Valuation of Stocks and Company Valuation

FINANCE 350 Global Financial Management

Professor Alon Brav Fuqua School of Business Duke University
1

Overview
Stocks and stock markets Valuation:
Use present value formula

Dividend growth models

Applications Extensions

Financial ratios
Dividend yields P/E multiples
2

Common Stock
Stockholders are owners of the firm. Stockholders are residual claimants. Stockholders have the right to:
vote at company meetings dividends and other distributions sell their shares

Stockholders benefit in two ways:

dividends - periodic payments capital gains - appreciation in value

Stock is issued by public corporations

to finance investments to acquire other companies to repurchase debt
3

Preferred Stock: Debt or Equity?

Preferred Stock:
Cash flows often look like debt:
Periodic dividend rate, typically cumulative

typically no maturity Senior to equity, junior to debt securities in case of default Control rights more like debt securities
Often no voting rights except in case of default on dividend

Why do firms issue preferred stock?

Often because of the favorable tax treatment when held by other firms
4

Transactions Involving Stocks

Buy
Savings motive Expect stock to appreciate in value Long position

Short Sell
Sell stock without first owning it. Borrow stock from your broker with the promise to return it at some later date. Sell the borrowed stock. Repurchase it at a later date to return it to your broker. Responsible for all dividends and other distributions while short the stock. Similar to interest on bank loan.

Sell
Liquidity needs Expect stock to decline in value

Short selling (in detail)

Why Short Sell? Short Selling is one way of benefiting from a stock that is expected to decline in price.
Instead of buying today and selling later, the short seller sells today and buys later.

How to Short Sell? The short-seller (A) finds an existing owner of the shares (B) who is willing and able to lend the shares to A. Once A has negotiated a loan, A can then sell the borrowed shares to any willing buyer (C). A posts collateral with B. In the US, the standard collateral is cash amounting to 102 per cent of the value of the shares, to be adjusted daily as their value fluctuates.
Note though that under Federal Reserve Regulation T, in case where B is a U.S. broker/dealer A has to post an additional 50% margin (any long securities can be pledged to satisfy this requirement). Further, broker-dealers may institute higher short sale margin requirements than those imposed by self-regulatory organization rules. e.g., the NASD Rule 2520(d) and NYSE Rule 431(d).
6

Short selling
A pays B a fee. The fee can be determined by the rebate rate, which is the interest that B pays A for use of the cash collateral. For example, if the market rate for cash funds were 5% and the stock loan fee were 1.5% then B would rebate A only 3.5%. (Note that is it possible to have fees that exceed the cash rate, which would result in negative rebate rates). A pays B any dividends/distributions made to the owners of the shares during the loan. B has the right to recall the shares from A at any time. Loans are open and effectively rolled over each night until either B wants the shares returned or A voluntarily returns them. Given notice of recall, A has three days to return the shares. After this, A can try borrowing the shares from another lender or can cover the short position by purchasing the shares.
7

Short selling
Who are the Participants? The role of B (the lenders) is largely assumed by the big custody banks in the U.S. who act as intermediaries for large institutional owners like pension funds, mutual funds etc. Loans of shares can also be made by a broker from his own inventory, from the margin account of another customer, or shares borrowed from another broker. These shares are used to make settlement with the buying broker within three days of the short sale transaction, and the proceeds are used to secure the loan. Another group that assume the role of B (lenders) consists of the broker-dealers (e.g. Goldman Sachs, Morgan Stanley). These broker-dealers lend from their internal supply of securities held by their market makers and proprietary trading desks, the accounts of institutional customers, and the margin accounts of individual investors.
Note that Section 8 of the Exchange Act of 1934 prohibits brokers from lending shares held in retail cash or non-margin accounts.

The role of A (the short-sellers) is assumed by a broader group. More obvious examples include:
Specialists and market makers (for balancing buy orders with sell orders) Traders of equity options, index futures, equity return swaps and convertible bonds (for hedging their positions) Hedge Funds (to execute arbitrage strategies) Speculators 8

Short selling
The NYSE, NASD and AMEX reported short interest (the number of shares that have already been sold short) with a market value in excess of $260 billion (just over 1.7% of total market capitalization) at June 2001. Shorting is subject to many restrictions on the size, price, and types of stocks able to be shorted. For example, you cannot short sell penny stocks (they are non-marginable due to Regulation T) and most short sales need to be done in round lots. Additionally, the SEC, NYSE and NASD have rules preventing short selling unless the last trade is at the same or higher price (known as an uptick or zero plus tick), the purpose of which is to prevent short selling in a declining market (since continuous short selling will exacerbate the fall of a falling stock). Equity loans can occur for reasons other than short selling. For instance in cases where A borrows from B but then doesnt short to C, A is treated as the legal owner of the shares and is therefore entitled to the dividends distributed during the course of the loan (which, as previously mentioned, are required to be reimbursed by A to B). This might happen in cases where A values the distribution received more than the reimbursements given (for taxation reasons, for example) In lending, B forfeits voting rights to A (to C in the case of the short sale).
9

Markets

Valuation: The Role of Financial

Primary Market New securities and investment opportunities. Secondary Market Provide price information Transform (short term) savings into (long term) investments Liquidity Investors need to buy and sell at correct prices

Companies need to acquire funds at a correct price

What is a correct price? Do markets generate correct prices?

