Chapter 9

Valuing Stocks

Learning Objectives
1.

Calculate the NPV of uneven cash flows and perpetuities

2.

Calculate the total return of a stock, given the dividend payment,

the current price, and the previous price.

3.

Use the dividend-discount model to compute the value of a

dividend-paying companys stock, whether the dividends grow at a
constant rate starting now or at some time in the future.

4.

Given the retention rate and the return on new investment,

calculate the growth rate in dividends, earnings, and share price.

5.

Describe circumstances in which cutting the firms dividend will

raise the stock price.

9-2

Learning Objectives (cont'd)

6.

Assuming a firm has a long-term constant growth rate after time

N + 1, use the constant growth model to calculate the terminal
value of the stock at time N.

7.

Compute the stock value of a firm that pays dividends as well as

repurchasing shares.

8.

Use the discounted free cash flow model to calculate the value of
stock in a company with leverage.

9.

Use comparable firm multiples to estimate stock value.

9-3

The Time Value of Money

Other Cash Flow Patterns
(Uneven Cash Flows)

3
9-4

Stock valuation
What does stock price indicates?
It reflected _______in investor __________ regarding the
value of the cash flows that ownership of stocks would
entitle them to receive.
Eg: 4% decline.

9-5

Stock Valuation
One of the approach used to develop a stock-valuation

model;
to compare the value estimate from the model with the
market price.

9-6

Ordinary Shares
Ordinary shareholders are residual claimants on the

income and assets of the company.

Voting rights are often important.
Book value is the accounting value of equity as shown in
the firms balance sheet.
Market value is the total value of the firm, as determined
in the market place.

9-7

Ordinary Shares Dividends

Dividends are cash payments made half-yearly to

shareholders.
Dividends are at the discretion of the company; can be
very volatile.
Dividend yield is the income component of a shares
return (D/P).
Payout ratio is the ratio of dividends to earnings (D/E).

9-8

Ordinary Shares Dividends

A share purchased on/after the ex-dividend

date does not have dividend entitlements.

Prior to the ex-dividend date is the cum-rights period.

A share dividend is a payment to the owners in shares

(instead of cash).

9-9

Common Stock vs Preferred Stock

Common Stock
an equity share with voting rights
represents the basic ownership claim in a corporation
the most common type of equity security
Preferred Stock
An equity share in a corporation
Entitles to claim before the stock holders in the event of
bankruptcy
No voting rights

9-10

DIVIDEND DISCOUNT
MODEL

9-11

The Dividend Discount Model

A One-Year Investor
Potential Cash Flows
__________
Sale of Stock (Capital Gain)
Timeline for One-Year Investor

Since the cash flows are risky (uncertainty), we must discount them

at the equity cost of capital.

9-12

Equity Cost of Capital?

It is the ___________ of other investments
available in the market with equivalent risk to the
firms shares.

Do You understand?

9-13

The Dividend Discount Model

(cont'd)
A One-Year Investor

P0

Div1 P1

If the current stock price were less than this amount- P 0, investors

are expected to rush in and buy it, driving up the stocks price.
If the stock price exceeded this amount, selling it would cause the

stock price to fall quickly.

Why?

9-14

Dividend Yields, Capital Gains and Total

Returns
Total return of stock investment (1 yr):
rE

Div1 P1

1
P0

Dividend Yield

Div1
P
{0

Dividend Yield

P1 P0
P
{0

Capital Gain Rate

Capital Gain
Capital Gain Rate

Total Return
Dividend Yield + Capital Gain Rate
The expected total return of the stock should equal the expected return

of other investments available in the market with equivalent risk.

9-15

Alternative Example 9.1

Problem
3M (MMM) is expected to pay paid dividends of $1.92 per share in

the coming year.

You expect the stock price to be $85 per share at the end of the

year.
Investments with equivalent risk have an expected return of 11%.
What is the most you would pay today for 3M stock?
What dividend yield and capital gain rate would you expect at

this price?

9-16

Alternative Example 9.1

Solution

Div1 P1
$1.92 $85
P0

$78.31
(1 rE )
(1 .11)
Div1
$1.92
Dividend Yield

2.45%
P0
$78.31

P1 P0
$85.00 $78.31
Capital Gains Yield

8.54%
P0
$78.31
Total Return = 2.45% + 8.54% = 10.99% 11%

9-17

Total return
The expected return for investor for one year;
or the expected total return of the stock = the expected

return of other investments available in the market with

equivalent ________.

