1. copyright © 2003 McGraw Hill Ryerson Limited 5-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 5-2 Chapter 5 Valuing Stocks Chapter Outline  Stocks and the Stock Market  Book Values, Liquidation Values, and Market Values  Valuing Common Stocks  Simplifying the Dividend Discount Model  Growth Stocks and Income Stocks

3. copyright © 2003 McGraw Hill Ryerson Limited 5-3 Stocks and the Stock Market Definitions  In the last chapter, we learned that Governments and corporations borrow money for the long term by issuing and selling securities which are called bonds.  Corporations can also raise long term money by issuing and selling securities which are called stocks or shares. Investors who purchase these shares are called stockholders or shareholders.

4. copyright © 2003 McGraw Hill Ryerson Limited 5-4 Stocks and the Stock Market Definitions  Issuing stock is like taking on new partners. Shareholders become part-owners of the issuing firm, electing a board of directors to represent their interests. The shareholders are entitled to the firm’s residual cash flow. The residual cash flow is the remaining cash flow after all employees, suppliers, lenders and the government have been paid.

5. copyright © 2003 McGraw Hill Ryerson Limited 5-5 Stocks and the Stock Market Definitions  The stockholders, as owners, share in the fortunes of the firm.  Shares of stock can be risky investments: For example, the shares of 360networks were first issued at $21 a share in April 2000. By September 2000, they were trading at $35.90. Less than a year later, they were worth $0.34 per share! No wonder investors want active markets in which to buy and sell their shares at will!

6. copyright © 2003 McGraw Hill Ryerson Limited 5-6 Stocks and the Stock Market Dividends  Dividends are periodic cash distributions from the firm to its shareholders.  Dividends represent that share of the firm’s profits which are distributed.  Profits can also be retained in the firm and reinvested in its operations: Profits which are kept in the firm are called retained earnings.

7. copyright © 2003 McGraw Hill Ryerson Limited 5-7 Stocks and the Stock Market Dividends  If you look at Figure 5.2, you will see that different firms have different dividends: Some firms pay no dividends at all! Molson pays an annual dividend of $0.72 per share.  Dividends, unlike coupon payments, are not fixed -- they represent a share in the profits and profits can go down …  Though you hope that profits, and thus the dividend, will grow with time!

8. copyright © 2003 McGraw Hill Ryerson Limited 5-8 Stocks and the Stock Market Dividends  If you look at Figure 5.2, you will also see, in the Yield column, the dividend yield.  The dividend yield is calculated the same way as the current yield on a bond – divide the annual income by the price of the security: Dividend Yield = Dividend Payment Stock Price

9. copyright © 2003 McGraw Hill Ryerson Limited 5-9 Stocks and the Stock Market Dividends  For Molson, the dividend is $0.72 on a price of $46.45.  Thus: Dividend Yield = Dividend Payment Stock Price = $0.72 4 $46.45 = 0.016 = 1.6%

10. copyright © 2003 McGraw Hill Ryerson Limited 5-10 Stocks and the Stock Market Dividends  Note that investors will accept low, or zero, current yields if they can look forward to: Higher future dividends. Rising share prices.  Note also, that like the current yield, the dividend yield calculation ignores potential capital gains or losses. Therefore, like the current yield, it is a poor measure of total return on your investment.

11. copyright © 2003 McGraw Hill Ryerson Limited 5-11 Stocks and the Stock Market Price-Earnings (P/E) Ratio  Table 5.6 shows the P/E ratio. The P/E ratio is the price of the stock divided by the earnings per share (eps).  Thus for Molson: P/E Ratio = Stock Price eps = $46.45 4 $2.25 = 20.6x

12. copyright © 2003 McGraw Hill Ryerson Limited 5-12 Stocks and the Stock Market Price-Earnings (P/E) Ratio  The P/E ratio measures how much an investor would pay for every $1 of eps: For Molson, investors are willing to pay $20.60 for each $1 of earnings the company generates. For Methanx, they are willing to pay only $4.30 for each $1 of earnings the company generates.  Key questions: Why does one stock sell for more than another? How do we value a stock?

