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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 =
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
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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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