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Vicentiu Covrig FIN303
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Vicentiu Covrig FIN303
Intrinsic Value and Stock Price
Outside investors, corporate insiders, and analysts use a variety
of approaches to estimate a stocks intrinsic value (P0).
In equilibrium we assume that a stocks price equals its
intrinsic value.
- Outsiders estimate intrinsic value to help determine which
stocks are attractive to buy and/or sell.
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Vicentiu Covrig FIN303
Different Approaches for Estimating the
Intrinsic Value of a Common Stock
Discounted dividend model
Corporate valuation model
P/E multiple approach
EVA approach (NOT for the exam)
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Vicentiu Covrig FIN303
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Vicentiu Covrig FIN303
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
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Vicentiu Covrig FIN303
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Vicentiu Covrig FIN303
If rRF = 7%, rM = 12%, and = 1.2, what is
the required rate of return on the firms
stock?
Use the SML to calculate the required rate
of return (rs):
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Vicentiu Covrig FIN303
If D0 = $2 and g is a constant 6%, What is
the stocks market value?
Using the constant growth model:
D1 $2.12
P0
rs - g 0.13 - 0.06
$2.12
0.07
$30.29
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Vicentiu Covrig FIN303
Find the Expected Dividend Stream for the Next
3 Years and Their PVs
D0 = $2 and g is a constant 6%.
0 g = 6%
1 2 3
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Vicentiu Covrig FIN303
What is the expected dividend yield, capital
gains yield, and total return during the first
year?
Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
Capital gains yield
= (P1 P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
Total return (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
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Vicentiu Covrig FIN303
What would the expected price today
be, if g = 0?
The dividend stream would be a perpetuity.
^ PMT $2.00
P0 $15.38
r 0.13
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Vicentiu Covrig FIN303
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
Can no longer use just the constant growth
model to find stock value.
However, the growth does become constant
after 3 years.
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Vicentiu Covrig FIN303
Valuing common stock with
nonconstant growth
0 r = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.6 3.380 4.394 4.658
2.6/(1+0.13) = 2.301
2.647
3.045
4.658
66.54/(1+0.13)^3 = 46.114 P$ 3 $66.54
0.13 - 0.06
^
54.107 = P0
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Vicentiu Covrig FIN303
Calculations:
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Vicentiu Covrig FIN303
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Vicentiu Covrig FIN303
Corporate value model
Also called the free cash flow method. Suggests the value of the
entire firm equals the present value of the firms free cash flows.
FCF EBIT(1 - T)
Depr. and Capital
- NOWC
amortizati on expenditur es
1. Find the market value (MV) of the firm.
- Find PV of firms future FCFs
2. Subtract MV of firms debt and preferred stock to get MV of
common stock.
- MV of = MV of MV of debt and
common stock firm preferred
3. Divide MV of common stock by the number of shares outstanding
to get intrinsic stock price (value).
- P0 = MV of common stock / # of shares
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Vicentiu Covrig FIN303
Issues regarding the corporate
value model
Often preferred to the dividend growth model, especially when
considering number of firms that dont pay dividends or when
dividends are hard to forecast.
Similar to dividend growth model, assumes at some point free
cash flow will grow at a constant rate.
Terminal value (TVn) represents value of firm at the point that
growth becomes constant.
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Vicentiu Covrig FIN303
Given the long-run gFCF = 6%, and WACC
of 10%, use the corporate value model to
find the firms intrinsic value.
0 r = 10% 1 2 3 4
...
g = 6%
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = = TV3
0.10 - 0.06
416.942
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Vicentiu Covrig FIN303
Calculations:
Present Value of CF1= -5/(1+0.1) = -4.545
Present Value of CF2= 10/(1+0.1)^2 = 8.264
Present Value of CF3= 20/(1+0.1)^3 = 15.026
CF 4= CF3*(1+g)=20*(1+0.06)= 21.2
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Vicentiu Covrig FIN303
If the firm has $40 million in debt and has 10
million shares of stock, what is the firms
intrinsic value per share?
MV of equity = MV of firm MV of debt
= $416.94m - $40m
= $376.94 million
Value per share = MV of equity / # of shares
= $376.94m / 10m
= $37.69
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Vicentiu Covrig FIN303
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Vicentiu Covrig FIN303
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Vicentiu Covrig FIN303
Preferred Stock
Hybrid security.
Like bonds, preferred stockholders receive
a fixed dividend that must be paid before
dividends are paid to common
stockholders.
However, companies can omit preferred
dividend payments without fear of pushing
the firm into bankruptcy.
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Vicentiu Covrig FIN303
If preferred stock with an annual dividend of $5
sells for $50, what is the preferred stocks
expected return?
D
Vp
rp
$5
$50
rp
$5
rp
$50
0.10 10%
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Vicentiu Covrig FIN303
Learning objectives
Read from the text the following topics: control of the firm; types of common
stock; The market for common stock
Know how to apply the dividend growth model, constant and non-constant growth
Know how to calculate total return, dividend yield and capital gains
Know how to use corporate value model to value common stock
Preferred stock
Recommended end-of-chapter problems: ST-1, Questions 9-3, 9-4;
Problems 9-1 to 9-5, 9-11,9-1 to 9-17
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