13. copyright © 2003 McGraw Hill Ryerson Limited 5-13 Stocks and the Stock Market Book Value, Liquidation Value, Market Value  There are three methods used for valuing a company’s shares: Book Value Liquidation Value Market Value

14. copyright © 2003 McGraw Hill Ryerson Limited 5-14 Valuing a Stock Book Value  Book value is the net worth of the firm according to its balance sheet and records all of the money the firm has raised from selling shares and from retained earnings.  In Table 5.1, you can see a balance sheet dated March 31, 2001, for Molson: Molson has $3,280.8 million in assets. It has liabilities of $2,485.4 million. Book Value = $3,280.8 - $2,485.4 = $795.4 million

15. copyright © 2003 McGraw Hill Ryerson Limited 5-15 Valuing a Stock Book Value  Assume Molson has 59.7 million shares outstanding.  That means the book value per share (bvps) for Molson is: $795.4 million / 59.7 million = $13.32 per share  On the same day, its market value per share was $43.70.  Thus, we see that investors do not equate book value and market value.

16. copyright © 2003 McGraw Hill Ryerson Limited 5-16 Valuing a Stock Book Value  Investors do not equate book value and market value because they know that book value is based on the historic cost of the assets.  Historic cost is not a good guide to the value of those assets today.

17. copyright © 2003 McGraw Hill Ryerson Limited 5-17 Valuing a Stock Liquidation Value  What if we were to liquidate all of the assets on Molson’s balance sheet and pay off the liabilities.  Key Question: Would the remaining cash per share equal the market value for Molson shares?

18. copyright © 2003 McGraw Hill Ryerson Limited 5-18 Valuing a Stock Liquidation Value NO IT WOULDN’T!  A successful company ought to be worth more than its liquidation value.  That is, the difference between liquidation value and market value may be attributed to what is known as going concern value.

19. copyright © 2003 McGraw Hill Ryerson Limited 5-19 Valuing a Stock Going Concern Value  Going concern value means that a well managed, profitable firm is worth more than the sum of the value of its assets. ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million Assets sold separately have liquidation value of $11 million ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million The same assets functioning as a firm have going concern value of $15 million

20. copyright © 2003 McGraw Hill Ryerson Limited 5-20 Valuing a Stock Sources of Going Concern Value Extra earning power.  If Molson can use its physical assets more efficiently than a competitor could, then those assets are worth more than their resale value (book value). Intangible assets.  Molson may have extremely valuable assets, such as brand names, which do not appear on the balance sheet, but are reflected in the market value. Value of future investments.  If Molson shareholders believe that Molson has opportunities to invest in lucrative projects which will increase the company’s future earnings, they will pay more for the company’s shares today.

21. copyright © 2003 McGraw Hill Ryerson Limited 5-21 Valuing a Stock Market Value  Book Value or Liquidation Value  Stocks rarely sell at either book value or liquidation value. Unlike market value, book value and liquidation value do not treat the firm as a going concern.  Market value is the amount investors are willing to pay today for the shares of the firm. This depends on the earning power of the existing assets and the expected profitability of future investments.

22. copyright © 2003 McGraw Hill Ryerson Limited 5-22 Valuing a Stock Market Value  The key question is: HOW DO WE MEASURE MARKET VALUE?

23. copyright © 2003 McGraw Hill Ryerson Limited 5-23 Valuing Common Stocks Expected Return  In Chapter 4, you learned how to calculate the expected return on a security: Assuming that: The current price of the shares is P 0. The expected price a year from now is P 1. The expected dividend a year from now is D 1. Expected Return = income + price change investment = D 1 + P 1 – P 0 P 0

24. copyright © 2003 McGraw Hill Ryerson Limited 5-24 Valuing Common Stocks Expected Return  Note that expected return can be divided into two parts: Expected return = Dividend Yield + Capital Gain = D 1 + P 1 – P 0 P 0 P 0

25. copyright © 2003 McGraw Hill Ryerson Limited 5-25 Valuing Common Stocks Expected Return  Assume that for Blue Sky shares: The current price of the shares is $75. The expected price a year from now is $81. The expected dividend a year from now is $3. What is Blue Sky’s expected return?

