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Common Stock Valuation


Whenever corporations have a need for long term financing, one of the ways to accomplish this is to issue common stock. Shares become available in the open markets to individual investors, mutual funds, and other buyers. When common stock is sold, the shareholders become part-owners of the firm. They assume all of the risks of a firm but have voting power to elect a board of directors, which sets policy and hires managers to run the firm. One of the most important factors when issuing common stock is how to value them. There are basically three ways of valuing common stock: 1) using the present value of future dividends, 2) using the present value of free cash flow, and 3) using the present value of current activities + the present value of growth opportunities. Lets look at each of these methods individually. Bear in mind that these are basic models which can have many additional variables not mentioned here. For the first method of valuing common stock, we consider what the future dividends will be. Also, you need to assign a required rate of return. There are a couple of variables concerning dividends that need to be considered. You have to have an idea of whether your dividends are growing over time and if so, at what rate. Lets look at when the annual dividend is constant. Heres the formula for valuing common stock with a constant annual dividend, Div PV stock = R Where Div = dividend amount R = required rate of return

EXAMPLE) Suppose a company pays an annual dividend of $2 per share, expects no growth in future dividends, and has a required rate of return of 14%. What should the price of its common stock be? ANSWER)
PV stock = Div $2 = = $14.29 R 0.14

When using future dividends to value common stock, there are cases when the dividend is not constant. Lets consider the case when the dividend grows at a constant rate. Heres the formula used, Div0 (1 + g ) PVstock = Rg Where Div0 = latest dividend paid per share R = required rate of return g = growth rate of dividends

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EXAMPLE) Suppose the latest dividend paid by a firm was $2.50 per share and they anticipate raising their annual dividend by 5%. Give an estimate of what their stock price should be if the required rate of return is 15%. ANSWER) PV stock =

Div 0 (1 + g ) $2.50(1.05) $2.625 = = = $26.25 Rg 0.15 .05 0.1

The second method of valuing common stock is by looking at the free cash flow. Free cash flow is the cash you generate from operation less your capital expenditures. Free cash flow is the cash a company has available after all their capital needs are taken care of. It is an important measurement because it shows how able the company is to pursue growth opportunities. You need cash to fund new product development, new marketing strategies, pay off debt, etc Just like when you work with dividends, this method is dependent on how well you estimate the free cash flow and how well you can estimate what the growth rate would be. Heres the formula for estimating the value of common stock for free cash flow with no growth,
PV stock = FCF R

Where FCF = free cash flow R = required rate of return And heres the formula for free cash flow with constant growth,
PV stock = FCF Rg

Where FCF= free cash flow R = required rate of return g = growth rate of free cash flow

The third method of valuing common stock is more comprehensive than the other two methods. This method looks at two items: 1) the value of current activities plus 2) the value of growth opportunities (PVGO). Lets look at current activities first. Current earnings on a stock are expressed as earnings per share or EPS. These are typically reported quarterly but calculations are generally performed using annual EPS figures. The PV formula for current activities is,
PVstock = EPS R

Where EPS = earning per share R = required rate of return

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PVGO includes the anticipated growth of the stock and takes into account the future dividends as was done earlier. Combining future dividends with current activities would yield a model like this formula for the third method of valuing common stock,
EPS Div0 (1 + g ) + R Rg EXAMPLE) XYZ company just posted annual earnings of $4.25 EPS and has an annual dividend that is estimated to grow at 3%. The latest dividend was $1.75 per share. Assuming a rate of return of 12%, at what price do you estimate their stock? PVstock =

ANSWER) PVstock =

EPS Div0 (1 + g ) $4.25 $1.75(1.03) + = + = $35.42 + $20.03 = $55.45 R Rg 0.12 0.12 0.03

The expected return, R, is also called the market capitalization rate. All stocks in the same risk class are generally priced to offer the same expected return. Should one stock in a class or sector offer a higher return, everyone would rush to buy it, pushing its price up and the expected return down. To express the market capitalization rate mathematically, we take our future dividends formula and solve for R,
PVstock = Div0 (1 + g ) Div0 (1 + g ) +g Expected Return = R = PVstock Rg

Another indicator that is often used by investors to determine the value of common stocks is the P/E ratio. The P/E ratio gives investors the ability to determine how much the stock price is inflated. Mathematically, it is very simple to calculate. This ratio is simple the stocks price divided by its annual earnings or EPS, P/E Ratio = (price of stock) (EPS) Basically, the P/E ratio is used to compare stocks against each other. The convention for many investors is to find stocks with lower P/E ratios. This implies that the stock is more of a bargain than a stock with a high P/E. However, you should bear in mind that stocks with high P/Es are usually very popular and can provide a great return, but caution should be exercised, as they are usually more volatile. EXAMPLE) Stock A is priced at $75 per share with EPS of $3.45, while Stock B is priced at $44 per share with annual earnings per share reported at $2.25. What are their respective P/E ratios and which one appears to be the best bargain? ANSWER) Stock A P/E = $75 $3.45 = 21.74 Stock B P/E = $44 $2.25 = 19.56 Stock B is the best bargain.

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Student Worksheet Common Stock Valuation


1. Corporations can raise capital for long term project by issuing ___________ ___________. 2. As part-owners of a firm, shareholders assume all of the _________ of a firm but have _______ power to elect a board of _________ . 3. Name the three basic ways of valuing common stock. Value the following stocks at the returns and constant dividends indicated 4. DDD: 11%, $1.20 5. XSX: 5%, $0.75 6. ASTT: 14%, $5.56 Value the following stocks at the returns with dividends growing at the rates indicated 7. PE: 10.5%, $3.00 @ 6% 8. FFDA: 9%, $4.15 @ 2% 9. HA: 7%, $1.11 @ 0.5% 10. GOTA: 12%, $6.75 @ 8% Value the following stocks 11. Company A has a rate of return of 15% and pays an annual dividend of $2.80 per share that is growing at 1.4%. Latest EPS was $3.50. 12. Company B has a rate of return of 5% and pays an annual dividend of $1.20 per share that is growing at 4%. Latest EPS was $2.15 13. The expected return is also called the market capitalization rate. True / False Calculate Expected Returns for the following stocks 14. Price: $45.25, Annual Dividend: $1.75 growing at 6% 15. Price: $25.50, Annual Dividend: $2 growing at 3.15% 16. Stocks with higher P/E ratios are generally better bargains. True / False 17. P/E ratios are calculated by dividing a stocks _________ by its __________ Calculate P/E ratios for the following stocks: 18. SDD: $415, EPS: $15.00 19. XWQ: $23.45, EPS: $2.34 20. LHK: $67.78, EPS: $4.65

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Student Worksheet Common Stock Valuation - Answers


1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. common stock risks, voting, directors PV of future dividends, PV of free cash flows, PV of current activities + PVGO $10.91 $15.00 $39.71 $30.29 $47.03 $15.94 $60.75 $18.97 $24.98 true 10.1% 11.2% false price, earnings 27.7 10.0 14.6

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