Valuing Stocks

Chapter 9, BDH
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Chapter Outline
9.1 Stock Basics
9.2 The Dividend-Discount Model
9.3 Estimating Dividends in the Dividend-
Discount Model
9.4 Total Payout and Free Cash Flow Valuation
Models
9.5 Valuation Based on Comparable Firms
9.6 Information, Competition, and Stock Prices
1
Learning Objectives
Understand the features of common stock
Value a stock as the present value of its expected future
dividends
Understand the tradeoff between dividends and growth
in stock valuation
Value a stock as the present value of either the
companys total payout or its free cash flows
Value a stock by applying common multiples based on
the values of comparable firms
Compare and contrast different approaches to valuing a
stock
Understand how information is incorporated into stock
prices through competition in efficient markets
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9.1 Stock Basics
Features of common stock (ordinary share)
investment with limited liability
a share of ownership in the corporation
gives its owner rights to vote on company
matters or other major events
carries the right to share in the profits of the
corporation through dividend payments
residual claims on firms net assets
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9.2 The Dividend-Discount Model
Intuitions
A One Year Investor
Dividend Yields, Capital Gains, and Total
Returns
Multiyear Investor and Dividend-Discount
Model Equation
The Dividend-Discount Model Equation
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A One-Year Investor
Two Potential Sources of Cash Flows from
Stock
The firm might pay out cash to its shareholders in
the form of a dividend
The investor might generate cash by selling the
shares at some future date (resulting in capital
gain/loss)
Total Cash Inflows
Dividends expected to be received during
investment period
Expected selling price of shares at end of holding
period
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Dividend Yields, Capital Gains, and
Total Returns
Total Return
Sum of the dividend yield and the capital gain rate
Dividend Yield
Expected annual dividend divided by its current
price.
Capital Gain
Difference between the expected sale price and the
original purchase price for the stock
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Dividend Yields, Capital Gains, and
Total Returns
The total return of a stock should also be equal
its equity cost of capital.
The expected total return of the stock should
equal the expected return of other investments
available in the market with equivalent risk.
1 0 1 1 1
0 0 0
Dividend Yield
Capital Gain Rate
1
E
P P Div P Div
r
P P P
+
= = +
Total Return Eq.(9.2)
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Equity Cost of Capital r
E
the expected
return of other investments available in the
market with equivalent risk to the firms share.
From a share return perspective,
If expected stock return exceeds equity cost of
capital, it would be a positive NPV investment. If
expected stock return is less than r
E
, it would
produce a negative NPV.
Equity Cost of Capital and Share
Investment
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From a share price perspective,
If current stock prices are less than the stock price
meeting the equity cost of capital, it would be a
positive NPV investment. Current stock price would
quickly rise.
If current stock price exceeds this amount, selling it
would produce a negative NPV. Current stock price
would quickly fall.
Equity Cost of Capital and Stock
Investment
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Example 9.1 Stock Prices and Returns
Problem:
Suppose you expect Longs Drug Stores to:
Pay an annual dividend of $.56 per share in the
coming year
Trade $45.50 per share at the end of the year
If investments with equivalent risk to Longs
stock have an expected return of 6.80%,
What is the most you would pay today for Longs
stock?
What dividend yield and capital gain rate would you
expect at this price?
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Execute:
Referring to Eq. 9.2 we see that at this price,
Dividend yield is 0.56/43.13 = 1.30%.
Expected capital gain is ($45.50-$43.13)/43.13 = 5.50%.
Expected total return is 1.30% + 5.50% = 6.80%
1 1
0
0.56 45.50
$43.13
1 1.0680
E
Div P
P
r
+ +
= = =
+
Example 9.1 Stock Prices and Returns
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Evaluate:
At a price of $43.13, Longs expected total
return is equal to its equity cost of capital.
This amount is the most we would be willing
to pay for Longs stock.
If we paid more, our expected return would be
less than 6.8%and we would rather invest
elsewhere.
Example 9.1 Stock Prices and Returns
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A Multiyear Investor
Extending the intuition to a multiyear investor
Suppose we planned to hold the stock for two
years. We would receive:
Suppose the next buyers at year 2 planned to
hold the stock also for two years, they would
receive:
0 1 2
-P
0
Div
1
Div
2
+P
2
2 3 4
-P
2
Div
3
Div
4
+P
4
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Dividend-Discount Model
The process continues (forever) and we
expressing all prices in terms of subsequent
dividends.
The current price of a stock should be equal to
the present value of all expected future
dividends it will pay.
(Eq. 9.5)
( ) ( )
3 1 2
0
2 3
1
1 1
E
E E
Div Div Div
P
r
r r
= + + +
+
+ +
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Dividend-Discount Model
But how do we know what future dividends are?
Pattern of dividend payments over time is a
matter of dividend policy
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9.3 Estimating Dividends in the
Dividend-Discount Model
Constant Dividend
Constant Dividend Growth
Dividends Versus Investment and Growth
Changing Growth Rate
Limitations of Dividend-Discount Model
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Constant Dividend Model
Dividends remain constant forever.
(Eq. 9.5)
( ) ( )
3 1 2
0
2 3
1
1 1
E
E E
Div Div Div
P
r
r r
= + + +
+
+ +
E
0
r
Div
P =
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Constant Dividend Growth Model
Dividends will grow at a constant rate, g,
forever.
The value of the firm depends on the dividend
level of next year, divided by the equity cost of
capital adjusted by the growth rate.
(Eq. 9.6)
1
0
E
Div
P
r g
=

