chapter 4 principles of corporate finance tenth edition the value of common stocks slides by matthew...

Chapter 4Principles of

Corporate FinanceTenth Edition

The Value of Common Stocks

Slides by

Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

4-2

Topics Covered

How Common Stocks Are TradedHow Common Stocks Are ValuedEstimating The Cost Of Equity CapitalThe Link Between Stock Price and Earnings

per ShareValuing a Business by Discounted Cash

Flow

4-3

How Common Stocks Are Traded

Primary Market - Market for the sale of new securities by corporations.

Secondary Market - Market in which previously issued securities are traded among investors.

Common Stock - Ownership shares in a publicly held corporation.

4-4

How Common Stocks Are Traded

Electronic Communication Networks ( ECN s) –A number of computer networks that connect traders with each other.

Exchange-Traded Funds (ETFs) - portfolios of stocks that can be bought or sold in a single trade.

SPDRs (Standard & Poor’s Depository Receipts or “spiders”) – ETFs, which are portfolios tracking several Standard & Poor’s stock market indexes.

4-5

How Common Stocks Are Valued

Book Value - Net worth of the firm according to the balance sheet.

Dividend - Periodic cash distribution from the firm to the shareholders.

P/E Ratio - Price per share divided by earnings per share.

Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.

4-6


dividends) future dPV(expectePV(stock)

The value of any stock is the present value of its future cash flows. This reflects the DCF formula. Dividends represent the future cash flows of the firm.

4-7


Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

Expected Return

rDiv P P

P1 1 0

0

4-8


Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

15.100

1001105Return Expected

4-9


The price of any share of stock can be thought of as the present value of the futures cash flows. For a stock the future cash flows are dividends and the ultimate sales price of the stock.

r

PDivP

1

Price 110

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Example - continued: Fledgling Electronics price can be thought of as follows.

10015.1

1105Price 0

P

4-11


Market Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation. It is also called the Cost of Equity Capital.

gP

Divr

gr

DivP

0

1

10Ratetion Capitaliza

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Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.

PDiv

r

Div

r

Div P

rH H

H01

12

21 1 1

( ) ( )

...( )

H - Time horizon for your investment.

4-13


Modified formula

PDiv

r

Div

r

Div P

rH H

H01

12

21 1 1

( ) ( )

...( )

HH

H

tt

t

r

P

r

DivP

)1()1(10

4-14


Example

Fledgling Electronics is forecasted to pay a $5.00 dividend at the end of year one and a $5.50 dividend at the end of year two. At the end of the second year the stock will be sold for $121. If the discount rate is 15%, what is the price of the stock?

00.100$

)15.1(

12150.5

)15.1(

00.521

PV

PV

4-15


Another Example

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

4-16


Another Example

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

PV

PV

300

1 12

324

1 12

350 94 48

1 12

00

1 2 3

.

( . )

.

( . )

. .

( . )

$75.

4-17


4-18

Estimating the Cost of Equity Capital

Dividend Yield – The expected return on a stock investment plus the expected growth in the dividends. Similar to the capitalization rate.

gP

Divr

gr

DivP

0

1

10Yield Dividend

4-19


Example - Northwest Natural Gas stock was selling for $42.45 per share at the start of 2009. Dividend payments for the next year were expected to be $1.68 a share. What is the dividend yield, assuming no growth?

04.45.42

68.1

Yield Dividend

r

r

r

4-20


Example - continued - Northwest Natural Gas stock was selling for $42.45 per share at the start of 2009. Dividend payments for the next year were expected to be $1.68 a share. What is the dividend yield, assuming a growth rate of 6.1%?

101.

061.45.42

68.1

Yield Dividend

r

r

r

4-21


Return Measurements

0

1

P

Div YieldDividend

Sharey Per Book Equit

EPS

Equityon Return

ROE

ROE

gP

Divr

gr

DivP

0

1

10 Restated

4-22


Dividend Growth Rate can also be derived from applying the return on equity to the percentage of earnings plowed back into operations.

g = return on equity X plowback ratio

4-23


Valuing Non-Constant Growth

HH

HH

r

P

r

Div

r

Div

r

DivPV

)1()1(...

)1()1( 22

11

gr

DivP H

H 1

4-24


Example – Phoenix produces dividends in three consecutive years of 0, .31, and .65, respectively. The dividend in year four is estimated to be .67 and should grow in perpetuity at 4%. Given a discount rate of 10%, what is the price of the stock??

13.9

)04.10(.

67.

)1.1(

1

)1.1(

65.

)1.1(

31.

)1.1(

03321

PV

4-25

Stock Price and Earnings Per Share

If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as dividends

Plowback Ratio - Fraction of earnings retained by the firm

4-26


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 plowback 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?

4-27


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 plowback 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?

56.55$15.

33.80 P

No Growth With Growth

00.100$10.15.

00.5

10.40.25.

0

P

g

4-28


Example - continuedIf 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).

44.44$56.5500.100 PVGO

4-29


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.

4-30

Valuing a Business

Valuing a Business or ProjectThe value of a business or Project is usually computed as the discounted value of FCF out to a valuation horizon (H).

The valuation horizon is sometimes called the terminal value and is calculated like PVGO.

HH

HH

r

PV

r

FCF

r

FCF

r

FCFPV

)1()1(...

)1()1( 22

11

4-31

Valuing a Business

Valuing a Business or Project

HH

HH

r

PV

r

FCF

r

FCF

r

FCFPV

)1()1(...

)1()1( 22

11

PV (free cash flows) PV (horizon value)

4-32

Valuing a Business

Example

Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%

66613132020202020(%) growth .EPS

1.891.791.681.59.23-.20-1.39-1.15-.96-.80- FlowCash Free

1.891.781.681.593.042.693.462.882.402.00Investment

3.783.573.363.182.812.492.071.731.441.20Earnings

51.3173.2905.2847.2643.2374.2028.1740.1400.1200.10ValueAsset

10987654321

Year

4-33

Valuing a Business

Example - continuedGiven the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%

4.2206.10.

59.1

1.1

1 value)PV(horizon 6

6.3

1.1

23.

1.1

20.

1.1

39.1

1.1

15.1

1.1

96.

1.1

.80-PV(FCF) 65432

4-34

Valuing a Business

Example - continuedGiven the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm. r=10% and g= 6%

$18.8

22.4-3.6

value)PV(horizonPV(FCF)s)PV(busines

4-35

Web Resources

Click to access web sitesClick to access web sites

Internet connection requiredInternet connection required

www.dividenddiscountmodel.com

www.valuepro.net

www.nyse.com

www.nasdaq.com

www.londonstockexchange.com

www.tse.or.jp

www.123world.com/stockexchanges

www.rba.co.uk

www.fibv.com

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