Stock and Its Valuation The application of the present value concept Financial management: lecture 5

Financial management: lecture 5 Today’s agenda Review what we have learned in the last lecture Stock and its valuation Some terminology about a stock Value a stock Simple dividend discount model Dividend growth model Financial management: lecture 5

What have we learned in the last lecture Bond? How to value a bond? Yield to maturity and spot rates? Term structure of interest rates and yield curve? Financial management: lecture 5

Financial management: lecture 5 Some questions A bond that pays annual coupon is issued with a coupon rate of 4%, maturity of 30 years, and a yield to maturity of 7%, what will be the rate of return if you buy it now and hold it for one year and the yield to maturity in the next year will be 8%? Financial management: lecture 5

Financial management: lecture 5 What is a stock? A (common) stock is a financial claim that has the following properties: A right to receive dividends after creditors have been paid A right to vote at the annual meeting A limited liability security Dividends are periodic cash flows paid to share holders. They are not guranted. Financial management: lecture 5

Financial management: lecture 5 Stocks & Stock Market Primary Market - Place where the sale of new stock first occurs. Secondary market - market in which already issued securities are traded by investors. P/E ratio - Price per share divided by earnings per share. Dividend yield- Dividends per share divided by the stock price Financial management: lecture 5 27

Financial management: lecture 5 Values of stocks Book Value of a stock- the value according to the balance sheet in the accounting. Market Value of a stock – the value according to the traded stock prices in the market. Financial management: lecture 5 28

Financial management: lecture 5 Stock valuation When you want to invest in a stock, you are very interested in whether the stock is under-priced or over-priced. To find out, you need to value the stock Two simple approaches to price a stock Simple dividend discount model Dividend growth model We will apply these two approaches to real stocks, for example, IBM Financial management: lecture 5

Simple dividend discount model: valuing IBM We will first use the dividend discount model to value the International Business Machine. What does the company do? http://finance.yahoo.com/ Symbol “IBM” Trades on the NYSE We see price is recently $116 hit “detailed” we see the company is paying $3 dividend per share (we will do an annualized problem for simplicity, here we assume that all the earnings are paid out as dividends) Financial management: lecture 5

Valuing IBM (continue) Let’s suppose IBM is going to continue paying $3 dividend per share, forever We are planning to buy the stock and hold it forever Of course, we must be able to draw the cash flow diagram $3 $3 $3 $3 $3 $3 PV ??? Yr1 Yr2 Yr3 Yr4 Yr5 Time=infinity Financial management: lecture 5

Valuing IBM (continue) How much is IBM worth? Suppose the required rate of return by the investor is 10%. The present value of future dividend cash flows should equal the price of IBM. Financial management: lecture 5

Financial management: lecture 5 Valuing IBM (3) Clearly, the price calculated using this simple model is below the current market price Why? we have undervalued the stock the market has overvalued the stock Let’s be humble and assume the former where did we go wrong? Financial management: lecture 5

Financial management: lecture 5 Valuing IBM (4) Sensitivity of our answer to discount rate: Clearly, this is still not the answer Discount rate Price 7% $42.9 $37.5 8% $33.3 9% 11% $27.27 Financial management: lecture 5

Financial management: lecture 5 Valuing IBM (5) What if the dividend is not constant ? Suppose the dividend were to grow at 4% per year: the next dividend will be $3 in two years we will receive $3.12 and so on … Can we derive the formula for a growing perpetuity? define g ≡ 4% the growth rate define C ≡ 3 the dividend received in year one Financial management: lecture 5

Financial management: lecture 5 Dividend growth model When dividends grow at a rate of g=4%, the cash flow diagram looks like as follows: $3*(1.04)∞ $3.0 $3.12 $3.24 $3.37 PV ??? Yr1 Yr2 Yr3 Yr4 Yr5 Time=infinity Financial management: lecture 5

Dividend growth model (2) Based on the diagram, we have the math equation: Financial management: lecture 5