(Eq. 9.5)
( ) ( )
3 1 2
0
2 3
1
1 1
E
E E
Div Div Div
P
r
r r
= + + +
+
+ +
Or
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g r
g Div
P

+
=
E
0
0
) 1 (
Example 9.2 Valuing a Firm with
Constant Dividend Growth
Problem:
Consolidated Edison, Inc. (Con Edison), is a
regulated utility company that services the
New York City area.
Suppose Con Edison plans to pay $2.30 per
share in dividends in the coming year. If its
equity cost of capital is 7%and dividends are
expected to grow by 2%per year in the future,
estimate the value of Con Edisons stock.
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Example 9.2 Valuing a Firm with
Constant Dividend Growth
Execute:
Evaluate:
You would be willing to pay 20 times this
years dividend of $2.30 to own Con Edison
stock because you are buying claim to this
years dividend and to an infinite growing
series of future dividends.
1
0
$2.30
$46.00
0.07 0.02
E
Div
P
r g
= = =

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Constant Dividend Growth Model
For another interpretation of Eq. 9.6, note that we can
rearrange it as follows:
The firms dividend each year is equal to the firms
earnings per share (EPS) multiplied by its dividend
payout rate.
The firms EPS can also be expressed as earnings for the
year divided the number of shares outstanding (i.e.
issued).
(Eq. 9.7)
1
0
E
Div
r g
P
= +
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Dividend and Dividend Payout Rate
Therefore, we have (Eq.9.8):
The firm can increase dividends in three ways:
1. Increase its earnings (net income)
2. Increase its dividend payout rate
3. Decrease its number of shares outstanding
Earnings
Dividend Payout Rate
Shares Outstanding
t
t
t t
t
Eps
Div =
22
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A Simple Model of Growth
Consider dividends grow as a result of
earnings growth.
If all increases in future earnings result
exclusively from new investment made with
retained earnings, then:
(Eq. 9.9)
Change in
Earnings
=
New
Investments

Return on New
Investments (RONI)
Earnings Retention Rate
(Eq. 9.10)
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Retention Rate
New investment equals the firms earnings
multiplied by its retention rate, or the fraction
of current earnings that the firm retains:
(Eq. 9.10)
New Investment Earnings Retention Rate =
24
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A Simple Model of Growth
Substituting Eq. 9.10 into Eq. 9.9:
Dividing by earnings gives an expression for
the growth rate of earnings
(Eq. 9.11)
Change in
Earnings
=
New
Investments

