1. comm 324 --- W. Suo Slide 1

2. comm 324 --- W. Suo Slide 2  Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios  Estimating Growth Rates and Opportunities Fundamental Analysis: Models of Equity Valuation

3. comm 324 --- W. Suo Slide 3  Intrinsic Value Self assigned Value Variety of models are used for estimation  Market Price Consensus value of all potential traders  Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced Intrinsic Value and Market Price

4. comm 324 --- W. Suo Slide 4 V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models (DDM): General Model

5. comm 324 --- W. Suo Slide 5  No growth: Stocks that have earnings and dividends that are expected to remain constant Preferred Stock  Example EPS 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 Special Cases

6. comm 324 --- W. Suo Slide 6 g = constant perpetual growth rate Constant Growth Model

7. comm 324 --- W. Suo Slide 7 EPS 1 = $5.00b = 40% k = 15% (1-b) = 60% D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 -.08) = $42.86 Constant Growth Model: Example

8. comm 324 --- W. Suo Slide 8 Model-Building Assumptions  k > g (otherwise denominator would be negative, leading to a negative stock price) Both k and g represent long-run averages  Ignores taxes, external financing and options Allowing for taxes and debt financing is relatively easy Allowing for executive stock options and warrants is more difficult

9. comm 324 --- W. Suo Slide 9 Structural Changes in Cash Dividend Payments  Corporate earnings will be used for Cash dividends paid to owners (shareholders) Retained earnings reinvested in firm Share buybacks to repurchase outstanding shares  Recently firms have decreased cash dividend growth rates and begun buying back stock Examples: IBM, American Express, Coca-Cola

10. comm 324 --- W. Suo Slide 10 Restating Present Value Models in Terms of Earnings  The retention ratio, or plowback ratio, b represents the portion of earnings not paid as dividends Therefore, it is retained earnings  The payout ratio is (1 –b)  Thus, a firm’s dividend can be rewritten as D t = (1 – b)*EPS t  A firm can use retained earnings to either repurchase shares or to reinvest and earn the firm’s ROE Reinvested earnings can finance internal growth at a periodic rate of g = b*ROE Therefore, EPS t = EPS 0 * (1+g) t = EPS 0 [1 + b*(ROE)] t

11. comm 324 --- W. Suo Slide 11 Restating Present Value Models in Terms of Earnings  Profitable firms can earn ROE > 0 by reinvesting RE in profitable projects or repurchasing shares Share repurchases can increase EPS because the firm’s earnings are now spread out over fewer shares (called reverse dilution) If the b>0, then the following equations are equivalent D t = (1 – b) EPS t D t = (1 – b) (1 + g) t EPS 0 D t = (1 – b) [1 + b*(ROE)] t EPS 0

12. comm 324 --- W. Suo Slide 12 Reformulated Present Value Model  Substituting the basic discounted dividend model  If D 1 is replaced with EPS 1 (1 – b) in the constant DDM, we obtain:  This allows us the ability to examine how dividend policy impacts share value Dividend policy is reflected in the retention rate b

13. comm 324 --- W. Suo Slide 13 Dividend Policy Irrelevance  Since g = b*(ROE)  If a firm has an ROE on new investments equal to the risk-adjusted discount rate then  Thus, regardless of a firm’s initial EPS or riskiness, the firm’s value is unaffected by dividend policy, as RR is no longer in the equation  So, when ROE = k dividend policy is irrelevant

14. comm 324 --- W. Suo Slide 14 Dividend Policy and Growth Firms  The relationship between a firm’s ROE and its discount rate determine the impact of dividend policy on firm value A firm earning an ROE > discount rate is considered a growth firm Declining firms have ROE below the discount rate, or ROE < k When ROE = k dividend policy is irrelevant

15. comm 324 --- W. Suo Slide 15 Example  Assume a firm has An ROE of 15% A discount rate, k, of 15% A retention rate b of 66.67% Leads to a growth rate of 0.6667 x.15 = 10% Cash dividends growth rate of 10%  If these assumptions hold, the firm’s value will remain a constant $50 (in present value terms)

16. comm 324 --- W. Suo Slide 16 Example Future Value at g = 10%Present Value at k = 15% Time PeriodDiv t Stock Price PV of cumulative dividend PV of future priceTotal T=0NA$50NA$50 T=1$2.5055$2.18$47.8250 T=2$2.7560.504.2645.7450 T=33.0366.556.2543.7650 T=43.3373.208.1541.8550 T=53.6680.539.9740.0350 T=105.89129.6817.9432.0650 T=2015.29336.3729.4420.5650 T=50266.805869.5544.585.4250 T=10031,319.57689,030.6249.410.5950 T=  500.050

17. comm 324 --- W. Suo Slide 17 P N = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Specified Holding Period Model

18. comm 324 --- W. Suo Slide 18 PVGO = Present Value of Growth Opportunities E 1 = Earnings per share for period 1 Partitioning Value: Growth and No Growth Components

19. comm 324 --- W. Suo Slide 19 ROE = 20% d = 60% b = 40% EPS 1 = $5.00 D 1 = $3.00 k = 15% Partitioning Value: Example g =.20 x.40 =.08 or 8%

20. comm 324 --- W. Suo Slide 20 Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example (cont’d)

21. comm 324 --- W. Suo Slide 21 Two Stages of Growth DDM  A firm’s common stock may have one of the following growth patters in dividends Two stages of positive growth (g 1 and g 2 ) One constant positive growth rate Zero growth One constant negative growth rate

22. comm 324 --- W. Suo Slide 22 Example  Battel Corporation has the following attributes: Paid an annual dividend of $2 per share Cost of equity capital is 10% Cash dividends are growing at 2% annually  What is Battel’s stock worth?

23. comm 324 --- W. Suo Slide 23 Example  Battel is now considering international expansion with the following adjustments Same dividend as above, but now the expected growth rate is 4%, not 2%, and the increased risk is expected to increase the cost of equity to 11%  Battel’s value should increase to:

24. comm 324 --- W. Suo Slide 24 Example  Example Initial stock price: $25.50 With international expansion: $29.71  What if the international expansion caused Battel's growth rate to rise to 4% for only four years and then the growth rate dropped to the original estimate of 2% forever? If the exposure to international risks increases Battel’s cost of equity to 11% permanently

25. comm 324 --- W. Suo Slide 25 DDM Criticism  Critics argue that it is too difficult to accurately forecast future cash dividends This criticism is true for some firms but not others Example: Coca-Cola’s dividend payment is relatively easy to forecast even though its operations cover over 200 different countries  Critics then argue that, even if earlier dividends are relatively easy to forecast, longer-term dividends (say 50 to 100 years from now) are more difficult to determine These long-range forecasts are unimportant

26. comm 324 --- W. Suo Slide 26 DDM Criticism Because the present value of these amounts are very low Time Present Value Of $1 (i=10%) Present Value Of $1 (i=16%) 1039¢23¢ 259.2¢2.5¢ 50< 1¢6/100 of 1¢ 100< 1/100 of 1¢3/100,000 of 1¢

27. comm 324 --- W. Suo Slide 27 Implications  It is only essential to accurately forecast cash dividends for 10 years in order to use the DDM  Cash dividends in years 11-30 only need to be forecasted within  40% of their actual values  All cash dividends received from years 31 to infinity have a present value of only $1 or $2  When a higher discount rate is used (as with smaller, riskier firms) it is only necessary to forecast dividends for a few years