10

Stock Market Indices

Return to holding a security:
Return = Price new Price old + Cash Price old

Stock market indices weigh the returns of the constituent securities. Uses: 1) Track average returns of stocks in a particular market (geographical) or market segments (e. g., small companies, value stocks, technology stocks). 2) Assess performance of managers, base of derivatives contracts. Examples:
Domestic indices: Dow Jones Industrial Average (30 Stocks), Standard & Poors 500 Composite, NASDAQ Composite, NYSE Composite, Wilshire 5000. International indices: Nikkei 225 & Nikkei 300, FTSE (Financial Times of London), Dax. Region and Country Indexes: EAFE, Far East, United Kingdom.
11

Stock Market Indices

How are the stocks weighted?

Price weighted (DJIA), Market-value weighted (S&P500, NASDAQ), Equally weighted (Value Line Index) Arithmetic (Value Line index, DJIA and S&P500), Geometric (Value Line Index)

How are returns averaged?

The general expression: R Index = stock

N i =1

wi Ri

Equally weighted wi = 1/N. Return on portfolio with $1 in each Value weighted wi = proportion of market capitalization. Return on

portfolio where more is invested in bigger companies.

12

U. S. Stock Markets
Major U. S. Stock Exchanges New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Over-The-Counter (OTC) National Association of Securities Dealers (NASDAQ)
U. S. Stock Market:
Stock Index Dow Jones Industrial NASDAQ S&P500 NYSE Composite* AMEX Composite Russell 2000 Value 7/01/05 10,303.44 2,057.37 1,194.44 7,245.59 1,554.74 643.04 Value 6/30/04 10,424.19 2,041.25 1,138.58 6,592.68 1,247.45 590.03 Value 7/04/03 9,070.21 1,663.46 985.7 558.46 976.16 546.35 Value 9/19/02 8,172.45 1,252.13 869.46 471.69 855.61 376.75

*The NYSE Composite index was recalculated to reflect a base value of 5,000 as of Dec/31, 2002

13

Number of Listed Companies on Nasdaq, Yearly Comparison with NYSE and AMEX

14

Market Capitalization of Domestically Listed Companies - NYSE and NASDAQ, 1985 2003
($ billions) 12,000

10,000 8,000 6,000 4,000 2,000 0 1985 1987 1989 1991 1993
NYSE

1995

1997

1999

2001

2003

NASDAQ

15

16

Why Short-Termists are Long-Termists

Shareholders require a rate of return re for buying a share. They buy for P0 and sell after one year for P1 and receive dividends D1: D + P1 P0 = 1 1 + re The next buyer also sells after one year: D D + P2 D + P2 P0 = 1 + 2 P1 = 2 1 + re 1 + re (1 + re )2 The same holds for P2. Continuing gives: D3 D D2 + + ... P0 = 1 + 1 + re (1 + r e )2 (1 + re )3 Share price = PV of dividends
17

Stock Valuation
Stock Price = PV of future dividends
The price an investor is willing to pay for a share of stock depends upon:
Magnitude and timing of expected future dividends. Risk of the stock.

The stocks discount rate, re, is the rate of return investors can expect to earn on securities with similar risk. Where are capital gains?
18

Another Application:
Dividend payouts Capital gains (stock appreciation P1-P0)
re = D1 P P0 + 1 P0 P0

Estimating the required return on equity

Holders of stock receive returns in two forms:

typically larger fraction of returns

Capital gain reflects growth in future dividend payments

Note:
The expected rate of return is not equal to the dividend yield The expression is in terms of the prospective yield, not the historic yield
19

The Constant Growth Formula

Assumption: Dividends grow at a constant rate g for ever:
D2 = D1 (1 + g ) , Dt = Dt 1 (1 + g ) = ... = D1 (1 + g ) t 1 = D0 (1 + g ) t

Then:

P0 =

D1 D (1 + g ) D (1 + g ) + 1 + ... + 1 2 1 + re (1 + re ) (1 + re )t

t 1

+ ... =

D1 re g

Share Price =

Prospective Dividend per Share Expected return - growth rate

Issues:
constant growth. g < re. Is this a real or a nominal calculation?
20

Simplifying the Dividend Discount Model

Constant Dividends
g = 0 D1 = D2 =... = D

Then the pricing relation simplifies to:

