Analysis of Common Stocks

Investments and Portfolio Management

Outline

Process of Valuation of a Financial Asset Process of Valuation of Common Stocks Determining parameters of models

How to determine the growth rate? Length of growth period How to determine the required rate of return

Models for Stock Valuation Dividend Discount Models Price-Earnings Models Free Cash Flow to Equity Valuation Models

Valuation of Financial Assets

Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows

Three step process: Estimate the expected cash flows Determine the appropriate interest rate or interest rates to

discount the cash flows Compute the present value of the expected cash flows in

step 1 by discounted them with interest rate(s) in step 2

Estimating Cash Flows

Holding aside the risk of bankruptcy, the cash flows of a common stock are:

Payment of dividend so long as we hold the stock Sale price of common stock when we sell the stock

Is it difficult to estimate the cash flows of a common stock?

Value of a Common Stock

Fair Market Value of a common stock depends on PV of cash flows from a stock PV of an infinite dividend stream OR PV of a finite dividend stream plus PV of the sale

price of the stock

Discounted Cash Flow Valuation

Value of any asset—a function of 3 variables How it generates its cash flows? When these cash flows are expected to occur? Uncertainty of these cash flows

t=n CFt

Value = ----------

t=1 (1+r)t

Dividend Discount Model (DDM)

Value of a share of common stock is the present value of all future dividends

n DPSt

Value per share of stock= ---------- t=1 (1+r)t

What if the stock is not held for an infinite period? One year holding period Multiple year holding periods

Dividend Discount Model

Two types of cash flows Dividends during the holding period Expected price at the end of holding period—this itself is

dependent on future dividends

How to determine the value of a share of common stock?

Infinite Holding Period

What will be the value of a share of common stock? Present value of an infinite stream of anticipated

dividends Simplified assumptions to simply valuation model

Zero Growth Model Constant Growth Model Two-stage growth model Three-stage growth model

Zero Growth Model

Dividend every year will be the same Investor anticipates to receive the same

amount dividend per year forever

DPS V = -------------

rcs

Constant Growth Model

Assume that firm grows at a stable growth rate of g per year forever

DPS1

V = ---------

r - g

Two-Stage DDM

In general version of the model, two stages of growth An initial period of extraordinary growth After initial period, a period of stable growth

n DPSt Pn

P0 = ---------- + --------- t=1 (1+r)t (1 + r)n

DPSn+1

Where Pn = -----------------

(r – gn)

Three-stage growth model

Four Basic Inputs

Length of high growth period Dividends per share each period Required rate of return by stockholders each

period Terminal price at the end of high growth

period

High Growth Rate and Stable Growth Rate

Stable Growth Rate? Growth rate expected to last forever Firm’s other measures of performance including can be

expected to grow at the same rate What growth rate is reasonable as a “stable” growth

rate? A firm cannot in the long term grow at a rate significantly

greater than the growth rate in the economy Length of High Growth Period?

How much is the current growth rate? Source of high growth?

High Growth Period

The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth period

The larger the current size of the firm, the shorter the high-growth period.

Guide to Length of High-Growth Period

Current Growth Length of High

Rate Growth Period

1% higher than stable No high growth

1 – 10% higher than stable 5 years

> 10% higher than stable 10 years

How do we Estimate Growth Rate?

g = b[ROA+D/E(ROA-I (1-t))] Where b refers to the retention ratio ROA is the return on assets D/E is the debt to equity ratio in book value terms i = interest expense/book value of debt

FCFE Valuation Model

The cash flow that the firm can afford as dividends and contrasted with actual dividends—may not payout as dividends

The residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and create new assets for future growth.

FCFE = Net Income + Depreciation – Capital Spending - Working Capital – Principal Repayments + New Debt Issues

If there is a target debt ratio, FCFE = Net Income - (1 - )(Capital

Expenditure – Depreciation) - ( 1- ) Working Capital

FCFE Model

n FCFEt Pn

P0 = ---------- + ---------

t=1 (1+r)t (1 + r)n

FCFEn+1

Where Pn = -----------------

(r – gn)