More Related Content Similar to Stock valuation from A to Z with real-life application (20) 1. M.Sc. Degree in Investment from AAST
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2. Stock Valuation
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A model called Discounted Dividend Model (DDM) evaluates
the fair price of the stock.
Why should we re-pricing the stock even though it is
already priced in the market??!!
The DDM model measure the fair price of the stock which differs
from the market price of the stock which is already quoted in the
stock exchanges.
The stock market is priced based on market forces (investors stock
demand and supply) depending on the information available in the
market.
Unlike the DDM approach is pricing based on the expected coming
dividends that will be distributed in the future discounted with the
required rate of returns by the investors to measure the fair price
of the stock.
3. What is the benefit from having the fair price?
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The fair price is the price that the investor expects his stock market
price will reach in the future and accordingly, the investor can make
up his mind when to buy, sell or hold shares to make capital gains in
the future.
Example for illustration,
If we assumed that Google stock in the market is $505 and we
applied the DDM approach to calculate the fair price and found it
$520. so under such situation, the investor will expect that that stock
market price will rise to $520 in the future so he has to buy if he
doesn’t hold or keep holding it if it is already bought and the opposite
situation would make the investor to sell it or to not buying it.
4. Conclusion
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Market price > Fair price = Overvalued Sell
Market price < Fair price = Undervalued Buy
Market price = Fair price = equal value Hold
(If you have positive Information)
5. Dividends paid with mixed streams
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Means that the company pays different amounts of dividends periodically
Therefore, the company should apply this formula to evaluate the fair
price of the stock
Basic model
Dt = Expected dividends
R = Required rate of return or discount rate
The powers = number of years
P0 =
6. Dividends paid with zero growth
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Means that the company pays fixed amounts of dividends
periodically
Therefore, the company should apply this formula to evaluate
the fair price of the stock
Zero Growth model
7. Dividends paid with constant growth
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Means that the company pays dividends that increase in a constant
growth rate periodically.
Therefore, the company should apply this formula to evaluate the fair
price of the stock
Constant growth model
8. Note
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Sometimes the expected dividends are not given so to get the Dt
you have to apply this formula:
9. R calculation under CAPM
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CAPM = Capital Asset Pricing model
CAPM = RFR + Beta x (MR – RFR)
RFR = Treasury bill rate
Beta = Covariance / variance
Covariance of stock and market index returns
Variance of the market index return
MR = Market index return
MR is the % change in market points (new MR points – old MR points / old
MR points)
10. R calculation under DDM
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R = Dt / P0 + g
R = discount rate or required rate of return
Dt = expected dividends
P0 = current stock price
g = Growth rate
11. 3 ways for Growth rate calculation
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1. G = (new dividend – old dividend)^(1/n) – 1
n = number of years between the new and old dividends
2. G = ROE x Retention ratio
Retention ratio = Retained earnings / Net income
3. G = ROE – (1 – Payout ratio)
1. Payout ratio = Dividends / Net income
12. Practical example: Excel application
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If we want to calculate the fair price of Microsoft stock
under DDM approach you have to follow the following
steps:
14. Step 2: insert Microsoft symbol MSFT in the
search box
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15. Step 3: Click on historical data section and adjust time
period to be the last 5 years of monthly prices and
dividends paid then click on apply to modify and
download
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16. Step 4: After downloading MSFT historical prices copy
and paste the closed prices in another separate column
and the same with Dividend data
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17. Step 5: open new excel file and paste historical
Dividends and stock prices of MSFT as shown
below:
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18. Note: need to apply the Gordon growth model
but before doing so we need to get the
following inputs for the formula:
Gordon Growth Model:
g= growth rate
p0= Current price
r= Required rate of return
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19. Step 6: apply the summation formula to get
the annual dividends paid from 2015-2019
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20. Step 7: apply the growth rate formula to get
the g
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21. Note: to get the r you need to apply the
following formula:
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And D1 will be calculated by using the following formula
CAPM = RFR + Beta x (MR – RFR)
22. Step 8: Apply the Dt formula to get the D1
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D0 = 1.89 D1 = 1.89 x (1+14.04%) = 2.16
P0 = 174.55
23. Step 9: Find the treasury bill rate of 2020 from
yahoo finance by clicking on markets section
and then on US Treasury Bonds Rates
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24. The US treasury bill rate of 13 week is 0.10%
as the RFR of the CAPM
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25. Step 10: Find the summary section to get MSFT
Beta is 0.96
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26. Step 11: Find the market index return (MR) of MSFT for 1 year
(Note MSFT is in the Dow jones industrial average index)
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27. Annual Market index return is
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New market index points (Apr 24, 2020) = 23775.27
Old market index points (Apr 29, 2019) = 26554.39
Market index return (MR)= (new-old) / old x 100= (23775.27 –
18010.68) / 18010.68 = -10.47%
28. Step 12: Apply the CAPM formula to get the r
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RFR = 0.10%
Beta = 0.96
MR = -10.47%
CAPM = 0.10% + 0.96 (-10.47%-0.10%) = -10.05%
29. Step 13: Apply the GGM approach:
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g= 14.04%
D1= 2.16
P0= 174.55
R= 30.73%
Fair price = D1 / (r – g) = 2.16 / (-10.05% - 14.04%) = $-8.94
30. Step 14: Decision making
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As long as the fair price is negative and far away
from the current market stock price we can conclude
that Microsoft stock price is going to fall sharply soon
so you need to not buy it or if you already bought it
you need to sell it as soon as possible.
