1. (Corporate Valuation) and Stock Valuation
CHAPTER 7
(Corporate Valuation) and Stock Valuation

2. Topics in Chapter
Read sections: 7-1, 7-2, 7-3, 7-11(abc), 7-8, 7-10, 7-12, 7-14.
Features of common stock
Valuing common stock
Dividend growth model
Market multiples
Preferred stock 1

3. Corporate Valuation and Stock Valuation
Firm’s debt/equity mix
Weighted average
cost of capital
(WACC)
Free cash flow
(FCF)
Cost of debt
Cost of equity: The required
return on stock
Dividends (D)

4. Overview
There are two widely used DCF valuation models: the free cash flow valuation model for corporate valuation (then through further calculations to indirectly get stock value) and the dividend growth model (directly) for stock valuation.
In this chapter we will focus on the dividend growth model, and defer the FCF method to Chapter 11. (Please see the previous slide for illustration and the box on P294 for discussion.)

5. 7-1 Legal Rights and Privileges of Common Stockholders
Represents ownership.
Ownership implies control.
Stockholders elect directors: vote in person or through proxy at annual meetings.
The board hires management.
Since managers are “agents” of shareholders, their goal should be: Maximize stock price.
But agency problem may exist.
Other: Preemptive Right (7-1b) and Dividend Right.

6. 7-2 Types of Common Stock
Most firms have only one type of common stock.
Classified stock has special provisions to meet special needs.
Could classify existing stock as founders’ shares (Class B), with voting rights but dividend restrictions.
New shares might be called “Class A” shares, with voting restrictions but full dividend rights.

7. 7-3 Stock Market Reporting
With the advancement in information technology, today you can get real time quotes from many different Internet sources:
etc.

8. Different Approaches for Valuing Common Stock: Overview
Dividend growth model
Constant growth stocks
Nonconstant growth stocks (skipped)
Free cash flow model (skipped)
Using the multiples of comparable firms

9. 7-11 Valuing Common Stocks with the Dividend Growth Model 7-11a Definitions of Terms Used in Stock Valuation Models (for this textbook) 7-11b Expected Dividends as the Basis for Stock Value
P0 = ^
(1 + rs)1 (1 + rs)2 (1 + rs) (1 + rs)∞
D D D D∞ +
+ … +
Stock value = PV of all future dividends discounted at required return
Conceptually correct, but how do you find the present value of an infinite stream?

10. Dividend Assumption: D1 = D0(1 + g)1 D2 = D0(1 + g)2 Dt = D0(1 + g)t
7-11c Valuing a Constant Growth Stock: the Gordon Model Assumption: Suppose dividends are expected to grow at a constant rate, g, forever.
Dividend Assumption:
D1 = D0(1 + g)1
D2 = D0(1 + g)2 …
Dt = D0(1 + g)t
What is the present value of a constant growth Dt when discounted at the stock’s required return, rs? See next slide.

11. Present Value of a Constant Growth Dividend Dt
PV(Dt) =
What happens to as t gets bigger?
If g<rs: Then < 1 and approaches zero as t gets large.
So PV(Dt) approaches zero as t gets large.

12. Constant Dividend Growth: PV of Dt if g<rs$
Years (t)
Dt = D0(1 + g)t
PV of Dt =
D0(1 + g)t
(1 + rs)t
g < r, PV(D∞) → 0
PV of D1 D1 1 2 D0 D2
PV of D2

13. Constant Dividend Growth: Cumulative Sum of PV of Dt if g<rs
What happens to as t gets bigger? Consider this: This sum converges to 1. Similarly, converges to a finite number. See next slide. t 1 2 3 4 5
(1/2)t
1/2
1/4
1/8
1/16
1/32
Σ(1/2)t
3/4
7/8
15/16
Boring

14. Constant Dividend Growth Model (g<rs)
If g is constant and less than rs, then
converges to:

15. What happens if g > rs?^
(1 + rs) (1 + rs) (1 + rs)∞
D0(1 + g)1 D0(1 + g) D0(1 + g)∞ +
+ … +
(1 + g)t
(1 + rs)t
> 1
So g must be less than rs for the constant growth model to be applicable!
If g > rs, then ^
And P0 = ∞
as t goes to infinity.

16. Use the CAPM/SML to calculate rs:
7-11c (continued) Illustration of a Constant Growth Stock First step: estimate required rate of return Example: if beta = 1.28, rRF = 7%, and RPM = 5%.
Use the CAPM/SML to calculate rs:
rs = rRF + (RPM)bFirm
= 7% + (5%)(1.28)
= 13.4%

17. Second step: Calculate Intrinsic Stock Value Using Gordon Model with dividend information Example Continued: D0 = $1.15, g = 8%
D1 = D0(1+g)
D1 = $1.15(1.08) = $1.242

18. 7-11c (continued) Expected Rate of Return on a Constant Growth Stock: Rearrange the Gordon Model to rate of return form Example: if P0=$23, D1=$1.242, and g=8%. What is the expected rate of return?
Then, rs = $1.242/$
= = 13.4% ^
P0 = D1
rs – g to P0 rs =
+ g