9-18

A Multi-Year Investor
What is the price if we plan on holding the stock for two

years?

Div1
Div2 P2
P0

2
1 rE
(1 rE )
9-19

The Dividend-Discount Model

Equation
What is the price if we plan on holding the stock for N

years?
Div1
Div2
P0

L
2
1 rE
(1 rE )

DivN
PN

N
(1 rE )
(1 rE ) N

This is known as the Dividend Discount Model.

Note that the above equation holds for any horizon N. Thus all investors

(with the same beliefs) will attach the same value to the stock,
independent of their investment horizons.

9-20

The Dividend-Discount Model Equation

(cont'd)
Div3
Div1
Div2
P0

L
2
3
1 rE
(1 rE )
(1 rE )

n 1

Divn
(1 rE ) n

The price of any stock is equal to the _________ value of

the expected future dividends it will pay.

Can it be summarised?

9-21

Zero-Growth Dividend Model

Dividends have a growth rate of zero, thus, the dividend

payment pattern remains constant over time

Div1 = Div2 = Div3 = = Div = Divn
Div3
Div1
Div2
P0

L
2
3
1 rE
(1 rE )
(1 rE )

n 1

Divn
(1 rE ) n

P0 = D/R

9-22

Applying the Discount-Dividend

Model
Constant Dividend Growth
The simplest forecast for the firms future dividends states that they

will grow at a constant rate, g, forever.

9-23

Applying the Discount-Dividend Model

(cont'd)
Constant Dividend Growth Model

Div1
P0
rE g

rE

Div1

g
P0

The value of the firm depends on the current dividend

level, the cost of equity, and the growth rate.

The expected dividends are a constant growth perpetuity,

i.e. div grow at a constant, g, forever.

9-24

The Maximisation of firms Share price

Div1
P0
rE g
-To maximise its share price, firms need to inc. both Div1
and g.
-But it involves trade-off: constraints of funds investment
for higher growth vs paying higher div.

9-25

Alternative Example 9.2

Problem
AT&T plans to pay $1.44 per share in dividends in the coming year.
Its equity cost of capital is 8%.
Dividends are expected to grow by 4% per year in the future.
Estimate the value of AT&Ts stock.

9-26

Alternative Example 9.2 - Solution

Div1
$1.44
P0

$36.00
rE g .08 .04

9-27

Dividends Versus Investment and Growth

A Simple Model of Growth
Dividend Payout Ratio
The fraction of earnings paid as dividends each year

Dividend per shr:

Earningst
Divt
Dividend Payout Ratet
Shares Outstanding
1 4 4 4 2 4 4 43 t
EPSt

9-28

Dividends Versus Investment and

Growth (cont'd)
A Simple Model of Growth
Assuming the number of shares outstanding is constant, the firm

can do few things to increase its dividend:

Increase its earnings (net income)
Increase its dividend payout rate
It can decrease its shares outstanding (buyback)

Divt

Earningst
Dividend Payout Ratet
Shares Outstanding
1 4 4 4 2 4 4 43 t
EPSt

9-29

Dividends Versus Investment and

Growth (cont'd)
A Simple Model of Growth
A firm can do one of two things with its earnings (Dividend

decisions):
It can pay them out to investors.
It can retain and reinvest them.

g Retention Rate Return on New Investment

9-30

Dividends Versus Investment and

Growth (cont'd)
Profitable Growth
If a firm wants to increase its share price, should it

cut its dividend and invest more, or should it cut

investment and increase its dividend?
The answer: it depend on the profitability of the

firms investments.
Cutting the firms dividend to increase investment

will raise the stock price if, and only if, the new
investments have a positive ______.

9-31

Alternative Example 9.4

Problem
Dren Industries is considering expanding into a new product line.
Earnings per share are expected to be $5 in the coming year and
are expected to grow annually at 5% without the new product line
but growth would increase to 7% if the new product line is
introduced. To finance the expansion, Dren would need to cut its
dividend payout ratio from 80% to 50%. If Drens equity cost of
capital is 11%, what would be the impact on Drens stock price if
they introduce the new product line? Assume the equity cost of
capital will remain unchanged.

