copyright © 2006 mcgraw hill ryerson limited6-1 prepared by: sujata madan mcgill university...

Copyright © 2006 McGraw Hill Ryerson Limited 6-1

prepared by:Sujata Madan

McGill University

Fundamentals

of Corporate

Finance

Third Canadian Edition


Chapter 6 Valuing Stocks

Stocks and the Stock Market Book Values, Liquidation Values, and Market

Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks No free lunches on Bay Street


Stocks and the Stock Market Definitions

Primary Market: Place where the sale of new stock first occurs.

Initial Public Offering (IPO): First offering of stock to the general public.

Seasoned Issue: Sale of new shares by a firm that has already been through an IPO.

Secondary Market: Market in which already issued securities are traded by investors.



Common Stock: Ownership shares in a publicly held corporation.

Dividend: Periodic cash distribution from the firm to the shareholders.

P/E Ratio: Price per share divided by earnings per share.


Stocks and the Stock Market Dividends and Retained Earnings

Dividends represent that share of the firm’s profits which are distributed.

Profits that are retained in the firm and reinvested in its operations are called retained earnings.


Stocks and the Stock Market Book Value, Liquidation Value, Market Value

There are three methods used for valuing a company’s shares:

Book Value Liquidation Value Market Value



Book Value: Net worth of the firm according to the balance sheet.

Liquidation Value: Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.

Market Value Balance Sheet: Financial statement that uses market value of assets and liabilities.


Valuing a Stock Going Concern Value

Going concern value means that a well managed, profitable firm is worth more than the sum of the value of its assets.

ASSET 1

$3 million

ASSET 2

$2 million

ASSET 3

$6 million

Assets sold separately have liquidation value

of $11 million

ASSET 1

$3 million

ASSET 2

$2 million

ASSET 3

$6 million

The same assets functioning as a firm have

going concern value of $15 million


Valuing a StockSources of Going Concern Value

Extra earning power

Intangible assets

Value of future investments


Valuing Common Stocks Expected Return

Expected Return: The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR).

0

011Return ExpectedP

PPDivr



Expected Return

rDiv

P

P P

P1

0

1 0

0

Dividend Yield Capital Gains Yield


Valuing Common StocksExpected Return

Assume that for Blue Sky shares: The current price of the shares is $75. The expected price a year from now is $81. The expected dividend a year from now is $3.

What is Blue Sky’s expected return?



Blue Sky’s expected return is:

Expected Return = D1 + P1 – P0

P0

= $3 + 81 – 75

$75 = 0.12 = 12%



For Blue Sky:

Expected return = Dividend Yield + Capital Gain

= D1 + P1 – P0

P0 P0

= $3 + $81 - $75

$75 $75

= 4% + 8%

= 12%


Valuing Common Stocks Dividend Discount Model (DDM)

Today’s stock price equals the present value of all expected future dividends:

PDiv

r

Div

r

Div P

rH H

H01

12

21 1 1

( ) ( )

...( )


Valuing Common Stocks Example

XYZ Company is expected to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?



XYZ Company is expected to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

00.75$

)12.01(

48.9450.3

)12.01(

24.3

)12.01(

00.3321

PV

PV


Valuing Common Stocks Simplifying the DDM

The PV of a constant perpetuity is calculated by dividing the cash payment (the dividend) by the discount rate:

r

DivP 1

0


Valuing Common Stocks Simplifying the DDM

The PV of a growing perpetuity is calculated by dividing the cash payment (the dividend) by the discount rate minus the constant growth rate:

PDiv

r g01



Calculate the price of Blue Sky shares if: Next year’s dividend (D1) will be $3. Dividends grow at 8% in perpetuity. The discount rate is 12%.

Price of stock today =Div 1

r-g

=$3.00

0.12 – 0.08

$75.00=


Valuing Common Stocks Expected Rate of Return revisited

Rearranging the DDM gives us the expected rate of return:

r = D 1

P0

+ g

Dividend Yield Growth Rate



What is the expected return for Blue Sky if:

Next year’s dividend (D1) will be $3. Dividends grow at 8% in perpetuity. The current price is $75.



The expected rate of return on Blue Sky would be:

r =D 1

P0

+ g = Dividend Yield + Growth Rate

=$3

$75+ .08

= .04 + .08 = 4% + 8% = 12%


Growth Stocks and Income Stocks Definitions

The fraction of earnings retained by the firm is called the plowback ratio.

The fraction of earnings a company pays out in dividends is called the payout ratio.


Growth Stocks and Income Stocks Calculating “g” (growth rate)

The growth rate for a company can be computed by multiplying the return on equity by the plowback ratio:

g = roe x plowback ratio


Growth Stocks and Income Stocks Example

Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 20%.

Calculate the value of the stock before and after the plowback decision?



D1 = $5.00 r = 12% Return on equity = 20%

67.41$12.0

510

r

DIVP

No Growth



D1 = $5.00 r = 12% Return on equity = 20%

With Growth

00.75$08.012.0

3

08.040.020.0

10

gr

DIVP

ratioplowbackroeg



Price without growth = $41.67 Price with growth = $75

Thus, growth accounts for $33.33 [=$75-

$41.67] of the price.

In other words, the Present Value of Growth Opportunities (PVGO) is $33.33.


Growth Stocks and Income Stocks Definitions

The Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.

Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.


Growth Stocks and Income Stocks Price-Earnings (P/E) Ratio

P/E Ratio = Stock Price

EPS

Is a high P/E ratio always good?


No Free Lunches on Bay Street Definitions

Technical Analysis – Attempting to identify undervalued stocky by searching for patterns in past stock prices.

Random Walk – Security prices change randomly, with no predictable trends or patterns.

Fundamental Analysis – Attempting to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects.


No Free Lunches on Bay Street Random Walk

smadan

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Summary of Chapter 6 Dividend Discount Model - price of a stock is

the present value of its future dividends.

If dividends are expected to remain constant, the value of the stock is equal to:

P0 = Div1 / r

If dividends are expected to grow forever at a constant rate “g”, then the value of the stock is equal to:

P0 = Div1 / (r – g)


Summary of Chapter 6 The growth rate of a company is equal to:

g = return on equity × plowback ratio

The current stock price comprises: The value of the assets in place; plus The Present Value of Growth Opportunities

(PVGO).

copyright © 2006 mcgraw hill ryerson limited6-1 prepared by: sujata madan mcgill university...

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