19. Expected Stock Price in 1 Year
In general, for constant growth stock,
In our example, D2 = D0(1+g)2 = 1.15(1+0.08)2 = $1.3414 So
= /( ) = /0.054 = $24.84

20. Expected Dividend Yield and Capital Gains Yield for Year 1
$1.242
$23.00 D1 P0
CG Yield = =
P1 – P0 ^
$24.84 – $23.00
= 8% 14

21. Total Year 1 Return
Total return = Dividend yield Capital gains yield.
Total return = 5.4% + 8% = 13.4%
Total return = 13.4% = rs
For constant growth stock:
capital gains yield = dividend growth rate g

22. 7-8 Do Stock Prices Reflect Long-term or Short-term Cash Flows?
The current stock price is $23.00.
The PV of the first 5 dividends is:
= 4.98 (see calculation on next slide)
The percentage of stock price due to “long-term” dividends is:
= 78%.
$23-$4.98
$23.00

23. % of P0 due to the first 5 PV(Divs.)
Suppose the stock price is $ Is this price based on short-term or long-term cash flows?
Year (t) 1 2 3 4 5
Dt = D0 (1+g)t
1.242
1.3414
1.4487
1.5646
1.6897
PV(Dt) = Dt/(1+rs)t
1.0952
1.0431
0.9934
0.9461
0.9010
Sum of PV(Divs. 1-5)
$4.98 P0
$23
% of P0 due to the first 5 PV(Divs.)
22%
% of P0 due
to long-term divs.
78%

24. Intrinsic Stock Value vs. Quarterly Earnings
If most of a stock’s value is due to long-term cash flows, why do so many managers focus on quarterly earnings?
Changes in quarterly earnings can signal changes in future cash flows. This would affect the current stock price.
Managers often have bonuses tied to quarterly earnings, so they have incentive to manage earnings (agency problem).

25. 7-10 Why Are Stock Prices So Volatile?^ D1
rs – g
rs could change: rs = rRF + (RPM)bi
Interest rates (rRF) could change
Risk aversion (RPM) could change
Company’s risk (bi) could change
g could change.

26. Estimated Stock Price: Changes in rs and g
Growth Rate: g
Required Return: rs
11.4%
12.4%
13.4%
14.4%
15.4% 7%
$27.97
$22.79
$19.23
$16.63
$14.65 8%
$36.53
$28.23
$23.00
$19.41
$16.78 9%
$52.23
$36.87
$28.49
$23.21
$19.59
Small changes in g or rs cause large changes in the estimated price.

27. Are volatile stock prices consistent with rational pricing?
Small changes in expected g and rs cause large changes in stock prices.
As new information arrives, investors continually update their estimates of g and rs.
If stock prices aren’t volatile, then this means there isn’t a good flow of information.

28. 7-12 The Market Multiple Method (Focus: estimate the firm’s relative value) (Market Value Ratios in Chapter 3) (Focus: examine market consensus on the firm’s prospect )
There are two basic approaches to Valuation:
The DCF Approach to estimate the intrinsic value: the dividend growth model and the free cash flow valuation model etc.
The Multiples Approach to evaluate the relative value: comparability is the key issue when applying this approach.

29. Using Stock Price Multiples to Estimate Stock Price
Analysts often use the P/E multiple (the price per share divided by the earnings per share).
Example:
Estimate the average P/E ratio of comparable firms. This is the P/E multiple.
Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.

30. Using Entity Multiples
The entity value (V) is the sum of:
The value of equity (# shares of stock multiplied by the price per share)
plus the value of debt.
Pick a measure, such as EBITDA, Sales, (Customers, Eyeballs) etc.
Calculate the average entity ratio for a sample of comparable firms. For example,
V/EBITDA
V/Customers

31. Using Entity Multiples (Continued)
Find the entity value of the firm in question. For example,
Multiply the firm’s EBITDA by the V/EBITDA multiple.
Multiply the firm’s # of customers by the V/Customers multiple.
The result is the firm’s total value.
Subtract the firm’s debt to get the total value of its equity.
Divide by the number of shares to calculate the price per share.

32. Problems with Market Multiple Methods
It is often hard to find comparable firms.
The average ratio for the sample of comparable firms often has a wide range.
For example, the average P/E ratio might be 20, but the range could be from 10 to How do you know whether your firm should be compared to the low, average, or high performers?

33. 7-14 Preferred Stock Hybrid security:
Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. The preferred stockholders usually don’t have voting rights.
However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy. 33

34. Value of Preferred Stock with Stated Maturity:
Value of Perpetual Preferred Stock: PV of Perpetuity Example: A perpetual preferred stock without stated maturity, Dividend = $8/year; Required return = rps = 8%
Value of Preferred Stock with Stated Maturity:
similar to Bond Valuation
Example: a preferred stock has a maturity of 50 years, par value of $100, stated annual dividend rate of 8%. The similar risk preferred stocks are yielding 6% annually, what is the intrinsic value of this preferred stock?
With Financial Calculator: N=50, I/Y=6, PMT=100*0.08=$8, FV=100
CPT PV=

35. Homework Problems Questions on P333: 7-1(aefgh), 7-3;
Problems on P334: 7-2, 7-3, 7-4, 7-8, 7-9, 7-14.