26. copyright © 2003 McGraw Hill Ryerson Limited 5-26 Valuing Common Stocks Expected Return  Blue Sky’s expected return is: Expected Return = D 1 + P 1 – P 0 P 0 = $3 + 81 – 75 $75 = 0.12 = 12%  Note that this expected return can be decomposed into two parts: The expected dividend yield. The expected capital gain.

27. copyright © 2003 McGraw Hill Ryerson Limited 5-27 Valuing Common Stocks Expected Return  For Blue Sky: Expected return = Dividend Yield + Capital Gain = D 1 + P 1 – P 0 P 0 P 0 = $3 + $81 - $75 $75 $75 = 0.04 + 0.08 = 4% + 8% = 12%

28. copyright © 2003 McGraw Hill Ryerson Limited 5-28 Valuing Common Stocks Expected Return vs Actual Return  Expected return is a forecast of what the return would be if your predictions about the price and the dividend are correct.  However, the actual return on a stock could be more or less than what you expect!  Calculate how well you did as versus the 12% expected return if the following occurs to Blue Sky stock: The actual price a year from now is $61. The actual dividend a year from now is $3.

29. copyright © 2003 McGraw Hill Ryerson Limited 5-29 Valuing Common Stocks Dividend Discount Model (DDM)  Like any other security, we can calculate the value of a common stock by getting the PV of all its future cash flows.  For stocks we can make a simplifying assumption that the firm will pay dividends (cash flows) in perpetuity.  In Chapter 3, you learned that there are two kinds of perpetuity: Perpetuities which grow at a constant rate. Constant value perpetuities (no growth).

30. copyright © 2003 McGraw Hill Ryerson Limited 5-30 Valuing Common Stocks Dividend Discount Model (DDM)  The PV of a growing perpetuity is calculated by dividing the cash payment (the dividend) by the discount rate less the growth rate: PV of a perpetuity = C r-g Dividend 1 Discount Rate – Growth Rate = = Div 1 r-g

31. copyright © 2003 McGraw Hill Ryerson Limited 5-31 Valuing Common Stocks Dividend Discount Model (DDM)  What would be the price of Blue Sky shares if: Next year’s dividend (D 1 ) will be $3. Dividends grow at 8% in perpetuity. The discount rate is 12%. PV of a perpetuity = Div 1 r-g = $3.00 0.12 – 0.08 $75.00=

32. copyright © 2003 McGraw Hill Ryerson Limited 5-32 Valuing Common Stocks Dividend Discount Model (DDM)  The PV of a constant value perpetuity is calculated by dividing the cash payment (the dividend) by the discount rate.  That is, the growth rate is zero and drops out! PV of a perpetuity = C r-g Dividend 1 Discount Rate – Growth Rate = = Div 1 r - 0 = Div 1 r

33. copyright © 2003 McGraw Hill Ryerson Limited 5-33 Valuing Common Stocks Dividend Discount Model (DDM)  What would be the price of Blue Sky shares if: All future dividends (D 1, D 2, D 3, …) will be $3 (i.e., dividends are constant at $3 and do not grow). The discount rate is 12%. PV of a perpetuity = Div 1 r = $3.00 0.12 $25.00 =

34. copyright © 2003 McGraw Hill Ryerson Limited 5-34 Valuing Common Stocks DDM vs Expected Rate of Return  The DDM can be rearranged so that we can calculate the expected rate of return on the stock: r = D 1 P0P0 + g = Dividend Yield + Growth Rate  What is the expected return for Blue Sky if: Next year’s dividend (D 1 ) will be $3. Dividends grow at 8% in perpetuity. The current price is $75.