9-32

Formula

EPS1

Without
New
Project

EPS0 (1+g) 5(1 +0.05)

= 5.25

With New
Project
5(1 +0.07)
= 5.35

Dividend (D1) EPS1 x

DPO

5.25 x 80%
= 4.20

5.35 x 50%
= 2.675

Stock Price
(P0)

4.2/(0.11
0.05)
= $70

2.675/(0.110.07)
= $66.875

D1/ (re g)

9-33

Changing Growth Rates

We cannot use the constant dividend growth model to

value a stock if the growth rate is not constant.

For example, young firms often have very high initial earnings

growth rates. During this period of high growth, these firms often
retain 100% of their earnings to exploit profitable investment
opportunities. As they mature, their growth slows. At some point,
their earnings exceed their investment needs and they begin to pay
dividends.

9-34

Changing Growth Rates (cont'd)

Although we cannot use the constant dividend growth

model directly when growth is not constant, we can use

the general form of the model to value a firm by applying
the constant growth model to calculate the future share
price of the stock once the expected growth rate stabilizes.

9-35

Changing Growth Rates (cont'd)

PN

DivN 1
rE g

Dividend-Discount Model with Constant Long-Term

Growth

Div1
Div2
P0

L
2
1 rE
(1 rE )

DivN 1
DivN
1

N
(1 rE )
(1 rE ) N rE g
9-36

Textbook Example 9.5 (p.261)

9-37

Textbook Example 9.5 (cont'd)

9-38

Textbook Example 9.5 (cont'd)

9-39

P0

Limitations of the Dividend-Discount

Model Div
P
Div
Div
1

1 rE

(1 rE ) 2

(1 rE ) N

(1 rE ) N

There is a tremendous amount of uncertainty associated

with forecasting a firms dividend growth rate and future

dividends (inc. firms earnings, div. payout ratio etc).
Small changes in the assumed dividend growth rate can

lead to large changes in the estimated stock price.

Cannot be used when g > re
Limited to firms that pay dividends

9-40

Total Payout and Free Cash Flow

Valuation Models

Share Repurchases and the Total Payout Model

Share Repurchase

When the firm uses excess cash to buy back its own stock (to replace div

payout)

Implications for the Dividend-Discount Model

The more cash the firm uses to repurchase shares, the less it has

available to pay dividends.

By repurchasing, the firm decreases the number of shares outstanding,

which increases its earnings per share and dividends per share.

Total Payout Model

PV0

PV (Future Total Dividends and Repurchases)

Shares Outstanding 0
9-41

Textbook Example 9.6 (p.264)

9-42

Textbook Example 9.6 (cont'd)

9-43

DISCOUNTED FREE CASH FLOW METHOD

Free cash flow (FCF) represents the cash that a company

is able to generate after laying out the money required to

maintain or expand its asset base.
It allows a company to pursue opportunities that enhance

shareholder value, i.e. to develop new products, make

acquisitions, pay dividends and reduce debt.
A negative FCF may not be bad since a company can be

making large investments for its L-T return.

9-44

The Discounted Free Cash Flow

Model
Discounted Free Cash Flow Model
Determines the value of the firm to all investors, including both

equity and debt holders

Enterprise Value Market Value of Equity Debt Cash

The enterprise value can be interpreted as the net cost of acquiring

the firms equity, taking its cash, paying off all debt, and owning the
unlevered business.

9-45

The Discounted Free Cash Flow Model

(cont'd)
Valuing the Enterprise
Unlevered Net Income
64
44 7 4 4 48
Free Cash Flow EBIT (1 c ) Depreciation

Capital Expenditures Increases in Net Working Capital

Free Cash Flow (FCFt) = Ct - It
Cash flow available to pay both debt holders and equity holders

Discounted Free Cash Flow Model

V0 PV (Future Free Cash Flow of Firm)

VEquity = VFirm
VDebt

V0 Cash 0 Debt 0
P0
Shares Outstanding 0
9-46

The Discounted Free Cash Flow Model

(cont'd)
Implementing the Model
Since we are discounting cash flows to both equity holders and

debt holders, the free cash flows should be discounted at the firms
weighted average cost of capital, rwacc If the firm has no debt, rwacc =
rE .