Return on New
Investments
Earnings Retention Rate RONI
Earnings Growth Rate = Retention Rate RONI
25
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A Simple Model of Growth
If the firm chooses to keep its dividend payout
rate constant, then the growth in its dividends
will equal the growth in its earnings, which
equals:
(Eq. 9.12)
Retention Rate Return on New Investment g =
26
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Example 9.3 Cutting Dividends for
Profitable Growth
Problem:
Crane Sporting Goods expects to have earnings
per share of $6 in the coming year.
Rather than reinvest these earnings and grow,
the firm plans to pay out all of its earnings as a
dividend.
With these expectations of no growth, Cranes
current share price is $60.
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Example 9.3 Cutting Dividends for
Profitable Growth
Problem (cont'd):
Suppose Crane could cut its dividend payout rate to
75%for the foreseeable future and use the retained
earnings to open new stores.
The return on investment in these stores is expected
to be 12%.
If we assume that the risk of these new investments is
the same as the risk of its existing investments, then
the firms equity cost of capital is unchanged.
What effect would this new policy have on Cranes
stock price?
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Example 9.3 Cutting Dividends for
Profitable Growth
Execute:
Using Eq. 9.7 to estimate r
E
we have
In other words, to justify Cranes stock price
under its current policy, the expected return of
other stocks in the market with equivalent risk
must be 10%.
1
0
10% 0% 10%
E
Div
r g
P
= + = + =
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Example 9.3 Cutting Dividends for
Profitable Growth
Execute (contd):
Under the new policy, Crane reduces its
dividend payout rate to 75%, then from Eq. 9.8
Div
1
= EPS
1
75% = $6 75% = $4.50
As the firm will now retain 25% of its earnings
to invest in new stores, from Eq. 9.12 its
growth rate will increase to
g = 25% 12% = 3%
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Example 9.3 Cutting Dividends for
Profitable Growth
Execute (contd):
Assuming Crane can continue to grow at this
rate, we can compute its share price under the
new policy using the constant dividend growth
model of Eq. 9.6
1
0
$4.50
$64.29
0.10 0.03
E
Div
P
r g
= = =

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Example 9.3 Cutting Dividends for
Profitable Growth
Evaluate:
Cranes share price should rise from $60 to
$64.29 if the company cuts its dividend in
order to increase its investment and growth,
implying that the investment has positive NPV.
By using its earnings to invest in projects that
offer a rate of return (12%) greater than its
equity cost of capital (10%), Crane has created
value for its shareholders.
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Changing Growth Rates
Specifically, if the firm is expected to grow at a
long-term rate g after year N + 1, then from the
constant dividend growth model:
(Eq. 9.13)
1 N
N
E
Div
P
r g
+
=

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Example 9.4 Unprofitable Growth
Problem:
Suppose Crane Supporting Goods decides to cut its
dividend payout rate to 75% to invest in new stores, as
in Example 9.3.
But now suppose that the return on these new
investments is 8%, rather than 12%.
Given its expected earnings per share this year of $6
and its equity cost of capital of 10%(we again assume
that the risk of the new investments is the same as its
existing investments), what will happen to Cranes
current share price in this case?
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Example 9.4 Unprofitable Growth
Execute:
As in Example 9.3, Cranes dividend will fall to
$6 75% = $4.50.
Under the new policy, given the lower return
on new investment,
g = 25% 8% = 2%
The new share price is therefore
1
0
$4.50
$56.25
.10 .02
E
Div
P
r g
= = =

