Chapter Four

Common Stocks valuation

 Equity market is one of the key sectors of financial markets
where long -term financial instruments are traded.
The purpose of equity instruments issued by corporations is to raise
funds for the firms. The provider of the funds is granted a residual
claim on the companys income, and becomes one of the owners of
the firm.
For market participants equity securities mean holding wealth as
well as a source of new finance, and are of great significance for
savings and investment process in a market economy.
Within the savings-investment process magnitude of retained
earnings exceeds that of the news stock issues and constitutes the
main source of funds for the firms.
Equity instruments can be traded publicly and privately.
Internal equity financing of companies is provided through
retained earnings; whereas the external source of equity is provided
through stock issuance.
Fundamental Stock Analysis:
Models of Equity Valuation
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earning Ratios
Estimating Growth Rates and
Opportunities
Intrinsic Value and Market Price
Intrinsic Value
Self assigned Value
Variety of models are used for estimation
Market Price
Consensus value of all potential traders
Trading Signal
IV > MP Buy
IV < MP Sell or Short Sell
IV = MP Hold or Fairly Priced
 Common Stock as Residual Ownership

Common stock is quite different than

bonds and preferred stock:
Return is dependent upon success of firm
Provides a residual claim on firms assets
Ownership rights to cash flows remaining
after all other claims are paid
Not a contractual obligation and no
stated maturity
 Difficulty of Estimating
Common Stock Value
The value of a security is the sum of the
present values of its future expected
cash flows. Common stock is difficult to
value because future cash flows are
uncertain.

Future common stock dividends are difficult

to forecast accurately.
The future common stock selling price is
difficult to forecast.
Valuation of common Stocks
Process of determining the fair market
value of a financial asset on the basis of
present value of the expected cash flows
Three step process:
Estimate the expected cash flows
Determine the appropriate discount rate or
required rates of return to discount the cash
flows
Compute the present value of the expected
cash flows in step 1 by discounted them with
discunt rate(s) in step 2
Value of Common-Stock
Two forms of expected cash flows
from common stocks:
1. Dividends received over
investors stock holding period
2. Price expected to be received
when stock is sold
Value of a Common Stock
The intrinsic Value of a common
stock equals PV of cash flows from
a stock which is:
1.PV of an infinite dividend stream
OR
2.PV of a finite dividend stream plus
PV of the sale price of the stock
Common stock valuation
Common stocks can be valued
using:
1. Dividend Discounted
model (DDM)
2. Free cash Flow to Equity
(FCFE) model
Dividend Discount Model
If the stock is held for finite period, Value
of a share of common stock is the
present value of all future dividends
If finite holding period there are two
types of expected cash flows
Dividends during the holding period
Expected price at the end of holding period
this itself is dependent on future dividends
 V k)(1k)(1k)
D
(1
012
N
N D .D
P
Specified/finite Holding Period Model

PN = the expected sales price for the stock

at time N
N = the specified number of years the stock
is expected to be held
Vo is value of stock
K- is RRR
Infinite Holding Period
What will be the value of a share of
common stock?
Present value of an infinite stream of
anticipated dividends
Simplified assumptions to simply
valuation model
Zero Growth Model
Constant Growth Model
Two-stage growth model
Zero Growth Model
Dividend every year will be the same
Investor anticipates to receive the
same amount dividend per year forever

DPS
Vs = -------------
rcs
 o
VD
k
No Growth Model

Stocks that have earnings and dividends

that are expected to remain constant
Preferred Stock
 o
VD
k
No Growth Model: Example

E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
Constant Growth Model
Assume that firm grows at a stable
growth rate of g per year forever

DPS1
Vs = ---------, where r>g
r-g
 D
(V
o
)ok
1
g
Constant Growth Model

g = constant perpetual growth

rate
 (V
o
)ok
D 1
g
Constant Growth Model: Example

E1 = $5.00 b = 40%
(1-b) = 60%
k = 15%
D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Two-Stage DDM
In general version of the model, two stages
of growth
An initial period of extraordinary growth
After initial period, a period of stable growth
n DPSt Pn
P0 = ---------- + ---------
t=1 (1+r)t (1 + r)n
DPSn+1
Where Pn = -----------------
(r gn)
 1
(VDgk)D
Tt
oot12T
1T2(1gk)
Shifting Growth Rate Model

g1 = first growth rate

g2 = second growth rate
T = number of periods of growth at
g1
 Shifting Growth Rate Model:
Example
D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T=3 D1 = 2.40
D2 = 2.88 D3 = 3.46 D4 = 3.63
V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +
D4 / (.15 - .05) ( (1.15)3

