Stocks and Their Valuation Chapter 9 Stocks and Their Valuation

Topics Covered Common and Preferred Stock Properties Valuing Preferred Stocks Valuing Common Stocks - the Dividend Growth Model No growth Constant growth Non-constant or supernormal growth Valuing the Entire Corporation – Free Cash Flow Approach Stock Market Equilibrium 2 2 2 2 3 2

Facts about common stock Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock price

Preferred Stock Characteristics Unlike common stock, no ownership interest Second to debt holders on claim on company’s assets in the event of bankruptcy. Annual dividend yield as a percentage of par value Preferred dividends must be paid before common dividends If cumulative preferred, all missed past dividends must be paid before common dividends can be paid.

Intrinsic 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 (above) its intrinsic value are undervalued (overvalued).

Preferred Stock Valuation Promises to pay the same dividend year after year forever, never matures. A perpetuity. VP = DP/rP Expected Return: rP = DP/P0 Example: GM preferred stock has a $25 par value with a 8% dividend yield. What price would you pay if your required return is 7%?

What do investors in common stock want? Periodic cash flows: dividends, and… To sell the stock in the future at a higher price Management to maximize their wealth

Stock Valuation: Dividend Growth Model Stock Value = PV of Future Expected Dividends 6 5

Stock Valuation: Dividend Patterns For Valuation: we will assume stocks fall into one of the following dividend growth patterns. Constant growth rate in dividends Zero growth rate in dividends, like preferred stock Variable (non-constant) growth rate in dividends 7 6

Stock Valuation Case Study: Doh! Doughnuts We have found the following information for Doh! Doughnuts: current dividend = $2.00 = Div0 The current T-bill rate is 5% and investors demand an 8.5% market risk premium. Doh!’s beta = 1.4.

Analysts Estimates for Doh! Doughnuts NEDFlanders predicts a constant annual growth rate in dividends and earnings of zero percent (0%) Barton Kruston Simpson predicts a constant annual growth rate in dividends and earnings of 10 percent (10%). Homer Co. expects a dramatic growth phase of 30% annually for each of the next 3 years followed by a constant 10% growth rate in year 4 and beyond.

Our Task: Valuation Estimates What should be each analyst’s estimated value of Doh! Doughnuts?

Valuing Common Stocks: No Growth If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Assumes all earnings are paid to shareholders. 38

Ned Flanders’ Valuation D0 = $2.00, rS = 16.9% or 0.169, g = 0%

Constant Growth Valuation Model Assumes dividends will grow at a constant rate (g) that is less than the required return (rS ) If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next year’s dividend as D1: Commonly called the Gordon growth model

Barton Kruston Simpson’s Valuation D0 = $2.00, g = 10%, rS = 16.9%

Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains Yield D1/P0 = Expected Dividend Yield g = Expected Capital Gains Yield r = (D1/P0) + g = (D0(1+g)/P0) + g

Example Burns International’s stock sells for $80 and their expected dividend is $4. The market expects a return of 14%. What constant growth rate is the market expecting for Burns International?

Homer Co. Valuation Variable (non-constant) growth Years 1-3 expect 20% growth After year 3: constant growth of 10%

Variable Growth Stock Valuation Framework: Assume Stock has period of non-constant growth in dividends and earnings and then eventually settles into a normal constant growth pattern (gc). 0 g1 1 g2 2 g3 3 gc 4 gc 5 gc ... D1 D2 D3 Non-constant Growth Period Constant Growth 15 14

Variable Growth Valuation Process 3 Step Process Estimate Dividends during non-constant growth period. Estimate Price, which is the PV of the constant growth dividends, at the end of non-constant growth period which is also the beginning of the constant growth period. This is called the horizon or terminal value. Find the PV of non-constant dividends and horizon value. The total of these PVs = Today’s estimated stock value. 16 15

Back to Homer Co’s Valuation: Step 1 D0 = $2.00, g = 20% or 0.2 for next 3 years

Homer Co’s Valuation: Step 2

Homer Co’s Valuation: Step 3

Homer Co’s Valuation: Step 3 Valuing common stock with nonconstant growth 1 2 3 4 D0 = 2.00 2.400 2.880 3.456 ... 3.802 rs = 16.9% g = 20% gc = 10% 2.053 2.107 2.163 34.491 40.814 = P0 = 0.10 $55.10 3 3.802 0.169 - $ P ^

Corporate 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. Remember, free cash flow is the firm’s after-tax operating income less the net capital investment FCF = NOPAT – Net capital investment

Applying the corporate value model Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs at the company’s weighted average cost of capital, WACC. Subtract MV of firm’s debt and preferred stock to get MV of common stock. Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).

Issues regarding the corporate value 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.

An Example: Advanced Micro Devices (AMD) AMD’s debt market value is $692 million. No preferred stock 486 million shares outstanding Current free cash flow is $286 million. Assume that AMD will experience 21% year 1, 19% year 2 and 18% FCF growth in year 3 and 11% constant annual growth thereafter. AMD’s WACC is approximately 17%.

An Example: AMD Projected FCFs($millions) End of Year Growth Status Growth Rate (%) FCF Calculation 1 Variable 21 $286(1.21) = $346.1 2 19 $346.1 x (1.19) = $411.8 3 18 $411.8 x (1.18) = $485.9 4 Constant 11 $485.9 x (1.11) = $539.4 Use nonconstant growth to estimate AMD!s corporate value.

AMD’s FCF Corporate Valuation ($millions) 1 2 3 4 346.1 411.8 485.9 ... 539.4 WACC =17% gc = 10% 295.8 300.8 303.4 5613.0 6513.0 = Firm Value = 0.11 8989.8 3 539.4 0.17 - $ TV ^

AMD’s Stock Value per share MV of firm = $6513 million MV of debt = $692 million MV of equity (stock) = $6513 - $692 = $5821 million 486 million shares outstanding P0 = MV of equity/shares = $5821/486 = $11.98

Stock Market Equilibrium In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. In equilibrium, two conditions hold: The current market stock price equals its intrinsic value (P0 = P0). Expected returns must equal required returns. ^

How is market equilibrium established? If price is below intrinsic value … The current price (P0) is “too low” and offers a bargain. Buy orders will be greater than sell orders. P0 will be bid up until expected return equals required return.

Doh! In equilibrium? Doh! Doughnuts current stock price is $30. Required return = 5% + 8.5%(1.4) = 16.9% Let’s assume the 2nd analyst is correct and Doh! Has a constant growth rate of 10% and its current dividend is $2. Is Doh! Doughnuts’ current stock price in equilibrium?

Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains Yield D1/P0 = D0(1+g)/P0 = Expected Dividend Yield g = Expected Capital Gains Yield From our example, D1=$2(1.10) = 2.20, P0=$30, g = 10% or 0.1 DOH! Doh! Doughnuts 12 11

The Effect On the Stock Price Expected Return needs to fall to the required return of 16.9%. This means the stock price must rise to the the equilibrium price which yields the required return of 16.9% New Price = D1/(rs- g)=$2.20/(.169 - .1)= $31.88 24 23

Stock Valuation Summary Looked at Dividend Discount Model: Value = PV of future expected dividends. All else equal: Higher interest rates yields lower stock prices (inverse relationship) Higher growth rate yields higher stock price. Other Stock Valuation Methods “Multiples” Method: P/E, P/CF, P/S For example: Price Estimate = PE Ratio x expected EPS