Basics of stock valuation

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Basics of stock valuation

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Basics of stock valuation

  1. 1. Analysis of Common Stocks Investments and Portfolio Management
  2. 2. Outline <ul><li>Process of Valuation of a Financial Asset </li></ul><ul><li>Process of Valuation of Common Stocks </li></ul><ul><li>Determining parameters of models </li></ul><ul><ul><li>How to determine the growth rate? </li></ul></ul><ul><ul><li>Length of growth period </li></ul></ul><ul><ul><li>How to determine the required rate of return </li></ul></ul><ul><li>Models for Stock Valuation </li></ul><ul><ul><li>Dividend Discount Models </li></ul></ul><ul><ul><li>Price-Earnings Models </li></ul></ul><ul><ul><li>Free Cash Flow to Equity Valuation Models </li></ul></ul>
  3. 3. Valuation of Financial Assets <ul><li>Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows </li></ul><ul><li>Three step process: </li></ul><ul><ul><li>Estimate the expected cash flows </li></ul></ul><ul><ul><li>Determine the appropriate interest rate or interest rates to discount the cash flows </li></ul></ul><ul><ul><li>Compute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2 </li></ul></ul>
  4. 4. Estimating Cash Flows <ul><li>Holding aside the risk of bankruptcy, the cash flows of a common stock are: </li></ul><ul><ul><ul><li>Payment of dividend so long as we hold the stock </li></ul></ul></ul><ul><ul><ul><li>Sale price of common stock when we sell the stock </li></ul></ul></ul><ul><li>Is it difficult to estimate the cash flows of a common stock? </li></ul>
  5. 5. Value of a Common Stock <ul><li>Fair Market Value of a common stock depends on </li></ul><ul><ul><li>PV of cash flows from a stock </li></ul></ul><ul><ul><li>PV of an infinite dividend stream OR </li></ul></ul><ul><ul><li>PV of a finite dividend stream plus PV of the sale price of the stock </li></ul></ul>
  6. 6. Discounted Cash Flow Valuation <ul><li>Value of any asset—a function of 3 variables </li></ul><ul><ul><li>How it generates its cash flows? </li></ul></ul><ul><ul><li>When these cash flows are expected to occur? </li></ul></ul><ul><ul><li>Uncertainty of these cash flows </li></ul></ul><ul><li>t=n CF t </li></ul><ul><li>Value =  ---------- </li></ul><ul><li>t=1 (1+r) t </li></ul>
  7. 7. Dividend Discount Model (DDM) <ul><li>Value of a share of common stock is the present value of all future dividends </li></ul><ul><li>n DPS t </li></ul><ul><li>Value per share of stock=  ---------- </li></ul><ul><li>t=1 (1+r) t </li></ul><ul><li>What if the stock is not held for an infinite period? </li></ul><ul><ul><li>One year holding period </li></ul></ul><ul><ul><li>Multiple year holding periods </li></ul></ul>
  8. 8. Dividend Discount Model <ul><li>Two types of cash flows </li></ul><ul><ul><li>Dividends during the holding period </li></ul></ul><ul><ul><li>Expected price at the end of holding period—this itself is dependent on future dividends </li></ul></ul><ul><li>How to determine the value of a share of common stock? </li></ul>
  9. 9. Infinite Holding Period <ul><li>What will be the value of a share of common stock? </li></ul><ul><ul><li>Present value of an infinite stream of anticipated dividends </li></ul></ul><ul><li>Simplified assumptions to simply valuation model </li></ul><ul><ul><li>Zero Growth Model </li></ul></ul><ul><ul><li>Constant Growth Model </li></ul></ul><ul><ul><li>Two-stage growth model </li></ul></ul><ul><ul><li>Three-stage growth model </li></ul></ul>
  10. 10. Zero Growth Model <ul><li>Dividend every year will be the same </li></ul><ul><li>Investor anticipates to receive the same amount dividend per year forever </li></ul><ul><li>DPS </li></ul><ul><li>V = ------------- </li></ul><ul><li>r cs </li></ul>
  11. 11. Constant Growth Model <ul><li>Assume that firm grows at a stable growth rate of g per year forever </li></ul><ul><li>DPS 1 </li></ul><ul><li>V = --------- </li></ul><ul><li>r - g </li></ul>
  12. 12. Two-Stage DDM <ul><li>In general version of the model, two stages of growth </li></ul><ul><ul><li>An initial period of extraordinary growth </li></ul></ul><ul><ul><li>After initial period, a period of stable growth </li></ul></ul><ul><ul><li>n DPS t P n </li></ul></ul><ul><li>P 0 =  ---------- + --------- </li></ul><ul><li>t=1 (1+r) t (1 + r) n </li></ul><ul><li>DPS n+1 </li></ul><ul><li>Where P n = ----------------- </li></ul><ul><li>(r – g n ) </li></ul>
  13. 13. Three-stage growth model
  14. 14. Four Basic Inputs <ul><li>Length of high growth period </li></ul><ul><li>Dividends per share each period </li></ul><ul><li>Required rate of return by stockholders each period </li></ul><ul><li>Terminal price at the end of high growth period </li></ul>
  15. 15. High Growth Rate and Stable Growth Rate <ul><li>Stable Growth Rate? </li></ul><ul><ul><li>Growth rate expected to last forever </li></ul></ul><ul><ul><li>Firm’s other measures of performance including can be expected to grow at the same rate </li></ul></ul><ul><li>What growth rate is reasonable as a “stable” growth rate? </li></ul><ul><ul><li>A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy </li></ul></ul><ul><li>Length of High Growth Period? </li></ul><ul><ul><li>How much is the current growth rate? </li></ul></ul><ul><ul><li>Source of high growth? </li></ul></ul>
  16. 16. High Growth Period <ul><li>The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth period </li></ul><ul><li>The larger the current size of the firm, the shorter the high-growth period. </li></ul>
  17. 17. Guide to Length of High-Growth Period <ul><li>Current Growth Length of High </li></ul><ul><li>Rate Growth Period </li></ul><ul><li>1% higher than stable No high growth </li></ul><ul><li>1 – 10% higher than stable 5 years </li></ul><ul><li>> 10% higher than stable 10 years </li></ul>
  18. 18. How do we Estimate Growth Rate? <ul><li>g = b [ROA+D/E(ROA- I (1-t))] </li></ul><ul><ul><li>Where b refers to the retention ratio </li></ul></ul><ul><ul><li>ROA is the return on assets </li></ul></ul><ul><ul><li>D/E is the debt to equity ratio in book value terms </li></ul></ul><ul><ul><li>i = interest expense/book value of debt </li></ul></ul>
  19. 19. FCFE Valuation Model <ul><li>The cash flow that the firm can afford as dividends and contrasted with actual dividends—may not payout as dividends </li></ul><ul><li>The residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and create new assets for future growth. </li></ul>
  20. 20. <ul><li>FCFE = Net Income + Depreciation – Capital Spending -  Working Capital – Principal Repayments + New Debt Issues </li></ul><ul><li>If there is a target debt ratio,  </li></ul><ul><li>FCFE = Net Income - (1 -  )(Capital Expenditure – Depreciation) - ( 1-  )  Working Capital </li></ul>
  21. 21. FCFE Model <ul><ul><li>n FCFE t P n </li></ul></ul><ul><li>P 0 =  ---------- + --------- </li></ul><ul><li>t=1 (1+r) t (1 + r) n </li></ul><ul><li> FCFE n+1 </li></ul><ul><li>Where P n = ----------------- </li></ul><ul><li>(r – g n ) </li></ul>

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