Professional Documents
Culture Documents
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Some Notes About Stock
In valuing the common stock, we have made two
assumptions:
We know the dividends that will be paid in the future.
We know how much you will be able to sell the stock
for in the future.
Both of these assumptions are unrealistic,
especially knowledge of the future selling price.
Furthermore, suppose that you intend on holding
on to the stock for twenty years, the calculations
would be very tedious!
Stock Valuation: An Example
Assume that you are considering the purchase of a stock
which will pay dividends of $2 (D
1
) next year, and $2.16
(D
2
) the following year. After receiving the second
dividend, you plan on selling the stock for $33.33. What
is the intrinsic value of this stock if your required return
is 15%?
2.00
2.16
33.33
?
Other Valuation Methods
Some companies do not pay dividends, or the
dividends are unpredictable.
In these cases we have several other possible
valuation models:
Earnings Model
Free Cash Flow Model
P/E approach
Price to Sales (P/S)
The Earnings Model
The earnings model separates a companys
earnings (EPS) into two components:
Current earnings, which are assumed to be repeated
forever with no growth and 100% payout.
Growth of earnings which derives from future
investments.
If the current earnings are a perpetuity with
100% payout, then they are worth:
k
EPS
V
CE
1
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The Earnings Model (cont.)
V
CE
is the value of the stock if the company does not
grow, but if it does grow in the future its value must be
higher than V
CE
so this represents the minimum value
(assuming profitable growth).
If the company grows beyond their current EPS by
reinvesting a portion of their earnings, then the value of
these growth opportunities is the present value of the
additional earnings in future years.
The growth in earnings will be equal to the ROE times
the retention ratio (1 payout ratio):
Where b = retention ratio and r = ROE (return on equity).
br g =
The Earnings Model (cont.)
If the company can maintain this growth rate
forever, then the present value of their growth
opportunities is:
Which, since NPV is growing at a constant rate
can be rewritten as:
( )
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k
NPV
PVGO
g k
k
r
RE
g k
RE
k
r
RE
g k
NPV
PVGO
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\
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=
1
1
1 1
1
The Earnings Model (cont.)
The value of the company today must be the sum
of the value of the company if it doesnt grow
and the value of the future growth:
Where RE
1
is the retained earnings in period 1, r
is the return on equity, k is the required return,
and g is the growth rate
g k
k
r
RE
k
EPS
g k
NPV
k
EPS
V
CS
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|
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+ =
+ =
1
1
1 1 1
The Free Cash Flow Model
Free cash flow is the cash flow thats left over
after making all required investments in
operating assets:
Where NOPAT is net operating profit after tax
Note that the total value of the firm equals the
value of its debt plus preferred plus common:
Cap Op NOPAT FCFA =
CS P D
V V V V + + =
The Free Cash Flow Model (cont.)
We can find the total value of the firms
operations (not including non-operating assets),
by calculating the present value of its future free
cash flows:
Now, add in the value of its non-operating assets
to get the total value of the firm:
( )
g k
g FCF
V
Ops
+
=
1
0
( )
NonOps NonOps Ops
V
g k
g FCF
V V V +
+
= + =
1
0
The Free Cash Flow Model (cont.)
Now, to calculate the value of its equity, we
subtract the value of the firms debt and the
value of its preferred stock:
Since this is the total value of its equity, we
divide by the number of shares outstanding to get
the per share value of the stock.
( )
P D NonOps CS
V V V
g k
g FCF
V +
+
=
1
0
Relative Value Models
Professional analysts often value stocks relative to one another.
For example, an analyst might say that XYZ is undervalued relative
to ABC (which is in the same industry) because it has a lower P/E
ratio, but a higher earnings growth rate.
These models are popular, but they do have problems:
Even within an industry, companies are rarely perfectly comparable.
There is no way to know for sure what the correct price multiple is.
There is no easy, linear relationship between earnings growth and price
multiples (i.e., we cant say that because XYZ is growing 2% faster that
its P/E should be 3 points higher than ABCs there are just too many
additional factors).
A companys (or industrys) historical multiples may not be relevant
today due to changes in earnings growth over time.
The P/E Approach
As a rule of thumb, or simplified model, analysts often
assume that a stock is worth some justified P/E ratio
times the firms expected earnings.
This justified P/E may be based on the industry average
P/E, the companys own historical P/E, or some other P/E
that the analyst feels is justified.
To calculate the value of the stock, we merely multiply
its next years earnings by this justified P/E:
1
EPS
E
P
V
CS
=
The P/S Approach
In some cases, companies arent currently earning any
money and this makes the P/E approach impossible to
use (because there are no earnings).
In these cases, analysts often estimate the value of the
stock as some multiple of sales (Price/Sales ratio).
The justified P/S ratio may be based on historical P/S for
the company, P/S for the industry, or some other
estimate:
1
Sales
S
P
V
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