STOCKS AND THEIR VALUATION

Facts about Common Stock:

 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors elect management.
 Management’s goal: Maximize stock
price
Advantages of Financing with Stock:

 No required fixed payments.

 No maturity.
 Improves debt ratio
 if prospects look bright, comm.
stock can be sold on better terms
than debt
Disadvantages of Financing with Stock:

 Controlling shareholders may lose some

control.
 Future earnings shared with new
stockholders. Dilution.
 Higher flotation costs vs. debt.
 Higher component cost of capital.
 Too little debt may encourage a takeover
bid.
 taxation
 When is a stock sale an
initial public offering (IPO)?
 A firm “goes public” through an IPO when the stock is
first offered to the public.

What is the difference between primary &

secondary markets?

 Primary market - Equities may be:

sold directly to investors by the firm
purchased and sold by investment bankers in an
underwriting offering
sold to existing shareholders in a rights offering
 Secondary market buy through broker from another
shareholder
 Common stock

 entitles owner to dividends - if company

earns profit & decides to pay dividends -
not like bond with contract - promise to
pay interest
 can be sold at future date - hopefully for a
capital gain
 hence price of common stock is the
present value of those expected cash
flows
 Approaches to Investing

 Top Down Approach: investors using a top-

down investing approach start their analysis by
looking at macroeconomic factors before working
their way down to individual stocks
For example, a top-down investor might start their
analysis by looking at what countries have the fastest
growing economies. Then, they might look at
individual sectors within these economies to find the
best opportunities. Finally, they will look at individual
companies within these specific sectors before
actually making an investment decision
 Approaches to Investing

 Bottom Up Approach: investors using a bottom-

up approach start their analysis by looking at
individual companies and then building a portfolio
based on their specific attributes
 For example, a bottom-up investor might screen for
stocks trading with a low price-earnings (P/E) ratio
and then review companies that meet that specific
criteria. Then, they will take a deeper look at each
individual company that comes up on the screener
and evaluate them based on other fundamental
criteria. The investor may also rely on external
factors, such as reading analyst research reports and
opinions for added insight
 Financial asset values:

0 1 2 n
k

Value CF1 CF2 CFn

CF1 CF2 CFn

PV =   ... +
1+ k  1  k 
1 2
1+ k  n

9
 Value of Common Stock

 Holders of common stock can also

receive dividends. However, dividends on
common stock are not guaranteed, nor
are they a fixed amount from year-to-year.
As such, we can value common stock
using dividends over various time
horizons
 Value of Common Stock

 One Year Holding Period

 Value of Common Stock

 Multiple Year Holding Period

 Infinite Period DDM

D1 D2 D3 D
P 0     . . .
1  k s  1
1  k s  2
1  k s  3
1  k s  

What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.
For a constant growth stock,

D 1  D 0 1  g  1

D 2  D 0 1  g 
2

D t  D 0 1  g 
t

Gordon
Growth
If g is constant:
Model

ˆ D0 1  g  D1
P0  
ks  g ks  g
 B. 3 What happens if g > ks?

 D
P0  1
req u ires k s  g .
ks  g

 If ks< g, get negative stock price, which is

nonsense
 We can’t use model unless (1) ks> g and
(2) g is expected to be constant forever
 B. 3 What happens if g > ks?

 D
P0  1
req u ires k s  g .
ks  g

 If ks< g, get negative stock price, which is

nonsense.
 We can’t use model unless (1) ks> g and
(2) g is expected to be constant forever
 D0 was $0.25 and g is a constant 6%.
Find the expected dividends for the next
3 years, and their PVs. ks = 12%.
0 1 2 3 4
g=6%

D0=0.25 0.265 0.2809 0.2978

12%
0.2366
0.2239
0.2120
What’s the stock’s market value?
D0 = 0.25, k = 12%, g = 6%.

Constant growth model:

D1 $0.265
P 0  
k s  g 0.12  0.06

$0.265
  $4.42.
0.06
 What is the stock’s market value one year
from now, P1?

 D1 will have been paid, so expected

dividends are D2, D3, D4 and so on. Thus,
D 2 $ 0 .2 8 0 9
P 1  
k s  g 0 .1 2  0 . 0 6
= $4.68.
If the stock is selling at $4.42, what is
the expected rate of return on the stock?
Rearrange model to rate of return form:

 D  D
P0  1
to k s  1
 g.
ks  g P0

Then, ks = $0.265/$4.42 + 0.06

= 0.06 + 0.06 = 12%.
 What would P0 be if g = 0?

The dividend stream would be a perpetuity.

0 1 2 3
12%

0.25 0.25 0.25

PMT $0.25
P0    $2.08.
k 0.12
G. If we have supernormal growth of
30% for 3 years, then a long-run constant
g=10%, what is P0? k is still 12%

 Can no longer use constant

growth model.
 However, growth becomes
constant after 3 years.
 Non-constant growth followed by constant
growth:
0 4
ks=12% 1 2 3
g = 30% g = 30% g = 30% g = 10%
D0 = 0.25 0.3250 0.4225 0.5493 0.6042

0.2902
0.3368
0.3910
21.5029 0.6042
P 3   $30.21
$22.52 = P0 0.12  0.10
 Suppose g = 0 for t = 1 to 3, and then g is a
constant 11%. What is P^0?