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Example 9.4 Unprofitable Growth
Evaluate:
Even though Crane will grow under the new
policy, the new investments have a negative
NPV.
The companys share price will fall if it cuts its
dividend to make new investments with a
return of only 8%.
By reinvesting its earnings at a rate (8%) that
is lower than its equity cost of capital (10%),
Crane has reduced shareholder value. 36
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Changing Growth Rates and Limitations
of Dividend-Discount Model
For successful young firms, we cannot use the
constant dividend growth model to value the
stock of such a firm for two reasons:
These firms often pay no dividends when they are
young
Their growth rate continues to change over time
until they mature
There is great uncertainty associated with any
forecast of a firms future dividends in
relationship to the Dividend-Discount Model
37
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Example 9.5 Valuing a Firm with
Two Different Growth Rates
Problem:
Small Fry, Inc., has just invented a potato chip that looks and
tastes like a french fry.
Given the phenomenal market response to this product, Small Fry
is reinvesting all of its earnings to expand its operations.
Earnings were $2 per share this past year and are expected to
grow at a rate of 20%per year until the end of year 4. At that
point, other companies are likely to bring out competing
products.
Analysts project that at the end of year 4, Small Fry will cut its
investment and begin paying 60%of its earnings and dividends.
Its growth will also slow to a long-run rate of 4%.
If Small Frys equity cost of capital is 8%, what is the value of a
share today?
38
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Example 9.5 Valuing a Firm with
Two Different Growth Rates
Execute:
The following spreadsheet projects Small Frys
earnings and dividends:
39
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Example 9.5 Valuing a Firm with
Two Different Growth Rates
Execute:
The following spreadsheet projects Small Frys
earnings and dividends:
0 1 2 3 4 5 6
EPS
20% 20% 20% 20% 4% 4% 4% g(EPS)
Payout rate
Dividend
4% 4% 4%
g(Div)
40
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2.00 2.40 2.88 3.46 4.15 4.31 4.49
0% 60% 60% 60% 0% 0%
0 2.49 2.59 2.69 0
0
Example 9.5 Valuing a Firm with
Two Different Growth Rates
Execute (contd):
From year 4 onward, Small Frys dividends will grow at the
expected long-run rate of 4% per year.
Given its equity cost of capital of 8%,
We then apply the dividend discount model (Eq. 9.4) with
this terminal value:
4
3
$2.49
$62.25
0.08 0.04
E
Div
P
r g
= = =

42 . 49 $
08 . 1
25 . 62 $
08 . 1
0
08 . 1
0
08 . 0 1
0
) 1 ( ) 1 ( ) 1 ( 1
3 3 2
3
3
3
3
2
2 1
0
= + + +
+
=
+
+
+
+
+
+
+
=
E E E E
r
P
r
Div
r
Div
r
Div
P
41
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Example 9.5 Valuing a Firm with
Two Different Growth Rates
Evaluate:
The dividend-discount model is flexible
enough to handle any forecasted pattern of
dividends...
42
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9.4 Total Payout and Free Cash Flow
Valuation Models
Share Repurchases and the Total Payout Model
The Discounted Free Cash Flow Model
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43
Share Repurchases and the Total
Payout Model
The dividend-discount model takes the perspective of a
single shareholder, where:
P
0
= PV (Future Dividends per Share) (Eq.9.14)
When firm repurchases shares, less dividends can be
paid and share count is decreased. Total Payout Model
can be more reliable.
Total Payout Model values all of the firms equity, when
the firm also repurchases shares
( )
0
0
Future Total Dividends and Repurchases
Shares Outstanding
PV
P =
(Eq. 9.14)
44
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Example 9.6 Valuation with Share
Repurchases
Problem:
Titan Industries has 217 million share outstanding
and expects earnings at the end of this year of $860
million.
Titan plans to pay out 50%of its earnings in total,
paying 30%as a dividend and using 20% to
repurchase shares.
If Titans earnings are expected to grow by 7.5% per
year and these payout rates remain constant,
determine Titans share price assuming an equity cost
of capital of 10%.
45
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Execute:
Titan will have total payouts this year of 50% $860 million =
$430 million. Using the constant growth perpetuity formula, we
have
PV (Future Total Payout) =
This present value represents the total value of Titans equity (i.e.
its market capitalization). To compute the share price, we divide
by the current number of shares outstanding:
Example 9.6 Valuation with Share
Repurchases
bn 2 . 17 $
075 . 0 10 . 0
million 430 $
=

