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Chapter 5

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Chapter 5

  1. 1. Chapter 5 Financial Analysis and Decisions SCH-MGMT 640 The Value of Common Stocks Mila Getmansky Sherman Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved .
  2. 2. Topics Covered <ul><li>How Common Stocks are Traded </li></ul><ul><li>How Common Stocks are Valued </li></ul><ul><li>Estimating the Cost of Equity Capital </li></ul><ul><li>Stock Prices and EPS </li></ul><ul><li>Valuing a Business by Discounted Cash Flows </li></ul>
  3. 3. Stocks & Stock Market <ul><li>Auction Markets </li></ul><ul><li>Dealer Markets </li></ul><ul><li>Over the counter </li></ul><ul><li>Exchange Traded Funds </li></ul>
  4. 4. Stocks & Stock Market <ul><li>Common Stock - Ownership shares in a publicly held corporation. </li></ul><ul><li>Secondary Market - market in which already issued securities are traded by investors. </li></ul><ul><li>Dividend - Periodic cash distribution from the firm to the shareholders. </li></ul><ul><li>P/E Ratio - Price per share divided by earnings per share. </li></ul>
  5. 5. Stocks & Stock Market <ul><li>Book Value - Net worth of the firm according to the balance sheet. </li></ul><ul><li>Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors. </li></ul><ul><li>Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities. </li></ul>
  6. 6. Valuing Common Stocks <ul><li>Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate . </li></ul>
  7. 7. Valuing Common Stocks <ul><li>Example : If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00? </li></ul>
  8. 8. Valuing Common Stocks <ul><li>Another Example : You purchase an ownership share in the Indianapolis Colts for $50,000, who just won the Super Bowl. In one year you expect the Colts to repeat as Super Bowl champions and pay you a dividend of $3,000. You think you will be able to sell your share for $58,000 at that time. What is your expected return? </li></ul>
  9. 9. Valuing Common Stocks <ul><li>The formula can be broken into two parts. </li></ul><ul><li>Dividend Yield + Capital Appreciation </li></ul>
  10. 10. Valuing Common Stocks <ul><li>Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends. </li></ul>H - Time horizon for your investment.
  11. 11. Valuing Common Stocks <ul><li>Example </li></ul><ul><li>Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return? </li></ul>
  12. 12. Valuing Common Stocks <ul><li>Example </li></ul><ul><li>Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return? </li></ul>
  13. 13. How to Calculate g <ul><li>Gordon growth model </li></ul><ul><li>Compare to other companies in the industry </li></ul><ul><li>Using balance sheet and ratios </li></ul>
  14. 14. Valuing Common Stocks <ul><li>Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model) . </li></ul>
  15. 15. Valuing Common Stocks <ul><li>Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation. </li></ul>
  16. 16. Valuing Common Stocks <ul><li>Example </li></ul><ul><li>If a stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends? </li></ul>Answer The market is assuming the dividend will grow at 9% per year, indefinitely.
  17. 17. Valuing Common Stocks <ul><li>If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY . </li></ul>Assumes all earnings are paid to shareholders.
  18. 18. Valuing Common Stocks <ul><li>If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher. </li></ul><ul><li>Payout Ratio - Fraction of earnings paid out as dividends </li></ul><ul><li>Plowback Ratio - Fraction of earnings retained by the firm. </li></ul>
  19. 19. Valuing Common Stocks <ul><li>Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations. </li></ul><ul><li>g = return on equity X plowback ratio </li></ul>
  20. 20. Valuing Common Stocks <ul><li>Example </li></ul><ul><li>Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision? </li></ul>
  21. 21. Valuing Common Stocks <ul><li>Example </li></ul><ul><li>Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision? </li></ul>No Growth With Growth
  22. 22. Valuing Common Stocks <ul><li>Example - continued </li></ul><ul><li>If the company did not plowback some earnings, the stock price would remain at $55.56. With the plowback, the price rose to $100.00. </li></ul><ul><li>The difference between these two numbers is called the Present Value of Growth Opportunities (PVGO). </li></ul>
  23. 23. Valuing Common Stocks <ul><li>Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments. </li></ul><ul><li>Growth stocks (PVGO > 0, not just g) </li></ul><ul><li>Income stocks (PVGO = 0) </li></ul>
  24. 24. Valuing a Business <ul><li>Valuing a Business or Project </li></ul><ul><li>The value of a business or Project is usually computed as the discounted value of FCF out to a valuation horizon (H). </li></ul><ul><li>The valuation horizon is sometimes called the terminal value and is calculated like PVGO. </li></ul>
  25. 25. Valuing a Business <ul><li>Valuing a Business or Project </li></ul>PV (free cash flows) PV (horizon value)
  26. 26. Valuing a Business <ul><li>Example </li></ul><ul><li>Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6% </li></ul>
  27. 27. Valuing a Business <ul><li>Example - continued </li></ul><ul><li>Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6% </li></ul>
  28. 28. Valuing a Business <ul><li>Example - continued </li></ul><ul><li>Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6% </li></ul>
  29. 29. Web Resources www.dividenddiscountmodel.com www.valuepro.net www.nyse.com www.nasdaq.com www.londonstockexchange.com www.tse.or.jp www.123world.com/stockexchanges www.rba.co.uk www.fibv.com Click to access web sites Internet connection required Web Links

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