V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40


V(1k)
D
ot1
t
Dividend Discount Models:
General Model

V0 = Value of Stock
Dt = Dividend
k = required return
Four Basic Inputs
Length of high growth period
Dividends per share each period
Required rate of return by
stockholders each period
Terminal price at the end of high
growth period
How do we Estimate Growth
Rate?
If the firms dividend growth rate is
not known, it can be estimated
using two ways:
1.geometric mean of past dividend
growth.
2.Retention model
How do we Estimate Growth Rate?
1. geometric mean of past dividend.
g =n (1 r1)(
-11 r 2)(1 r 3)...(1 rn)
Where
rn dividend growth rate in nth year
G dividend growth rate
2. Retention growth model
Most firms pay out some of their net
income as dividends and reinvest, or
retain, the rest.
g = (retention rate) (ROE)
 gRO
Eb
Estimating Dividend Growth Rates

g = growth rate in dividends

ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
Example
Ameritech Corporation just paid dividends per
share of $7.04 and dividends are expected to
grow 5% a year forever. The stock has a beta
of 0.90 the market risk premium is 7.5 % and
the treasury bond rate is 6.25%.
a)What is the current value per share, using the
DDM?
b)The stock was trading for $80 per share.
What would the growth rate in dividends have
to be to justify this price?
Example: multiple growth rate
Chain Reaction, Inc., has been growing at a
phenomenal rate of 30 percent per year
because of its rapid expansion and explosive
sales. You believe that this growth rate will
last for three more years and that the rate
will then drop to 10 percent per year. The
growth rate then remains at 10 percent
indefinitely. Total dividends just paid were $5
million, and the required return is 20 percent.
Require: what is the total value of the stock?
Exercise
The next dividend for the Gordon Growth
Company will be $4 per share. Investors
require a 16 percent return on companies
such as Gordon. Gordons dividend increases
by 6 percent every year. Based on the
dividend growth model, what is the value of
Gordons stock today?

Required: What is the value in four years?

Price Earnings Ratios
P/E Ratios are a function of two
factors
Required Rates of Return (k)
Expected growth in Dividends
Uses
Relative valuation
Extensive Use in industry

E
P
k
1
E
1
0
1
P/E Ratio: No expected growth

E1 - expected earnings for next year

E1 is equal to D1 under no growth
k - required rate of return
 P


D
kE
g

E
(
1
kb
)
()
R
R
1b
1()
01O
1O
E
P/E Ratio with Constant Growth

b = retention ration
ROE = Return on Equity
Numerical Example: No Growth
E0 = $2.50 g=0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8
Numerical Example with Growth

b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P0 = 1.09/(.125-.09) = $31.14
PE = 31.14/2.73 = 11.4
PE = (1 - .60) / (.125 - .09) = 11.4
Free Cash Flow to Equity
(FCFE) Valuation Model
The cash flow that the firm can
afford as dividends and contrasted
with actual dividendsmay not
payout as dividends
The residual cash flow left over
after meeting interest and principal
payments and providing for capital
expenditures is the FCFE
FCFE
FCFE model is suitable under the
following conditions :
the firm is not dividend paying, or
the firm is dividend paying but dividends
differ significantly from the firms capacity to
pay dividends,
FCFE =FCFF-Interest exp (1- tax rate) + net
borrowing
Where FCFF is free cash flow to the firm
FCFE .
FCFE is the cash flow from operations
minus capital expenditures minus
payments to (and plus receipts from)
debt-holders.
Computed as:
FCFE = Net Income
+ non cash charges (Income)
- Capital Spending
+ net borrowing
Valuing FCFE
The value of equity can be found by discounting
FCFE at the required rate of return on equity (r):

FCFE t
Equity Value
t 1 (1 r )t
Since FCFE is the cash flow remaining for equity
holders after all other claims have been satisfied,
discounting FCFE by r (the required rate of return
on equity) gives the value of the firms equity.
Dividing the total value of equity by the number of
outstanding shares gives the value per share.
 Constant-growth FCFE valuation
model
FCFE in any period will be equal to FCFE
in the preceding period times (1 + g):
FCFEt = FCFEt1 (1 + g).
The value of equity if FCFE is growing at a
constant rate is
FCFE1 FCFE 0 (1 g )
Equity Value
rg rg