26 . 79 $
shares million 217
billion 2 . 17 $
0
= = P
46
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Evaluate:
Using the total payout method, we did not need to know
the firms split between dividends and share repurchases.
To compare this method with the dividend-discount model,
note that Titan will pay a dividend of 30% $860
million/(217 million shares) = 1.19 per share, for a
dividend yield of 1.19/79.26 = 1.50%.
From Eq. 9.7, Titans expected EPS, dividend, and share
price growth rate g = r
E
Div
1
/P
0
= 8.50%. This growth
rate exceeds the 7.50% growth rate of earnings because
Titans share count will decline over time owing to its share
repurchases.
Example 9.6 Valuation with Share
Repurchases
47
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Discounted Free Cash Flow Model
The Discounted Free Cash Flow Model focuses on the cash
flows to all of the firms investors, both debt and equity
holders.
That is,
V
0
= Market Value of Equity + Debt Cash* (Eq. 9.16)
(i.e. unlevered value of the business)
* Cash invested at a competitive market interest rate
Free Cash Flow (FCF)
FCF = EBIT(1 t) + Dep
n
Cap Exp Inc in NWC (Eq. 9.17)
Enterprise Value (V
0
)
V
0
= PV(Future Free Cash Flow of Firm) (Eq.9.18)
48
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Discounted Free Cash Flow Model
To estimate Enterprise Value,
By using Eq. 9.16, we can estimate the share price as
(Eq.9.19)
0
0 0 0
0
ding tan Outs Shares
Debt Cash +
=
V
P
49
N
WACC
N
N
WACC
N
WACC WACC
r
V
r
FCF
r
FCF
r
FCF
V
) 1 ( ) 1 (
...
) 1 ( 1
2
2 1
0
+
+
+
+ +
+
+
+
=
FCF WACC
FCF N
FCF WACC
N
N
g r
g FCF
g r
FCF
V

+
=

=
+
) 1 (
1
(Eq.9.20) & (Eq.9.21)
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Example 9.7 Valuing KCP Stock
Using Free Cash Flow
50
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51
Example 9.7 Valuing KCP Stock
Using Free Cash Flow
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52
Example 9.7 Valuing KCP Stock
Using Free Cash Flow
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Figure 9.3 A Comparison of Discounted
Cash Flow Models of Stock Valuation
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9.5 Valuation Based on Comparable
Firms
Method of Comparables
Estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate
very similar cash flows in the future.
Valuation Multiples
To adjust for differences in scale between firms by expressing
their values as a ratio to some measure of the firms scale, e.g.
P/E ratio
Trailing earnings and trailing P/E (using earnings over the
prior 12 months
Forward Earnings and forward P/E (using expected earnings
over the coming 12 months)
54
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9.5 Valuation Based on Comparable
Firms
Forward P/E =
P
0
EPS
1
Div
1
/EPS
1
R
E
- g
Dividend
Payout Rate
R
E
- g
= =
55
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Figure 9.4 Relating the P/E Ratio to Expected Future
Growth in the Dividend-Discount Model
56
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Example 9.9a Valuation Using the
Price-Earnings Ratio
Problem:
Suppose furniture manufacturer RC Willey, has
earnings per share of $1.65.
If the average P/E of comparable furniture
stocks is 24.8, estimate a value for RC Willeys
stock using the P/E as a valuation multiple.
What are the assumptions underlying this
estimate?
57
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Example 9.9a Valuation Using the
Price-Earnings Ratio
Execute:
P
0
= $1.65 24.8 = $40.92.
This estimate assumes that RC Willey will have
similar future risk, payout rates, and growth
rates to comparable firms in the industry.
58
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Example 9.9a Valuation Using the
Price-Earnings Ratio
Evaluate:
Although valuation multiples are simple to
use, they rely on some very strong
assumptions about the similarity of the
comparable firms to the firm you are valuing.
It is important to consider these assumptions
are likely to be reasonableand thus to
holdin each case.
59
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Stock Valuation Techniques: The
Final Word
No single technique provides a final answer
regarding a stocks true value
Practitioners use a combination of these
approaches
Confidence comes from consistent results
from a variety of these methods
60
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9.6 Information, Competition, and
Stock Prices
Information in Stock Prices
Competition and Efficient Markets
Lessons for Investors and Corporate Managers
The Efficient Markets Hypothesis Versus No
Arbitrage
61
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Information in Stock Prices
For a publicly traded firm, its market price should
already provide very accurate information, aggregated
from a multitude of investors, regarding the true value
of its shares.
In most situations, a valuation model is best applied to
tell us something about the firms future cash flows or
cost of capital, based on its current stock price.
Only in the relatively rare case in which we have some
superior information that other investors lack
regarding the firms cash flows and cost of capital
would it make sense to second-guess the stock price.
62
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Figure 9.6 The Valuation Triad
63
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Competition and Efficient Markets
Efficient markets hypothesis
Competition among investors works to eliminate all positive-
NPV trading opportunities.
It implies that securities will be fairly priced, based on their
future cash flows, given all information that is available to
investors.
Public, Easily Available Information
Information available to all investors includes information in
news reports, financial statements, corporate press releases,
or other public data sources.
Private or Difficult-to-Interpret Information
Gathered and compiled by individual analyst, or public
information being hard to interpret.
64
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C
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o
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D
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C
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a
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,

