fin437 vicentiu covrig 1 stocks and their valuation (chapter 12)

FIN437Vicentiu Covrig

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Stocks and their valuationStocks and their valuation(chapter 12)(chapter 12)


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Intrinsic Value and Stock PriceIntrinsic Value and Stock Price Outside investors, corporate insiders, and analysts use a variety of

approaches to estimate a stock’s intrinsic value (P0). In equilibrium we assume that a stock’s price equals its intrinsic

value.- Outsiders estimate intrinsic value to help determine which

stocks are attractive to buy and/or sell.

- Stocks with a price below its intrinsic value are undervalued Buy or Sell?

- Stocks with a price above its intrinsic value are overvaluedBuy or Sell?


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Dividend growth modelDividend growth model Value of a stock is the present value of the future dividends

expected to be generated by the stock. r s is the required rate of return (think the one from CAPM)

)r(1

D ...

)r(1

D

)r(1

D

)r(1

D P

s3

s

32

s

21

s

10

^


44

Constant growth stockConstant growth stock A stock whose dividends are expected to grow forever at a

constant rate, g.

D1 = D0 (1+g)1

D2 = D0 (1+g)2

Dt = D0 (1+g)t

If g is constant, the dividend growth formula converges to:

g -r

D

g -r

g)(1D P

s

1

s

00

^


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What happens if g > rWhat happens if g > rss??

If g > rs, the constant growth formula leads to a negative stock price, which does not make sense.

The constant growth model can only be used if:- rs > g

- g is expected to be constant forever


66

If rIf rRFRF = 7%, r = 7%, rMM = 12%, and = 12%, and ββ = 1.2, what is = 1.2, what is the required rate of return on the firm’s the required rate of return on the firm’s

stock?stock?

Use the SML to calculate the required rate of return (rs):

rs = rRF + (rM – rRF)β

= 7% + (12% - 7%)1.2

= 13%


77

If DIf D00 = $2 and g is a constant 6%, = $2 and g is a constant 6%, What is What is the stock’s market value?the stock’s market value?

Using the constant growth model:

$30.29

0.07

$2.12

0.06 - 0.13

$2.12

g - r

D P

s

10


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What is the expected dividend yield, capital What is the expected dividend yield, capital gains yield, and total return during the first gains yield, and total return during the first

year?year?

Dividend yield= D1 / P0 = $2.12 / $30.29 = 7.0%

Capital gains yield= (P1 – P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0%

Total return (rs)= Dividend Yield + Capital Gains Yield

= 7.0% + 6.0% = 13.0%


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Supernormal growth:Supernormal growth:What if g = 30% for 3 years before What if g = 30% for 3 years before achieving long-run growth of 6%?achieving long-run growth of 6%?

Can no longer use just the constant growth model to find stock value.

However, the growth does become constant after 3 years.


1010

Valuing common stock with Valuing common stock with nonconstant growthnonconstant growth

rs = 13%

g = 30% g = 30% g = 30% g = 6%

P 0.06

$66.543

4.658

0.13

2.6/(1+0.13) = 2.301

2.647

3.045

66.54/(1+0.13)^3 = 46.114

54.107 = P0

^

0 1 2 3 4

D0 = 2.00 2.6 3.380 4.394

...

4.658


1111

Calculations:

D1 = D0*(1+g1)= 2x(1+0.3)= 2.6D2 = D1*(1+g1)= 2.6x(1+0.3)= 3.38D3 = D2*(1+g1)= 3.38x(1+0.3)= 4.394

D4 = D3*(1+g2)= 4.394x(1+0.06) = 4.658

Present Value of D1= 2.6/(1+0.13) = 2.301Present Value of D2= 3.38/(1+0.13)^2 = 2.647Present Value of D3= 4.394/(1+0.13)^3 = 3.045


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Corporate value modelCorporate value model Also called the free cash flow method. Suggests the value of the entire firm

equals the present value of the firm’s free cash flows. FCF = NOPAT – Net capital investment

1. Find the market value (MV) of the firm.- Find PV of firm’s future FCFs

2. Subtract MV of firm’s debt and preferred stock to get MV of common stock.- MV of = MV of – MV of debt and

common stock firm preferred3. Divide MV of common stock by the number of shares outstanding to get

intrinsic stock price (value).

- P0 = MV of common stock / # of shares


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Issues regarding the corporate Issues regarding the corporate value modelvalue model

Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast.

Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate.

Terminal value (TVn) represents value of firm at the point that growth becomes constant.


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Given the long-run gGiven the long-run gFCFFCF = 6%, and WACC = 6%, and WACC of 10%, use the corporate value model to of 10%, use the corporate value model to

find the firm’s intrinsic value.find the firm’s intrinsic value.

g = 6%

r = 10%

21.20

0 1 2 3 4

-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20

530 = = TV30.10 0.06-


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Calculations:Present Value of CF1= -5/(1+0.1) = -4.545Present Value of CF2= 10/(1+0.1)^2 = 8.264Present Value of CF3= 20/(1+0.1)^3 = 15.026

CF 4= CF3*(1+g)=20*(1+0.06)= 21.2

Present Value of Terminal Value in 3 years (at time 3)= = 530/(1+0.1)^3 = 388.197


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If the firm has $40 million in debt and has 10 If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s million shares of stock, what is the firm’s

intrinsic value per share?intrinsic value per share?

MV of equity = MV of firm – MV of debt

= $416.94m - $40m

= $376.94 million Value per share = MV of equity / # of shares

= $376.94m / 10m

= $37.69

fin437 vicentiu covrig 1 stocks and their valuation (chapter 12)

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