Dividend growth (continue) To calculate the PV of dividend flows with a growth, we can have some math exercise as follows: because Financial management: lecture 5

Dividend growth (continue) How to calculate dividend perpetuity with a growth: Financial management: lecture 5

Dividend growth model (5) Do you think that this formula makes sense ? When g increases, what will happen to the stock price? When r increases, what will happen to the stock price? When g =0, what happens? When g>r, what will happen to the stock price? In order to use the formula, r must be greater than g. Financial management: lecture 5

Back to the valuation of IBM Sensitivity of our answer to growth rate of dividends Next year’s dividend is still $3.0 Discount rate is constant at 10% Certainly, we are close, but g=5% is reasonable? Growth rate Stock price $33.3 1% $37.5 2% $50.0 3% $60.0 4% $75.0 5% Financial management: lecture 5

Sensitivity analysis with respect to discount and growth rates Discount rate Stock price 6% 7% 8% 9% 10% 11% 12% 60 1% 50 43 38 33 30 27 2% 75 Dividend Growth rate 60 50 43 38 33 30 3% 100 75 60 50 43 33 38 4% 150 100 75 60 50 38 43 5% 300 150 100 75 60 50 43 67 5.5% 600 200 120 86 55 46 Financial management: lecture 5

Another way of looking at stock valuation Suppose stock A pays dividend of $3 every year, with a discount rate of 10%. What is the stock price now in the following three cases (a) hold it for ever (b) hold for five years (c) hold it for twenty years Financial management: lecture 5

More on the dividend discount model So far, we have used the dividend cash flows to calculate the stock price. In the real world, can we apply this formula to figure out the stock prices for all the stocks? How? Financial management: lecture 5

How to decide on the growth rate If a firm chooses 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. Financial management: lecture 5 44

More on the dividend growth Growth can be calculated by the return on equity times the plowback ratio Let g= the dividend growth rate g = return on equity X plowback ratio Financial management: lecture 5 45

Financial management: lecture 5 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%. What is the value of the stock before and after the plowback decision? Financial management: lecture 5 46

Financial management: lecture 5 Solution 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%. What is the value of the stock before and after the plowback decision? No Growth With Growth Financial management: lecture 5 47

Financial management: lecture 5 Solution 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%. What is the value of the stock before and after the plowback decision? With Growth No Growth Financial management: lecture 5 48

The present value of growth opportunities If the company did not plowback some earnings, the stock price would remain at $41.67. With the plowback, the price rose to $75.00. The difference between these two numbers (75.00-41.67=33.33) is called the Present Value of Growth Opportunities (PVGO). Financial management: lecture 5 49

Financial management: lecture 5 PVGO again Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments. Financial management: lecture 5 50

Financial management: lecture 5 Valuing Common Stocks Expected rate of 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). Financial management: lecture 5 29

Financial management: lecture 5 Expected return Expected Return – the ratio of the profit over the initial cost Here, P1 is the expected price in period 1, P0 is the current price and Div1 is the expected dividend payment in period 1. Financial management: lecture 5 30

Financial management: lecture 5 An example Example: A stock pays dividend of $3 every year. The current stock price is $100. The expected price is $110 for the next year. If you hold the stock this year, what is the expected rate of return? Financial management: lecture 5

Financial management: lecture 5 My solution The expected return is 13/100=13% P0=$100 P1=$110 Div=$3 Financial management: lecture 5

Financial management: lecture 5 Another example Imagine Corporation has just paid a dividend of $0.40 per share. The dividends are expected to grow at 30% per year for the next two years and at 5% per year thereafter. If the required rate of return in the stock is 15% (APR), calculate the current stock price. Financial management: lecture 5

Financial management: lecture 5 Solution Answer: First: visualize the cash flow pattern; C1, C2 and P2 Then, you know what to do? P0 = [(0.4 *1.3)/1.15] + [(0.4 * 1.3^2)/(1.15^2)] + [(0.4 * 1.3^2*1.05)/((1.15^2 * (.15 -.05))] = $6.33 Financial management: lecture 5