H
K
P
o
l
y
U
Prices fully and instantaneously reflect
available information.
How completely?
How speedily?
By EMH, prices always equals fair values.
Efficient Markets Hypothesis
Three Forms of Efficiency by
Information Type
Weak Form
Semistrong Form
Strong Form
(Past)
(Publicly available)
(Private)
Example 9.11 Stock Price Reactions
to Public Information
Problem:
Myox Labs announces that it is pulling one of its
leading drugs from the market, owing to the potential
side effects associated with the drug.
As a result, its future expected free cash flow will
decline by $85 million per year for the next 10 years.
Myox has 50 million shares outstanding, no debt, and
an equity cost of capital of 8%.
If this news came as a complete surprise to investors,
what should happen to Myoxs stock price upon the
announcement.
67
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Example 9.11 Stock Price Reactions
to Public Information
Execute:
Using the annuity formula, the decline in
expected free cash flow will reduce Myoxs
enterprise value by
Thus the share price should fall by $570/50 =
$11.40 per share.
m 570 $
08 . 1
1
1
08 . 0
1
m 85 $
10
=
|
.
|

\
|

68
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Example 9.11 Stock Price Reactions
to Public Information
Evaluate:
Because this news is public and its effect on
the firms expected free cash flow is clear, we
would expect the stock price to drop by $11.40
per share nearly instantaneously.
69
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Figure 9.7 Possible Stock Price Paths
for Phenyx Pharmaceuticals
Experts trade on
their private
information.
This helps change
market prices
into what reflects
the information.
Cost vs profits
from information
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Lessons for Investors and Corporate
Managers
Implications for Corporate Managers
Cash flows paid to investors determine value
Managers should:
Focus on NPV and free cash flows
Avoid accounting illusions
Use financial transactions to support investment
71
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Lessons for Investors and Corporate
Managers
Consequences for Investors
Positive-NPV trading opportunities are hard to
come by.
Investors can expect to earn returns that
compensate them for the risks of their investments.
Average investor can invest with confidence, even if
he is not fully informed.
Amount of normal return to investor is
determined by (unavoidable) risk that needs to be
undertaken.
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s
The Efficient Markets Hypothesis
Versus No Arbitrage
An arbitrage opportunity is a situation in which two
securities (or portfolios) with identical cash flows have
different prices.
Because anyone can earn a sure profit in this situation by
buying the low-priced security and selling the high-
priced one, we expect investors to immediately exploit
and eliminate these opportunities.
Thus, in a normal market, arbitrage opportunities will
not be found.
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The Efficient Markets Hypothesis
Versus No Arbitrage
The efficient markets states that securities with
equivalent risk should have the same expected return.
The efficient markets hypothesis is, therefore,
incomplete without a definition of equivalent risk.
Furthermore, different investors may perceive risks and
returns differently (based on their information and
preferences).
There is no reason to expect the efficient markets
hypothesis to hold perfectly; rather, it is best viewed as
an idealized approximation for highly competitive
markets.
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