P0 = P1 = Pt = ... = D D re = re P0

Stock similar to perpetual bond

If dividends are constant, then we have that: Capital gains are zero Expected return on equity = Dividend yield

21

Constant Dividends: An Example

Consider a company that pays a dividend of: $3 per share in bad years (Probability = 50%) $15 per share in good years (Probability = 50%)
Required rate of return is 18% What is the share price?
E ( Div) = 0.5 * $3 + 0.5 * $15 = $9 P0 = $9 = $50 0.18
22

Constant Dividends:
RJR Nabisco Preferred Stock Suppose that RJR Nabisco has a preferred stock outstanding
annual dividend of $2.50 per share. Securities with similar risk are expected to return 9.6%
what is the price of the preferred stock?
P0 = D $2.50 = = $26.04 re 0.096

23

Valuation with Growing Dividends

An Example: Valuation of XYZ Inc. Generally, companies have growing dividends on stocks, hence apply general formula:
P0 = D1 re g

Consider data for XYZ Inc.:

Number of shares: Market capitalization Historic dividend Your forecast: 856,695 $46.31m $1.60 per share $1.75

What valuation do you obtain for XYZ, depending on g and r?

24

Valuation of XYZ
Alternative valuations:
Return/ Growth 7% 8% 9% 10% 11% 12% 3% 37.48 29.98 24.99 21.42 18.74 16.66 4% 49.97 37.48 29.98 24.99 21.42 18.74 4.50% 59.97 42.83 33.32 27.26 23.06 19.99 5% 74.96 49.97 37.48 29.98 24.99 21.42 6% 149.92 74.96 49.97 37.48 29.98 24.99 7% 149.92 74.96 49.97 37.48 29.98

Example: 856,695*$1.75=$1.499m
MCAP = XYZ Dforecast $1.499m = = $37.48m rXYZ g XYZ 0.09 0.05
25

Valuing a Business
A Hybrid Approach
Sometimes equity analysts have knowledge about the immediate, but not the distant future
Dividend forecasts for immediate future (2-5 years) Assume constant growth for distant future (>5 years) How do you change the model? Dividends

Value

26

Modify the Growth Model

The formula for a T-year horizon can be written as:
P0 = t =1
t =T

(1 + re )

Dt

(1 + re )T

PT

Apply the growth model to the price in T:

PT = DT +1 re g

Then the current value of the share is:

P0 = t =1
t =T

(1 + re )

Dt

1+ g

(1 + re )

DT re g
27

Valuing a Business
Consider a company with cash flows from operations of $1 million for the most recent year.
The companys cash flows are expected to grow at a rate of 10% for the next 5 years and at a constant rate of 5% thereafter. To generate this increase in cash flows, the company is required to reinvest 50% of its cash flows for the first 5 years and 25% of its cash flows thereafter. Given the risk of the business, the required rate of return is 15%.

What is the value of the business?

28

Valuing a Business (continued)

Year 1 Year 2 Year 3 Year 4 Year 5 Operating Cash Flows New Capital Investment Net Cash Flow (Div) Present Value 1.10 -0.55 0.55 0.48 1.21 -0.61 0.60 0.45 1.33 -0.67 0.66 0.43 1.46 -0.73 0.73 0.42 1.61 -0.81 0.80 0.40

Present value= CF(1)+...+CF(5)=0.48+0.45+0.43+0.42+0.40=2.18

29

Valuing a Business (cont.)

Value of dividends over the first 5 years is $2.18. Value of business at the end of the 5th year:
P= 5 D6 1.611.05(10.25) = = $12.68 re g 0.150.05

Value of the Business:

P0 = $2.18 + $12.68 = $8.48 1155 .
30

Expected Returns and the Dividend Growth Model

Use the growth model formula to solve for the required rate of return to give: D re = 1 + g P0 Hence, the required rate of return is equal to the prospective dividend yield plus the growth rate. Note that you can synthesize the previous results: P P g = 1 0 P = (1 + g )P0 1 P0 If dividends grow at a constant rate, then:
share prices grow at the same rate yield stays constant

31

P/E-ratios:
Next years EPS: Pay-out ratio: P/E-ratio: Earnings yield:
d =

A Simple Approach to Valuation

E1
D1 E1

P0 / E1 E1 / P0

The we obtain the following results: D1 = dE 1

re = E1 *d + g P0

P0 d = E1 re g

Which assumptions do you have to make in order to argue that stocks with a low P/E multiple are undervalued? 32

Historical and Prospective Ratios:

