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Stock Valuation

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  • 1. Analysis of Common Stocks Investments and Portfolio Management (MB 72)
  • 2. Outline
    • Process of Valuation of a Financial Asset
    • Process of Valuation of Common Stocks
    • Determining parameters of models
      • How to determine the growth rate?
      • Length of growth period
      • How to determine the required rate of return
    • Models for Stock Valuation
      • Dividend Discount Models
      • Price-Earnings Models
      • Free Cash Flow to Equity Valuation Models
  • 3. Valuation of Financial Assets
    • Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows
    • Three step process:
      • Estimate the expected cash flows
      • Determine the appropriate interest rate or interest rates to discount the cash flows
      • Compute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2
  • 4. Estimating Cash Flows
    • Holding aside the risk of bankruptcy, the cash flows of a common stock are:
        • Payment of dividend so long as we hold the stock
        • Sale price of common stock when we sell the stock
    • Is it difficult to estimate the cash flows of a common stock?
  • 5. Value of a Common Stock
    • Fair Market Value of a common stock depends on
      • PV of cash flows from a stock
      • PV of an infinite dividend stream OR
      • PV of a finite dividend stream plus PV of the sale price of the stock
  • 6. Discounted Cash Flow Valuation
    • Value of any asset—a function of 3 variables
      • How it generates its cash flows?
      • When these cash flows are expected to occur?
      • Uncertainty of these cash flows
    • t=n CF t
    • Value =  ----------
    • t=1 (1+r) t
  • 7. Dividend Discount Model (DDM)
    • Value of a share of common stock is the present value of all future dividends
    • n DPS t
    • Value per share of stock=  ----------
    • t=1 (1+r) t
    • What if the stock is not held for an infinite period?
      • One year holding period
      • Multiple year holding periods
  • 8. Dividend Discount Model
    • Two types of cash flows
      • Dividends during the holding period
      • Expected price at the end of holding period—this itself is dependent on future dividends
    • How to determine the value of a share of common stock?
  • 9. Infinite Holding Period
    • What will be the value of a share of common stock?
      • Present value of an infinite stream of anticipated dividends
    • Simplified assumptions to simply valuation model
      • Zero Growth Model
      • Constant Growth Model
      • Two-stage growth model
      • Three-stage growth model
  • 10. Zero Growth Model
    • Dividend every year will be the same
    • Investor anticipates to receive the same amount dividend per year forever
    • DPS
    • V = -------------
    • r cs
  • 11. Constant Growth Model
    • Assume that firm grows at a stable growth rate of g per year forever
    • DPS 1
    • V = ---------
    • r - g
  • 12. Two-Stage DDM
    • In general version of the model, two stages of growth
      • An initial period of extraordinary growth
      • After initial period, a period of stable growth
      • n DPS t P n
    • P 0 =  ---------- + ---------
    • t=1 (1+r) t (1 + r) n
    • DPS n+1
    • Where P n = -----------------
    • (r – g n )
  • 13. Three-stage growth model
  • 14. Four Basic Inputs
    • Length of high growth period
    • Dividends per share each period
    • Required rate of return by stockholders each period
    • Terminal price at the end of high growth period
  • 15. High Growth Rate and Stable Growth Rate
    • Stable Growth Rate?
      • Growth rate expected to last forever
      • Firm’s other measures of performance including can be expected to grow at the same rate
    • What growth rate is reasonable as a “stable” growth rate?
      • A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy
    • Length of High Growth Period?
      • How much is the current growth rate?
      • Source of high growth?
  • 16. High Growth Period
    • The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high-growth period
    • The larger the current size of the firm, the shorter the high-growth period.
  • 17. Guide to Length of High-Growth Period
    • Current Growth Length of High
    • Rate Growth Period
    • 1% higher than stable No high growth
    • 1 – 10% higher than stable 5 years
    • > 10% higher than stable 10 years
  • 18. How do we Estimate Growth Rate?
    • g = b [ROA+D/E(ROA- I (1-t))]
      • Where b refers to the retention ratio
      • ROA is the return on assets
      • D/E is the debt to equity ratio in book value terms
      • i = interest expense/book value of debt
  • 19. FCFE Valuation Model
    • The cash flow that the firm can afford as dividends and contrasted with actual dividends—may not payout as dividends
    • 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.
  • 20.
    • FCFE = Net Income + Depreciation – Capital Spending -  Working Capital – Principal Repayments + New Debt Issues
    • If there is a target debt ratio, 
    • FCFE = Net Income - (1 -  )(Capital Expenditure – Depreciation) - ( 1-  )  Working Capital
  • 21. FCFE Model
      • n FCFE t P n
    • P 0 =  ---------- + ---------
    • t=1 (1+r) t (1 + r) n
    • FCFE n+1
    • Where P n = -----------------
    • (r – g n )