Download Presentation
## Investments

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -

**Investments**BSC III Winter Semester 2010 Lahore School of Economics**Investments**Chap 10 Common Stock Valuation**Common Stock Valuation**Learning Objectives • Common Stock Valuation • Dividend Growth model • Zero Growth • Constant Growth • Multiple growth model • Intrinsic Value & Market price • Relative Valuation Techniques (P/E,P/S,P/S) • Components of Required Return**Capital Market Securities**• Fixed Income (Bonds) • Treasuries • Corporates • Equities • Preferred Stock • Common Stock**Common Stock**It is an equity ownership in a corporation, initially issued to raise capital Points to keep in mind! • C/F’s are NOT known in advance • Life of stocks is forever – no maturity • Difficult to observe required rate of return for discounting**Common stock valuation**The two approaches to valuing common stock using fundamental security analysis are: • Discounted Cash flow techniques • Relative valuation techniques**Common stock valuation**The two approaches to valuing common stocks using fundamental security analysis are: • Discounted Cash flow techniques Attempts to estimate the value of a stock today using a present value analysis. • Relative valuation techniques A stock is valued relative to other stocks based on the basis of ratios. Key difference!**Discounted Cash Flow Techniques**The estimated value of a security is equal to the discounted value (Present Value) of the future stream of cash flows that an investor expects to receive from the security: Estimated Value of any security= V0 V0= Expected Cash Flows/(1 + K)t Where: K is the appropriated Discount Rate**Discounted Cash Flow Techniques**To use Discounted Cash flow Model, an investor must: • Estimate the amount & timing of future stream of Cash flows. • Estimate an appropriate Discount Rate • Use these two components in PV Model to estimate the value of the security, which is then compared to the current Market Price of the security.**Discounted Cash Flow Techniques**Two different approaches to the cash flows & discount rates can be used in the valuation of stocks: • Value the Equity of the Firm, using the required rate of Return to shareholders. • Value the entire firm using the Weighted Average Cost of Capital (WACC).**Discounted Cash Flow Techniques**How to come up with the Price of a Stock? Assumptions: • Assume a dividend the stock will pay. • Assume a selling price at the end of 1 year. • Come up with a required rate of return.**Discounted Cash Flow Techniques - Example**Example: Stock selling price after 1 year is $70 Stock dividend will be $10 Investors require 25% return PV= 80/(1.25) =$64**Discounted Cash Flow Techniques - Example**Example: Stock selling price after 1 year is $70 Stock dividend will be $10 Investors require 25% return PV= 80/(1.25) =$64 • Or, • Po=(D1+P1)/(1+k)**Discounted Cash Flow Techniques**P1 at t1, could also be found the same way by assuming year 2 price & dividend: P1=(D2+P2) / (1+K)**Discounted Cash Flow Techniques**Substituting P1 in Po equation: Po= (D1+(D2+P2)/(1+K))/ (1+K) =[D1/(1+K)1]+ [D2/(1+K)2]+[P2/(1+K)2]**Dividend Discount Model**Formula: Po=E [Dn/ (1+K)n] Present Value of all future dividends as a general valuation framework!**Dividend Discount Model**• Investors must value a stream of dividends that may be paid forever, since common stock has no maturity value. • The dividend Stream is uncertain: • There is no specified number of dividends, if in fact any are paid at all. • Dividends are Expected to grow in most cases.**Dividend Discount Models – Special cases**Growth Rate Cases for the DDM: • The Zero Growth rate Case • The Constant Growth rate Case • The Multiple Growth rate Case**The Zero Growth Rate Model**Zero-growth: A Dividend Stream resulting from Fixed dollar Dividend equal to the current Dividend, Do. So, Value of the stock is a Present value of a Perpetuity! Po=D/K**The Zero Growth rate model- Example**A company pays a dividend of $2 per share, which is not expected to change. Required return is 20%.What’s the price per share today?**Discounted Cash Flow Techniques – Zero Growth - Example**A company pays a dividend of $2 per share, which is not expected to change. Required return is 20%.What’s the price per share today? Po = Do/ k = 2/0.2 = 10**The Constant Growth Rate Model**The constant Growth rate Case for the DDM reflects a dividend stream that is expected to grow at a constant rate g, forever. Which implies: If dividend just paid is Do, then the next D1 is: D1 = Do*(1+g) Dividend for period 2, D2: D2= D1*(1+g) =[Do*(1+g)]* (1+g) = Do*(1+g)2**The Constant Growth Rate Model**Stock Price with constant growth dividends: Po=Do*(1+g)/(K-g) OR P0=D1/(K – g)**Dividend Discount Model - Assumptions**• Dividend paying stock • Required Return by investors is greater than the Growth Rate of Dividends. • Dividends will grow at a constant Rate forever.**The Constant Growth Rate Model - example**Suppose Do = 2.30, K=13%, g=5%.What’s the price per share?**The Constant Growth Rate Model - example**Suppose Do = 2.30, K=13%, g=5%.What’s the price per share? P0 = D1/(k – g) = 2.3 *(1.05)/(0.13 - 0.05) = 2.415 / 0.8 = 30.19**The Constant Growth Rate Model**Constant Growth Model can be used to find thestock price at any pointin time! Find the Dividend for that year. Grow it at (1+g) Divide by K-g**The Constant Growth Rate Model - example**Suppose Do = 2.30, K=13%, g=5%.What’s the price per share in 5 years? Hint: P5= D6/ (K – g)**The Constant Growth Rate Model - example**Suppose Do = 2.30, K=13%, g=5%.What’s the price per share in 5 years? P5= D6/ (K – g) =[2.3 *(1.05)^5]/ (0.13-0.05) = [2.935x(1.05)]/ 0.8 = 3.0822 / .08 =38.53**The Constant Growth Rate Model - example**Suppose Company XYZ’s next dividend will be $4. Required return is 16%. Dividend increases by 6% every year, forever. What’s the price per share today? & in 4 years?