Valuation Of Common Stock

Topics: Discounted cash flow, Time value of money, Stock market Pages: 16 (788 words) Published: July 16, 2015
Valuation of Common Stock
Ashok Banerjee

Common (Equity) Stocks
• Because common stock never matures, today’s
value is the present value of an infinite stream of
cash flows (i.e., dividend).
• But dividends are not fixed.
• Not knowing the amount of the dividends—or
even if there will be future dividends— makes it
difficult to determine the value of common stock.
• So what are we to do?

Valuation Models
• Dividend Valuation Model (DVM):
– Constant dividend: Let D be the constant
DPS:

The required rate of return (re) is the return shareholders
demand to compensate them for the time value of money tied
up in their investment and the uncertainty of the future cash flows from these investments.

Valuation Models
• Dividend growth at a constant rate (g):
(also known as Gordon Model)

OR

OR

Exercise 1
• You buy a stock for Rs.230 and you
expect the next year’s dividend to be
Rs.12.42. Furthermore, you expect the
dividend to grow at a constant rate of 8%
p.a.
– What is the expected return of the stock?
– What is the dividend yield?
– What is the expected price of the stock in five
years?

Dividend and Earnings Growth
• Growth in dividends occurs primarily as a result
of growth in EPS.
• Growth in earnings, in turn, results from a
number of factors, including (1) inflation, (2)
retention ratio; and (3) ROE.
• Shareholders care about all dividends, both
current and those in the future.
• If most of a stock’s value is due to long-term
cash flows, why do managers and analysts pay
so much attention to quarterly earnings?

Valuation Models
• Varying Dividend Growth Rate:
– For many companies, it is unreasonable to
assume that it grows at a constant rate.
– P0 = Present value of dividends based on
short-run non-constant rate + Present value of
dividends using constant growth rate.

Example 2
• A company’s stock just paid a Rs.11.50
dividend, which is expected to grow at
30% for next three years. After that, the
dividend is expected to grow at 8%
constantly forever. The stock’s required
return is 13.4%.
– What is the price of the stock today?

Link between stock price and EPS
• Stock price can be thought of as the
capitalized value of average earning under
a no-growth policy, plus PVGO, the net
present value of growth opportunities:
– P0=EPS1/r +PVGO

Valuing Common Stocks
Example
Our company forecasts to pay a $8.33
dividend next year, which represents
100% of its earnings. This will provide
investors with a 15% expected return.
Instead, we decide to plow back 40%
of the earnings at the firm’s current
return on equity of 25%. What is the
value of the stock before and after the
plowback decision?

Valuing Common Stocks
Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

No Growth

8.33
P0 
$55.56
.15

With Growth

g .25 .40 .10
5.00
P0 
$100.00
.15  .10

Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, the stock
price would remain at $55.56. With the plowback, the price
rose to $100.00.
The difference between these two numbers is called the
Present Value of Growth Opportunities (PVGO).

PVGO 100.00  55.56 $44.44

Valuing Common Stocks
Present Value of Growth Opportunities
(PVGO) - Net present value of a firm’s
future investments.
Sustainable Growth Rate - Steady rate at
which a firm can grow: plowback ratio X
return on equity.

Do stock prices reflect long-term or
short-term cash flows?
• Managers often complain that the stock market
is shortsighted, and that it cares only about next
quarter’s performance. Is this true?
• The current stock price is Rs.230. Current...
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