnings Ratios
9-49
P/E Ratio: Constant Growth
D1 E 1 (1− b )
P0 = =
k − g k − (b × ROE )
P0 1− b
=
E 1 k − (b × ROE )
b = retention ratio
ROE = Return on Equity
9-50
Compute P/E Ratio
o Retention ratio(b)=60%
o ROE = 15%
o K=12.5%
o Previous years Earnings = Rs 2.5
9-51
Numerical Example: Growth
9-52
Effect of ROE and Ploughback on Growth and
the P/E Ratio
9-53
P/E Ratios and Stock Risk
9-54
Why would investors pay high price earning
multiple for a company?
o There are two key drivers of higher Price/
Earnings ratios, namely:
n Future growth prospects of company (& industry)
The future earnings of the company are expected to
be high due to the future growth potential.
n Perceived risk of company (or industry)
Shares that are considered lower risk usually offer a
higher Price/Earnings ratio. This is due to the
security they provide.
n Forward P/E vs. trailing P/E
9-55
PE Ratios from India(as on 30th August,
2019)
Companies PE Ratio
Ashok Leyland 12.07
HPCL 6.57
Asian Paints 72.57
ICICI Bank 78.67
Motilal Oswal Financial Services 26.08
Infosys 24.14
Larsen & Toubro 27.90
Pidilite 71.48
Nestle 77.10
Page Industries 52.90
9-56
Earning and Earnings Multiples
9-57
Problem1
o ABC is a young start up company. No
dividends are paid on the stock over the next
nine years, because the firm needs to plow
back its earnings to fuel growth. The company
will pay its first dividend of Rs 15 per share
dividend in the 10th year and will increase the
dividend by 5.5% per year thereafter. If the
required rate of return on this stock is 13%,
what is the current share price?
9-58
Problem2
A company is growing quickly. Dividends are
expected to grow at a rate of 20% for the next
three years, with the growth rate falling off to
a constant 5% thereafter. If the required rate
of return is 12% and the company just paid a
Rs 2.80 dividend, what is the current share
price?
9-59
Problem3
A company is experiencing rapid growth.
Dividends are expected to grow at 30% during
the next three years, 18% over the following
year, and then 8% per year indefinitely. The
required return on the stock is 11%, and the
stock currently sells for Rs 65 per share. What
is the projected dividend for the coming year?
9-60
Problem 4
ABC co. earned 18 million for the fiscal year ending
yesterday. The payout ratio of the firm is 30%. The firm
will continue to pay 30% of its earnings as annual, end-
of-year dividends. The remaining 70% of earnings is
retained by the company for use in projects. The
company has 2 million shares of common stock
outstanding. The current stock price is Rs 93. The
historical return ROE of 13% is expected to continue in
the future. What is the required rate of return on the
stock?
9-61