Post on 28-Jan-2016
Chapter 4Principles of
Corporate FinanceTenth Edition
The Value of Common Stocks
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
4-2
Topics Covered
How Common Stocks Are TradedHow Common Stocks Are ValuedEstimating The Cost Of Equity CapitalThe Link Between Stock Price and Earnings
per ShareValuing a Business by Discounted Cash
Flow
4-3
How Common Stocks Are Traded
Primary Market - Market for the sale of new securities by corporations.
Secondary Market - Market in which previously issued securities are traded among investors.
Common Stock - Ownership shares in a publicly held corporation.
4-4
How Common Stocks Are Traded
Electronic Communication Networks ( ECN s) –A number of computer networks that connect traders with each other.
Exchange-Traded Funds (ETFs) - portfolios of stocks that can be bought or sold in a single trade.
SPDRs (Standard & Poor’s Depository Receipts or “spiders”) – ETFs, which are portfolios tracking several Standard & Poor’s stock market indexes.
4-5
How Common Stocks Are Valued
Book Value - Net worth of the firm according to the balance sheet.
Dividend - Periodic cash distribution from the firm to the shareholders.
P/E Ratio - Price per share divided by earnings per share.
Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.
4-6
How Common Stocks Are Valued
dividends) future dPV(expectePV(stock)
The value of any stock is the present value of its future cash flows. This reflects the DCF formula. Dividends represent the future cash flows of the firm.
4-7
How Common Stocks Are Valued
Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.
Expected Return
rDiv P P
P1 1 0
0
4-8
How Common Stocks Are Valued
Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?
15.100
1001105Return Expected
4-9
How Common Stocks Are Valued
The price of any share of stock can be thought of as the present value of the futures cash flows. For a stock the future cash flows are dividends and the ultimate sales price of the stock.
r
PDivP
1
Price 110
4-10
How Common Stocks Are Valued
Example - continued: Fledgling Electronics price can be thought of as follows.
10015.1
1105Price 0
P
4-11
How Common Stocks Are Valued
Market Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation. It is also called the Cost of Equity Capital.
gP
Divr
gr
DivP
0
1
10Ratetion Capitaliza
4-12
How Common Stocks Are Valued
Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.
PDiv
r
Div
r
Div P
rH H
H01
12
21 1 1
( ) ( )
...( )
H - Time horizon for your investment.
4-13
How Common Stocks Are Valued
Modified formula
PDiv
r
Div
r
Div P
rH H
H01
12
21 1 1
( ) ( )
...( )
HH
H
tt
t
r
P
r
DivP
)1()1(10
4-14
How Common Stocks Are Valued
Example
Fledgling Electronics is forecasted to pay a $5.00 dividend at the end of year one and a $5.50 dividend at the end of year two. At the end of the second year the stock will be sold for $121. If the discount rate is 15%, what is the price of the stock?
00.100$
)15.1(
12150.5
)15.1(
00.521
PV
PV
4-15
How Common Stocks Are Valued
Another Example
Current forecasts are for XYZ Company 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?
4-16
How Common Stocks Are Valued
Another Example
Current forecasts are for XYZ Company 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?
PV
PV
300
1 12
324
1 12
350 94 48
1 12
00
1 2 3
.
( . )
.
( . )
. .
( . )
$75.
4-17
How Common Stocks Are Valued
4-18
Estimating the Cost of Equity Capital
Dividend Yield – The expected return on a stock investment plus the expected growth in the dividends. Similar to the capitalization rate.
gP
Divr
gr
DivP
0
1
10Yield Dividend
4-19
Estimating the Cost of Equity Capital
Example - Northwest Natural Gas stock was selling for $42.45 per share at the start of 2009. Dividend payments for the next year were expected to be $1.68 a share. What is the dividend yield, assuming no growth?
04.45.42
68.1
Yield Dividend
r
r
r
4-20
Estimating the Cost of Equity Capital
Example - continued - Northwest Natural Gas stock was selling for $42.45 per share at the start of 2009. Dividend payments for the next year were expected to be $1.68 a share. What is the dividend yield, assuming a growth rate of 6.1%?
101.
061.45.42
68.1
Yield Dividend
r
r
r
4-21
Estimating the Cost of Equity Capital
Return Measurements
0
1
P
Div YieldDividend
Sharey Per Book Equit
EPS
Equityon Return
ROE
ROE
gP
Divr
gr
DivP
0
1
10 Restated
4-22
Estimating the Cost of Equity Capital
Dividend Growth Rate can also be derived from applying the return on equity to the percentage of earnings plowed back into operations.
g = return on equity X plowback ratio
4-23
Estimating the Cost of Equity Capital
Valuing Non-Constant Growth
HH
HH
r
P
r
Div
r
Div
r
DivPV
)1()1(...
)1()1( 22
11
gr
DivP H
H 1
4-24
Estimating the Cost of Equity Capital
Example – Phoenix produces dividends in three consecutive years of 0, .31, and .65, respectively. The dividend in year four is estimated to be .67 and should grow in perpetuity at 4%. Given a discount rate of 10%, what is the price of the stock??
13.9
)04.10(.
67.
)1.1(
1
)1.1(
65.
)1.1(
31.
)1.1(
03321
PV
4-25
Stock Price and Earnings Per Share
If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as dividends
Plowback Ratio - Fraction of earnings retained by the firm
4-26
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?
4-27
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?
56.55$15.
33.80 P
No Growth With Growth
00.100$10.15.
00.5
10.40.25.
0
P
g
4-28
Stock Price and Earnings Per Share
Example - continuedIf the company did not plowback some earnings, the stock price would remain at $55.56. With the plowback, the price rose to $100.00.
The difference between these two numbers is called the Present Value of Growth Opportunities (PVGO).
44.44$56.5500.100 PVGO
4-29
Stock Price and Earnings Per Share
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.
4-30
Valuing a Business
Valuing a Business or ProjectThe value of a business or Project is usually computed as the discounted value of FCF out to a valuation horizon (H).
The valuation horizon is sometimes called the terminal value and is calculated like PVGO.
HH
HH
r
PV
r
FCF
r
FCF
r
FCFPV
)1()1(...
)1()1( 22
11
4-31
Valuing a Business
Valuing a Business or Project
HH
HH
r
PV
r
FCF
r
FCF
r
FCFPV
)1()1(...
)1()1( 22
11
PV (free cash flows) PV (horizon value)
4-32
Valuing a Business
Example
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%
66613132020202020(%) growth .EPS
1.891.791.681.59.23-.20-1.39-1.15-.96-.80- FlowCash Free
1.891.781.681.593.042.693.462.882.402.00Investment
3.783.573.363.182.812.492.071.731.441.20Earnings
51.3173.2905.2847.2643.2374.2028.1740.1400.1200.10ValueAsset
10987654321
Year
4-33
Valuing a Business
Example - continuedGiven the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%
4.2206.10.
59.1
1.1
1 value)PV(horizon 6
6.3
1.1
23.
1.1
20.
1.1
39.1
1.1
15.1
1.1
96.
1.1
.80-PV(FCF) 65432
4-34
Valuing a Business
Example - continuedGiven the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%
$18.8
22.4-3.6
value)PV(horizonPV(FCF)s)PV(busines
4-35
Web Resources
Click to access web sitesClick to access web sites
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www.dividenddiscountmodel.com
www.valuepro.net
www.nyse.com
www.nasdaq.com
www.londonstockexchange.com
www.tse.or.jp
www.123world.com/stockexchanges
www.rba.co.uk
www.fibv.com