0 4
ks=12% 1 2 3
g = 0% g = 0% g = 0% g = 11%
0.25 0.25 0.25 0.2775

0.2232
0.1993
0.1779
19.7519 ^ 0.2775
P 3   27.75.
$20.3523 0.01
If g = -6%, would anyone buy the stock?
If so, at what price?

Firm still has earnings and still pays

dividends, so P0 > 0:
^
0  D D 1 g
P 1
 0
.
ks  g ks  g
$0.25 0.94  $0.235
   $1.31.
0.12    0.06  0.18
Using DDM to Develop an Earnings
Multiplier Model
 What is a Price Multiple

 A price multiple is any ratio that uses the share price of a company in
conjunction with some specific per-share financial metric for a snapshot
on valuation. The share price is typically divided by a chosen per-share
metric to form a ratio
 Some common price multiples are the price-to-earnings (P/E)
ratio, price-to-forward earnings (Forward P/E), price-to-book (P/B) ratio,
and price-to-sales (P/S) ratio
 Cost of Equity

CAPM (Capital Asset Pricing Model)

Cost of Equity = Risk Free Rate + Beta x Risk Premium

 Risk free Rate: the return investor expects from a completely risk free
investment
 Beta: The degree to which a company’s equity returns vary with the
return of the overall market, beta is a measure of systematic risk
 Non-Systematic Risks include risks that are specific to a company or
industry. This kind of risk can be eliminated through diversification
across sectors and companies
 Systematic Risks are those risks that affect the overall stock
markets. Systematic risks can’t be mitigated through diversification
 Risk Premium: Investors expect a higher return to induce them to take
the higher risk of investing in equities
Beta
 Beta

 If Beta = 1: If Beta of the stock is one, then it has the same level of risk
as the stock market. Hence, if stock market rises up by 1%, the stock
price will also move up by 1%. If the stock market moves down by 1%,
the stock price will also move down by 1%
 If Beta > 1: it implies higher level of risk and volatility as compared to
the stock market; assume the Beta of the ABC stock is two, then if
stock market moves up by 1%, the stock price of ABC will move up by
two percent (higher returns in the rising market). However, if the stock
market moves down by 1%, the stock price of ABC will move down by
two percent (thereby signifying higher downside and risk)
 If Beta >0 and Beta<1: If the Beta of the stock is less than one and
greater than zero, it implies the stock prices will move with the overall
market, however, the stock prices will remain less risky and volatile. For
example, if the beta of the stock XYZ is 0.5, it means if the overall
market moves up or down by 1%, XYZ stock price will show a an
increase or decrease of only 0.5% (less volatile)
Compute Cost of Equity?
 Security Market Line

Security market line (SML) is

the graphical representation
of the Capital Asset Pricing
Model (CAPM). SML gives
the expected return of the
market at different levels of
systematic or market risk. It
is also called ‘characteristic
line’ where the x-axis
represents beta or the risk of
the assets and y-axis
represents the expected
return.
 Characteristics of Security Market Line

 Zero-beta security or zero-beta portfolio has an expected return on the portfolio

which is equal to the risk-free rate
 The slope of the SML is determined by market risk premium. Higher the market
risk premium steeper the slope and vice-versa
 All the assets which are correctly priced are represented on Security Market Line
(SML).
 The assets which are above the SML are undervalued as they give the higher
expected return for a given amount of risk.
 The assets which are below the SML are overvalued as they have lower expected
returns for the same amount of risk
 Levered vs Unlevered Beta

 Levered Beta is the Beta that contains the effect of capital structure i.e. Debt
and Equity both. It measures the risk of a firm with debt and equity in its capital
structure to the volatility of the market
 Unlevered Beta is the Beta after removing the effects of the capital structure

Unlevered Beta can be calculated using the following formula:

 Beta of Unlisted or Private Company

In case of private companies (not listed), we can find an Implied Beta

from the comparable analysis.

Implied Beta is found using the following three steps:

 Find all the listed comparables whose Beta’s are readily available:
Available Beta’s are Levered Betas and hence, it is important to remove the
effect of capital structure
 Unlever the Betas:
Use the formula discussed previously to Unlever the Beta
 Relever the Beta:
We then relever the beta at an optimal capital structure of the PRIVATE
company as defined by industry parameters or management expectations
 Beta of Unlisted or Private Company: Example
Let us assume here that we want to find the Beta of a private company.
We find all the listed peers For each competitor, find D/E ratio & tax
and identify their Betas rates;
(levered) While unlevering, we will be able to remove
the effect of financial leverage
 Beta of Unlisted or Private Company

We then relever the beta at an optimal capital structure of the PRIVATE

company as defined by industry parameters or management expectations. In
this case, the following has been assumed:
Debt/Equity of 0.25x and Tax Rate of 30%.
The calculation for the relevered beta is as follows:

It is this relevered Beta that is used for calculating the Cost of Equity of
the Private companies.
 Valuation of Preferred Stock

Preferred shares have the qualities of a stock and a bond,

which makes valuation a little different than a common
share.
There is a fixed payment which is in the form of a
dividend and will be the basis of the valuation method for
a preferred share.
These payments could come quarterly, monthly or yearly,
depending on the policy stated by the company.
 Valuation of Preferred Stock

The value of a preferred stock equals the present value of

its future dividend payments discounted at the required
rate of return of the stock. In most cases the preferred
stock is perpetual in nature, hence the price of a share of
preferred stock equals the periodic dividend divided by the
required rate of return.
Valuation of Preferred Stock