The discount rate is r, the required return

on equity. The growth rate (g) is the
growth rate of FCFE.
Example
Gray Furniture Company earned net income of
$350,000 last year. Investment in fixed capital was
$200,000, depreciation was $160,000, and the
investment in working capital was $50,000. Gray is
currently operating at its target debt-to-asset ratio of
40%. Thus, 40% of annual investments in working
capital and fixed capital will be financed with new
borrowings. Shareholders require a return of 14% on
their investment, and the expected growth rate of the
FCFE is 4%. The company has 100,000 outstanding
shares.
Required: what is the value of Gray companys stock?
Example 2
Ridgeway Construction has FCFE of $ 2,500,000
and 1 million shares. The firm is currently
operating at a target debt-to-equity ratio of 0.4.
The expected return on the market is 9%, the risk
free rate is 4%, and Ridgeway stock has a beta of
1.5. The expected growth rate of FCFE is 4.5%.
Required:
A)Calculate the value of Ridgeway stock
B)What is the total value of Ridgeway company
Types of Stock Analysis
Technical Analysis - using prices
and volume information to predict
future prices
Weak form efficiency & technical analysis

Fundamental Analysis - using

economic and accounting
information to predict stock prices
Semi strong form efficiency & fundamental analysis
 Fundamental analysis is one of the methods of
valuing stocks, which involves the analysis of a
companys operations to assess its economic prospects.
It is based on fundamental financial characteristics
(e.g. earnings) about the company and its
corresponding industry that are expected to influence
stock values.
The analysis is based on financial statements of the
company in order to investigate the earnings, cash
flow, profitability, and financial leverage.
The fundamental analysis includes analysis of the
major product lines, the economic outlook for the
products (including existing and potential competitors),
and the industries in which the company operates.
 This analysis results in projections of earnings growth.
Based on the growth prospects of earnings, the fair value
of the stock using one or more of the equity valuation
models is determined.
The fair value is based on present value calculations.
Present value the current value of a future cash flow.
It is obtained by discounting future cash flow by
the market required rate of return.
There are various models to estimate the fundamental
value of company shares.
One approach is to estimate expected earnings and then
multiply by expected price/ earnings ratio.
Another approach is to estimate the value of the assets of
the company.
 The estimated fair value is compared to the market price to
determine if the stock is fairly priced in the market, cheap
(a market price below the estimated fair value), or rich
(a market price above the estimated fair value).
In a perfectly efficient market all securities are always
correctly priced.
The market price equals to the fundamental value of the
security.
In a market that is partially inefficient, the market prices
deviate from fundamental value.
Financial analysts aim to discover the fundamental value
ahead of the rest of the market participants before the
market prices approach the fundamental value in order
to make profits.
The actions of such profit seeking investors push the
 Technical Analysis
The aim of the technical analysis is to identify stocks that
are candidates for purchase or sale, and the investor can
employ technical analysis to define the time of the
purchase or sale.
Such analysis is used not only for investigation of
common shares, but also in the trading of
commodities, bonds, and futures contracts.
This analysis can be traced back to the seventeenth
century, where it was applied in Japan to analyze the
trend in the price of rice.
The father of modern technical analysis is Charles Dow,
a founder of the Wall Street Journal and its first editor in
the period of 1889 -December 1902.
 Technical analysis ignores company
fundamental information, focusing instead on
the study of internal stock market
information on price and trading volume of
individual stocks, groups of stocks, and the
overall market, resulting from shifting supply
and demand.
Technical analysts believe that stock markets
have a dynamic of their own, independent of
outside economic forces.
Technical analysis a forecasting method for
asset prices based solely on information about
the past prices.
 Technical analysis is aimed to determine past
market trends and patterns from which
predictions of future market behavior are derived.
It attempts to forecast short-term price
movements.
The methodology of analysis is based on the belief
that stock market history tends to repeat itself.
If a certain pattern of prices and volumes has
previously been followed by particular price
movements, it is suggested that a repetition of that
pattern will be followed by similar price
movements.