35. copyright © 2003 McGraw Hill Ryerson Limited 5-35 Valuing Common Stocks DDM vs Expected Rate of Return  The expected rate of return on Blue Sky would be: r= D 1 P0P0 + g = Dividend Yield + Growth Rate = $3 $75 +.08 =.04+.08=4%+8%=12%

36. copyright © 2003 McGraw Hill Ryerson Limited 5-36 Valuing Common Stocks Calculating “g” (growth rate)  How fast a firm grows depends on how much of its profits are reinvested in operations: The fraction of earnings retained by the firm is called the plowback ratio. The fraction of earnings a company pays out in dividends is called the payout ratio.  What is Blue Sky’s payout ratio and plowback ratio if: It has eps of $5. It pays a dividend of $3 and retains the balance.

37. copyright © 2003 McGraw Hill Ryerson Limited 5-37 Valuing Common Stocks Calculating “g” (growth rate)  What is the payout ratio? The plowback ratio? Payout ratio= Dividend/ eps = $3/ $5 = 0.60 = 60% Plowback ratio = 1 – payout ratio = 1 – 0.60 = 0.40 = 40%

38. copyright © 2003 McGraw Hill Ryerson Limited 5-38 Valuing Common Stocks Calculating “g” (growth rate)  Assume that Blue Sky can earn a 20% return on new equity investments. If all of its earnings were reinvested, Blue Sky would grow at 20% per year. If all of its earnings were paid out as dividends – i.e., none of the earnings were reinvested – then Blue Sky would forgo any growth (growth = 0%). If part of its earnings were reinvested, then Blue Sky would grow at between 0% and 20% per year. You should see that the higher the plowback rate, the higher the growth rate.

39. copyright © 2003 McGraw Hill Ryerson Limited 5-39 Valuing Common Stocks Calculating “g” (growth rate)  You can calculate the growth rate for a company by multiplying the return on equity by the plowback ratio: g= roe x plowback ratio  For Blue Sky, the growth rate would be: g= roe x plowback ratio = 20% x 40% = 8%

40. copyright © 2003 McGraw Hill Ryerson Limited 5-40 Valuing Common Stocks Calculating “g” (growth rate)  Growth rates calculated this way: Sustainable Growth Rates g= roe x plowback ratio  are known as sustainable growth rates.

41. copyright © 2003 McGraw Hill Ryerson Limited 5-41 Valuing Common Stocks Growth Stocks vs Income Stocks  Let’s try a few problems with Blue Sky and see what we can learn about growth and stock value.  In all cases, assume that Blue Sky has: Expected eps of $5 next year. A discount rate of 12%.

42. copyright © 2003 McGraw Hill Ryerson Limited 5-42 Valuing Common Stocks Growth Stocks vs Income Stocks Problem 1:  Assume that Blue Sky has: A payout ratio of 100%. What is the value of Blue Sky stock? Problem 2:  Assume now that Blue Sky has: A payout ratio of 60%. The roe on new investment is 10%. What is the value of Blue Sky stock?

43. copyright © 2003 McGraw Hill Ryerson Limited 5-43 Valuing Common Stocks Growth Stocks vs Income Stocks Problem 3:  Assume now that Blue Sky has: A payout ratio of 60%. The roe on new investment is 12%. What is the value of Blue Sky stock? Problem 4:  Assume now that Blue Sky has: A payout ratio of 60%. The roe on new investment is 20%. What is the value of Blue Sky stock?

44. copyright © 2003 McGraw Hill Ryerson Limited 5-44 Valuing Common Stocks Growth Stocks vs Income Stocks Prob. # Plowback RatioROE g (Sustainable growth rate) Div 1 P0P0 10%*0.0%$5.00$41.67 240%10%4.0%$3.00$37.50 340%12%4.8%$3.00$41.67 440%20%8.0%$3.00$75.00 * Since the plowback ratio = 0%, sustainable growth rate will equal 0% regardless of the ROE. Thus, ROE is irrelevant. You should get the following results: *

45. copyright © 2003 McGraw Hill Ryerson Limited 5-45 Valuing Common Stocks Growth Stocks vs Income Stocks  You should see the following in your calculations: Problem 1 o If Blue Sky does not reinvest any of its earnings, then its stock price would be $41.67. This price represents the value of earnings from assets which are already in place.