**The Constant Growth Rate Model - example**Suppose Company XYZ’s next dividend will be $4. Required return is 16%. Dividend increases by 6% every year, forever. What’s the price per share today? P0 = D1 /(k – g) =4/(.16-.06) =4/.1 =$40**The Constant Growth Rate Model - example**Suppose Company XYZ’s next dividend will be $4. Required return is 16%. Dividend increases by 6% every year, forever. Price in 4 years? P4= D5/ (k – g) D5=D1* (1+g)4 =4(1.06)4 = 5.05 P4=5.05/0.1 =50.50**Investments**BSC/BBA III Winter Semester 2010 Lahore School of Economics**Investments**Chap 10 Common Stock Valuation**Common Stock Valuation**Learning Objectives • Common Stock Valuation • Dividend Growth model • Zero Growth • Constant Growth • Multiple growth model • Intrinsic Value & Market price • Relative Valuation Techniques (P/E,P/S,P/S) • Components of Required Return**Dividend discount models -Multiple Growth Rate Case**For many companies, it is inappropriate to assume that dividends will grow at a constant rate as Firms typically go through life cycles. P0 =PV of Expected Future Cash flows**Dividend discount models -Multiple Growth Rate Case**For many companies, it is inappropriate to assume that dividends will grow at a constant rate as Firms typically go through life cycles. P0 =PV of Expected Future Cash flows P0=PV of Dividends during the non Constant period PLUS PV of Dividends during the constant Growth Period**Multiple Growth Rate Case**To findValue of Stock with Non Constant Growth, we go through the followingthree steps: • Find thePV of Dividendsduring the period of Non Constant Growth. • Find thePV of Stock at the end of Non Constant Growthperiod at which point it has become a constant growth Stock, and discount the price back to the present. • Add these two componentsto find the intrinsic Value of the Stock.**Dividend discount models -Multiple Growth Rate Case**Multiple Growth model Company grows at a certain high rate first, then slows down to grow at a constant sustainable rate.**Dividend discount models -Multiple Growth Rate Case**Multiple Growth model Company grows at a certain high rate first, then slows down to grow at a constant sustainable rate. Value=PV of dividends+PV of terminal price = E [Dt /(1+k)t]+{[Dn+1 /(k-g)]*[(1/1+k)n]}**Multiple Growth Rate Case - Example**The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on equity (ks) is 12 percent. What is the current price of Klein’s common stock?**Multiple Growth Rate Case - Example**The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on equity (ks) is 12 percent. What is the current price of Klein’s common stock?**Multiple Growth Rate Case - Example**The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on equity (ks) is 12 percent. What is the current price of Klein’s common stock? Financial calculator solution: Enter in Cash register CF0 = 0, CF1 = 1.05, and CF2 = 61.74. Then, Enter I = 12, and press NPV to getNPV=P0= $50.16.**Multiple Growth Rate Case - Example**Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for 1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate is expected to be a constant 7 percent thereafter. The required rate of return on equity (ks) is 10 percent.What is the current stock price?**Multiple Growth Rate Case - Example**Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for 1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate is expected to be a constant 7 percent thereafter. The required rate of return on equity (ks) is 10 percent.What is the current stock price?**Multiple Growth Rate Case - Example**Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for 1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate is expected to be a constant 7 percent thereafter. The required rate of return on equity (ks) is 10 percent.What is the current stock price? Financial calculator Solution: CF0= 0; CF1= 2.08; CF2= 2.1840; and CF3= 84.8848; I = 10; and press NPV to getNPV = P0 = $67.47.**Intrinsic Value & Market Price**If Intrinsic Value>Market Price=under-valued Intrinsic Value<Market Price= over-valued**Assignment (7 Questions)**Q1:A stock is expected to pay $0.45 dividend at the end of the year. The dividend is expected to grow at a constant rate of 4 percent a year, and the stock’s required rate of return is 11 percent.What is the expected price of the stock 10 years from today?**Q#2**A stock that currently trades for $40 per share is expected to pay a year-end dividend of $2 per share. The dividend is expected to grow at a constant rate over time. The stock has a required rate of return of 11%. What is the stock’s expected price seven years from today?**Q#3**Motor Homes Inc. (MHI) is presently in a stage of abnormally high growth because of a surge in the demand for motor homes. The company expects earnings and dividends to grow at a rate of 20 percent for the next 4 years, after which time there will be no growth (g = 0) in earnings and dividends. The company’s last dividend was $1.50. MHI’s required return on stock is 18%. What should be the current common stock price?