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- 1. MC11-253Muhammad NAWAZHAILEY COLLEGE OF COMMERCE PUNJAB UNIVERSITY LAHORE PAKISTAN
- 2. Common Stock Valuation
- 3. Common StockA security that represents ownership in a company.Holders of common stock exercise control by electinga board of directors.In the event of liquidation, common shareholdershave rights to a companys assets only afterbondholders, preferred shareholders and other debtholders have been paid in full.
- 4. What is Value In general, the value of an asset is theprice that a willing and able buyer pays toa willing and able seller. Note that if either the buyer or seller is notboth willing and able, then an offer doesnot establish the value of the asset.
- 5. Valuation of Financial AssetsProcess of determining the fair market valueof a financial asset on the basis of presentvalue of the expected cash flowsThree step process:1. Estimate the expected cash flows.2. Determine the appropriate interest rate todiscount the cash flows.3. Compute the present value of the expected cashflows by discounted them with interest ratedetermine in step 2.
- 6. Intrinsic ValueMaximum price which an investor isready to pay for purchase of a security.Intrinsic value is present value and isalso called estimated value or economicvalue.
- 7. Intrinsic ValueIntrinsic value is compared with marketvalue of security and is based on thesefactors: Future cash inflows Timing of return Required rate of return i.e. ’’k’’k=risk free rate of return + risk premium.
- 8. Discounted Cash Flow ModelThis technique estimates the value of asecurity by discounting its expected futurecash flows back to the present value andadding them together.The estimated value of a security = presentvalue of future cash flowst=n expected cash flowValue = V0 = ∑ -----------------------------t=1 (1+k)t
- 9. Discounted Cash Flow ModelTo use this model, an investor must: Estimate the amount of future cash flows Estimate the timing of future cash flows Estimate an appropriate discount rate Using above components value of a securityis calculated which is then compared to thecurrent market price of the security This calculated value is denoted by V0 and iscalled intrinsic value
- 10. Discounted Cash Flow Model
- 11. Dividend Discount Model(DDM)Value of a common stock is the present valueof all future dividends.D1 D2 DnValue of stock= ------- + ------- + --- + --------(1+k)1(1+k)2(1+k)nn DnValue of stock = ∑ ----------t=1 (1+k)n
- 12. Dividend Discount Model(DDM)Types of dividend discount model:1.Zero dividend growth2.Constant growth3.Variable growth
- 13. Zero Growth ModelDividend every year will be the sameInvestor anticipates to receive the sameamount dividend per year foreverD1Vcs = ------------- where D1 =D0 (1+g)KcsDividend Discount Model(DDM)
- 14. Dividend Discount Model(DDM)Constant Growth ModelAssume that firm grows at a stablegrowth rate of g per year foreverD1Vcs = ---------Kcs - g
- 15. Variable growth rateAssume that firm’s growth rate is variableD0(1+g1 )tDn +1 1Vcs = ∑ ------------ + ---------- ---------( 1+Kcs )tKcs – g2 (1+Kcs )ng1 = growth in 1stphaseDividend Discount Model(DDM)
- 16. 10-17Intrinsic Value & Market ValueWhen market value is less than or equal tointrinsic value then common stock must beretained or purchased.When market value is greater than intrinsic valuethen common stock must be sold or avoid.
- 17. Other Valuation MethodsSome companies do not pay dividends,or the dividends are unpredictable.In these cases we have several otherpossible valuation models:Free Cash Flow ModelP/E approachPrice to Sales (P/S)
- 18. The Free Cash Flow ModelFree cash flow is the cash flow that’s leftover after making all required investments inoperating assets:Where NOPAT is net operating profit aftertaxNote that the total value of the firm equalsthe value of its debt plus preferred pluscommon:CapOpNOPATFCF ∆−=CSPD VVVV ++=
- 19. The Free Cash Flow ModelWe can find the total value of the firm’soperations (not including non-operatingassets), by calculating the present value ofits future free cash flows:Now, add in the value of its non-operatingassets to get the total value of the firm:( )gkgFCFVOps−+=10( )NonOpsNonOpsOps VgkgFCFVVV +−+=+=10
- 20. The Free Cash Flow ModelNow, to calculate the value of its equity, wesubtract the value of the firm’s debt and thevalue of its preferred stock:Since this is the total value of its equity, wedivide by the number of shares outstandingto get the per share value of the stock.( )PDNonOpsCS VVVgkgFCFV −−+−+=10
- 21. 10-22Price/Earnings RatioAlternative approach often used bysecurity analystsP/E ratio is the strength with whichinvestors value earnings as expressed instock priceDivide the current market price of the stock bythe latest 12-month earnings
- 22. 10-23To estimate share valueP/E ratio can be derived fromIndicates the factors that affect the estimatedP/E ratio11 /EPEoP/E ratijustifiedearningsestimatedPoo×=×=k - g/ED/Eor Pk - gDP oo1111 ==P/E Ratio Approach
- 23. 10-24P/E Ratio ApproachThe higher the payout ratio, the higher thejustified P/EPayout ratio is the proportion of earnings thatare paid out as dividendsThe higher the expected growth rate, g,the higher the justified P/EThe higher the required rate of return, k,the lower the justified P/E
- 24. 10-25P/E Ratios and Interest RatesA P/E ratio reflects investor optimism andpessimismRelated to the required rate of returnAs interest rates increase, required ratesof return on all securities generallyincreaseP/E ratios and interest rates are indirectlyrelated
- 25. 10-26Other Valuation MethodsPrice-to-book value ratioRatio of share price to stockholder equity asmeasured on the balance sheetPrice-to-sales ratioRatio of a company’s total market value (pricetimes number of shares) divided by salesMarket valuation of a firm’s revenues
- 26. 10-27Which Approach Is Best?Best estimate is probably the presentvalue of the (estimated) dividendsP/E multiplier remains popular for its easein use and the objections to the dividenddiscount model

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