46. copyright © 2003 McGraw Hill Ryerson Limited 5-46 Valuing Common Stocks Growth Stocks vs Income Stocks Problem 2 o If Blue Sky invests in projects which generate a return less than its discount rate, then its stock price would drop to $37.50. o With zero growth, Blue Sky stock was worth $41.67. o The share price is $4.17 lower because of investing in projects with an unattractive rate of return! Lesson from Problem 2: o Successful financial managers do not invest in projects which earn less than the discount rate – it would reduce the value of the company’s shares!

47. copyright © 2003 McGraw Hill Ryerson Limited 5-47 Valuing Common Stocks Growth Stocks vs Income Stocks Problem 3 o If Blue Sky invests in projects with a return equal to its discount rate, then its stock price would be $41.67. o But, this is the same price as for zero growth … why didn’t growth translate into a higher share price? Lesson from Problem 3: Successful financial managers know that plowing earnings back into a company does not add value unless investors believe the reinvested earnings will earn more than the discount rate.

48. copyright © 2003 McGraw Hill Ryerson Limited 5-48 Valuing Common Stocks Growth Stocks vs Income Stocks Problem 4 o If Blue Sky invests in projects with a return which is greater than its discount rate, then its stock price would rise to $75. o We know from Problem 1, that $41.67 is the value of the earnings from assets which are already in place. o Thus, $33.33 ($75 - $41.67) represents the value to investors of the superior return on future investments. Lesson from Problem 4: o This superior return is know as the Present Value Of Growth Opportunities (PVGO)

49. copyright © 2003 McGraw Hill Ryerson Limited 5-49 Valuing Common Stocks Growth Stocks vs Income Stocks  The earnings potential of Blue Sky will be reflected in its Price-Earnings ratio.  Blue Sky has expected earnings of $5.  With high growth prospects, its price is $75: Its P/E ratio = P/eps = $75 / $5 = 15x15.0 x  With no growth prospects, its price is $41.67: Its P/E ratio = P/eps = $41.67 / $5 = 8.3X8.3 x

50. copyright © 2003 McGraw Hill Ryerson Limited 5-50 Valuing Common Stocks Price Earnings Ratio and Growth  Successful financial managers know that to justify a high P/E ratio on their company’s stock, they must deliver … … lots of growth opportunities!

51. copyright © 2003 McGraw Hill Ryerson Limited 5-51 Summary of Chapter 5  Firms which wish to raise long-term capital may issue bonds (borrow money) or equity.  Issuing equity is like taking on new partners.  Equity may be called shares or stocks.  Information on stocks is regularly reported in the financial pages of newspapers and online financial services.

52. copyright © 2003 McGraw Hill Ryerson Limited 5-52 Summary of Chapter 5  Calculate the value of a stock by working out the PV of the stock’s future dividends. This model is called the Dividend Discount Model (DDM).  If dividends are expected to grow forever at a constant rate “g”, then the value of the stock is equal to: P 0 = Div 1 / (r – g)  The expected return on the stock under these conditions will be equal to: The dividend yield (Div 1 / P 0 ) plus The expected growth rate (g)

53. copyright © 2003 McGraw Hill Ryerson Limited 5-53 Summary of Chapter 5  You can think of a share’s value as the sum of two parts: The value of the assets in place plus The Present Value of Growth Opportunities (PVGO).  The PVGO represents the firm’s future ability to invest in high-return projects.  The firm’s P/E ratio will reflect the market’s assessment of the firm’s PVGO.  The higher the PVGO, the higher the firm’s P/E ratio will be.