9-47

Textbook Example 9.7(p.266)

9-48

Textbook Example 9.7 (cont'd)

9-49

Textbook Example 9.7 (cont'd)

9-50

The Discounted Free Cash Flow Model

(cont'd)
Connection to Capital Budgeting
The firms free cash flow is equal to the sum of the free cash flows

from the firms current and future investments, so we can interpret

the firms enterprise value as the total NPV that the firm will earn
from continuing its existing projects and initiating new ones.
The NPV of any individual project represents its contribution to the firms

enterprise value. To maximize the firms share price, we should accept

projects that have a positive NPV.
NPV

9-51

Figure 9.1 A Comparison of Discounted

Cash Flow Models of Stock Valuation

9-52

Valuation Multiples
Valuation Multiple
A ratio of firms value to some measure of the firms scale or cash

flow

The Price-Earnings Ratio

P/E Ratio
Share price divided by earnings per share (EPS)
When you buy a stock = buying the rights to entitle for the firms future

earnings.

9-53

Alternative Example 9.9

Problem
Best Buy Co. Inc. (BBY) has earnings per share

of $2.22.
The average P/E of comparable companies stocks

is 19.7.
Estimate a value for Best Buy using the P/E as a valuation

multiple.

9-54

Alternative Example 9.9

Solution
The share price for Best Buy is estimated by multiplying its
earnings per share by the P/E of comparable firms.
P0 = $2.22 19.7 = $43.73

9-55

The basic process of valuation

9-56

3 basic steps in determining the value

of an asset (using the formula):
1: Estimate the amount and timing of future CFs = Ct ;
2: Determine the investors required rate of return (R)

Rf + RP;
3: Calculate the intrinsic value, V/PV = The
intrinsic/present value of expected future CFs discounted
at the R.

57

9-57

Back to Basic:
1: the risk-return trade-off: we wont take on additional risk
unless being compensated with additional return;
2: The time value of money: a dollar received today is
worth more than a dollar receive in the future;
3: Cash not profits is king.

58

9-58

Stock Valuation Techniques:

The Final Word

No single technique provides a final answer regarding a

stocks true value. All approaches require assumptions or

forecasts that are too uncertain to provide a definitive
assessment of the firms value.
Most real-world practitioners use a combination of these

approaches and gain confidence if the results are consistent

across a variety of methods.

9-59

Making sense of news

Local news
KUALA LUMPUR: The Malaysian ringgit hit a new 13-

year high of 3.0345 in intra-day trading yesterday before

ending trade at 3.036. (the star, 8th Feb 2011)
Malaysia's ringgit hit a near six-year low on Tuesday

after the government adjusted its economic targets to

cope with sliding oil prices, the ringgit fell as much as
0.9 percent to 3.6030 per dollar, its weakest since April
2009.(the star, Tuesday, 20 January 2015)
How should you respond to this news?
9-60

Making sense of news

Local news
The overall health effects of a changing climate are

likely to be overwhelmingly negative. Climate change

affects the fundamental requirements for health such as
clean air, safe drinking water, sufficient food and secure
shelter. Infections and diseases are expected to
worsen with the extreme weather conditions likely to be
experienced by the country in the next few years (The
Star, 8th Feb 2011)
How should you respond to this news?
9-61

Making sense of news

Many companies involved in commodities trading also
need to know the changes in the weather condition to help
them predict commodity prices, he said.
The weather forecast is even more important for oil
companies and fishermen.
Studying investments will help you to understand how to

use information to make personal financial decisions.

9-62

Making sense of news

And more latest news

9-63

Investment strategy
Passive
Determine initial investment proportions in assets and asset
classes
Make few changes over time
Active
Change proportions and or assets in an effort to make higher
profits
The more information efficient the market is, the less likely profits
are available from frequent portfolio adjustments

9-64

Factors Affecting the Process

Uncertainty in ex post returns dominates the decision

process.
Foreign financial assets.
How efficient are financial markets in processing new
information?
Institutional investors are important.

9-65

The Great Unknown

The realised return on any risky asset is often different

from the expected return.

All investors are affected by uncertainty.
No returns are guaranteed.
A thorough understanding of the basic principles of
investing allows investors to cope intelligently

9-66

The Global Investments Arena

Existence of around-the-clock investing opportunities.
Opportunities exist to increase returns, reduce risk, or

both.
Existence of emerging markets.

9-67

The Rise of the Internet

Revolutionised the flow of investment information.
Dramatically lowered commission rates for individual

investors.

9-68

Institutional Investors
Manage funds far greater in value than individual

investors.
Trade over-the-counter privately in sizeable portions.
Most are buy-and-hold strategists.

9-69