Expected values have to be estimated Use model to forecast future yields or multiples: D1 = (1 + g )D0 E1 = (1 + g )E0 Find relationships as before:
P d(1+g) 0 = E0 re g D re g 0 = P 1+g 0

Example d = 0.5, g = 10%, r = 12%

Prospective: Historic: DY=2.0%, DY=1.81%, PE=25 PE=27.5
33

P/E Ratios and Growth

You can use the expression for the historic yield to infer the growth rate:
g= re D0 P0 Expected return Yield = 1 + D0 P0 1 + Yield

Consider the following firms (same industry):

MCAP ($million) No. of shares Share Price Dividend p. share Dividend Yield EPS P/E ratio Firm 1 30.92 702,500 $44.01 $1.35 3.07% $5.03 8.75 Firm 2 40.71 1,187,000 $34.30 $1.43 4.17% $3.72 9.22 Firm 3 46.31 856,695 $54.06 $1.60 2.96% $6.06 8.92

34

Growth rates
Infer growth rates:
Expected Returns 9% 10% 11% 12% 13% 14% 15% Firm 1 5.76% 6.73% 7.70% 8.67% 9.64% 10.61% 11.58% Implied growth rates Firm 2 4.64% 5.60% 6.56% 7.52% 8.48% 9.44% 10.40% Firm 3 5.87% 6.84% 7.81% 8.78% 9.75% 10.72% 11.69%

Example: 0.12 0.0417 g firm2 ( Exp. ret.=12% ) = = 0.0752 = 7.52%

1.0417

35

Valuing a Company Using P/EMultiples

The three steps of using P/E multiples company valuation
1 2 3

Find sample of comparable companies Compute average of their P/E ratios Multiply earnings by average P/E from step 2.

Example: Value Firm 3:

Use firms 1 & 2 as comparables: Average P/E=(8.75+9.22)/2=8.99 Estimated value of firm 3 share=8.99*$6.06=$54.45 Market price is $54.06

36

Valuation Ratios and Stock Market Outlook

Stock market valuation ratios have been at extreme levels a few years ago by historical standards. When stock prices are very high relative to indicators of fundamental values (such as dividends and earnings), prices tend to fall in the future ... Consider two measures of fundamental values:

(i) dividend-price ratio (D/P ratio), or dividend yield. (ii) price-earnings ratio (P/E ratio).

37

Valuation Ratios and Stock Market Outlook (continued)

The dividend-price ratio is measured as previous years total dividends divided by current stock price
D/P ratios have normally moved in the range from 3% to 7% (with an extreme of much less than 2% a few years ago).

The price-earnings ratio is measured as current stock price divided by previous years total earnings
P/E ratios have normally moved in the range 820. Graham and Dodd (1934) said that one should use an average of earnings of no less than five years, preferably seven or ten years.

38

D ividend yield
10 15 20 25 30 35 40 45 50 0 5
80 18

Price-Earnings Ratio

10%

12%

14%

16%

18

0%
90 18

2%

4%

6%

8%

P/E ratio 1880-2003

D/P ratio 1880-2002

Source: Robert Shiller

81

Source: Robert Shiller

00 19 10 19 20 19 30 19 40 19

Year

Year

50 19 60 19 70 19 80 19 90 19 00 20

18 .01 84 18 .04 87 . 18 0 7 9 18 0 .1 94 18 .01 97 19 .04 00 . 19 0 7 0 19 3 .1 07 19 .01 10 19 .04 13 . 19 0 7 1 19 6 .1 20 19 .01 23 19 .04 26 . 19 0 7 2 19 9 .1 33 .0 19 1 36 19 .04 39 . 19 0 7 4 19 2 .1 46 19 .01 49 19 .04 52 . 19 0 7 5 19 5 .1 59 19 .01 62 19 .04 65 . 19 0 7 6 19 8 .1 72 19 .01 75 19 .04 78 . 19 0 7 8 19 1 .1 85 19 .01 88 19 .04 91 . 19 0 7 9 19 4 .1 98 20 .01 01 .0 4

40

39

Growth Stock and Value Stocks

Value of stock depends on two components:
Profits generated by assets in place, past capital budgeting decisions Profits generated by growth opportunities in the future

Decompose value of stock:

P0 = E1 gP 0 (1 d )E 1 + re re = gP 0 (1 d )E 1 re
41

PVGO

Summary
Stocks and equity securities can be valued by using present value techniques
The discounting horizon does not depend on the investment horizon of individual investors in the stock market

Investors are compensated through cash dividends and through capital gains
Required returns on equity are generally not equal to the dividend yield, but to the dividend yield plus the growth rate

P/E-ratios should be used with caution:

Depends on simplifying assumptions
42