Stock Valuations

Bond and Stock Valuation

Private and Confidential

Analyst Training Program

Private and Confidential – Not for Circulation

1

Discussion topics

Bond and Stock Valuation





Stock Valuation 

Stock terminologies



Introduction to stock valuation



Intrinsic Value Method



Dividend Discount Model (DDM)



Non-constant growth: Two stage DDM



Non-constant growth: Three stage DDM

Sum Up..

Private and Confidential – Not for Circulation

2

Bond and Stock Valuation

Stock Valuation

Private and Confidential – Not for Circulation

3

Stock terminologies

Bond and Stock Valuation







Common stock 

Security that represents ownership in a corporation



Holders of common stock exercise control by electing a board of directors and voting on corporate policy



Common stockholders are on the bottom of the priority ladder for ownership structure



In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt-holders have been paid in full

Dividend Payments 

Dividends are payments made by a corporation to its shareholder members



When a corporation earns a profit or surplus, that money can be put to two uses:





It can either be re-invested in the business (called retained earnings)

•

It can be paid to the shareholders of the company as a dividend.

Dividend payout ratio 



•

The percentage of earnings paid to shareholders in dividends

Dividend _ payout _ ratio 

Dividend Net _ Income

Preferred stock 

Class of ownership in a corporation that has a higher claim on assets and earnings than common stock



Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights

Capital gains 

Capital gain is profit that results from the sale or exchange of a stocks with proceeds of sale exceeding purchase price Private and Confidential – Not for Circulation

4

Stock Valuation – Fundamental Approach

Bond and Stock Valuation







Intrinsic Value Method 

Capitalization of expected income



Intrinsic value based on the discounted value of the expected stream of cash flows

Dividend Discount Model (DDM) 

Constant Growth: Gordon Growth Method



Non-constant growth: Two stage DDM



Non-constant growth: Three stage DDM

Relative Valuation 

Valuation relative to a financial performance measure



P/E



EV/EBITDA



P/S



P/BV

Note: Relative Valuation will be discussed later, when we take the full valuation module!

Private and Confidential – Not for Circulation

5

Bond and Stock Valuation

Stock valuation: Intrinsic Value Method 

The first step in valuing common stocks is to determine the expected future cash flows



Find the present values of these cash flows and adding them together : 

 



Instrinsic _ valuestock   t 1

CFt 1  k t

For a stock, there are two cash flows: 

Future dividend payments



The future selling price

Illustration Example: Dividend discount model

Assume that you are considering the purchase of a stock which will pay dividends of $20 (Div 1) next year, and $21.6 (Div 2) the following year. After receiving the second dividend, you plan on selling the stock for $333.3 What is the intrinsic value of this stock if your required return is 15%? Present Value?

Dividend 1: $20.0

Stock Price: $333.3 Dividend 2: $21.6

Instrinsic _ valuestock 

20.0  (1  0.15)1

2 . 00



21.6  333.3 (1  0.15) 2

Unrealistic Assumptions 

Do we know the exact dividends that will be paid in the future?



Do we know how much will we be able to sell the stock for in the future?

Private and Confidential – Not for Circulation

6

Dividend Discount Model (DDM)

Bond and Stock Valuation





Lets make the following assumptions, to derive a simple model for common stock valuation 

Stock holding period is infinite (i.e., never sell the stock so we don’t have to worry about forecasting a future selling price)



The dividends will grow at a constant rate forever

Constant Growth DDM (Gordon Growth Method) 



Computes the value of a share of stock as the PV of its expected future cash dividends

Value _ stock 

D0 (1  g )  (Ke  g )

D1 (Ke  g )

Can you derive this formula?



Constant growth DDM gives us the present value of an infinite stream of dividends that are growing at a constant rate



Illustration Example : Gordon Growth Model (Constant Growth Model)

In the previous example, the same stock is selling at $315. What might the market assuming the growth rate of dividends for this stock

315 

20.0 (0.15  g )

Implied growth = 8.7%

Private and Confidential – Not for Circulation

7

Dividend Discount Model (DDM) DDM requires estimation of two inputs

Bond and Stock Valuation







Required rate of return (Using CAPM formula) 

Will focus on this when we talk about valuations!



As of now assume that we are provided with the required rate of return

Estimation of growth rate 

Use the historical growth rate and assume it will continue



Generate your own forecast with whatever method seems appropriate for calculation of growth



Use Payout ratio formula

Payout ratio formula 

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



Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations •

Payout Ratio: Fraction of earnings paid out as dividends

•

Plowback Ratio: Fraction of earnings retained by the firm

Growth Rate

=

Return on Equity

X

Private and Confidential – Not for Circulation

Plowback Ratio

8

Dividend Discount Model (DDM)

Bond and Stock Valuation

Example : Calculation of Growth Rate

Denco Inc forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 20%. What is the value of the stock before and after the plowback decision?

Value _ stock 

5  42 (0.12)

Value _ stock 

5 * 0.6  75 (0.12  0.08)

Growth Rate = 8% (20% * 40%)

Growth Rate = 0%

Note: If the company did not plowback, the stock would have remained at $42. With plowback, the stock price rose to $75



Extended DDM model 

We can use the DDM at any point in time. for example we can calculate the price that a stock should sell for in two years



Value _ stock N 



To value a stock at year 2, we simply use the dividend for year 3 (D3).



In our earlier example, dividends were growing by 8% and required rate of return was 15%

Value _ stock 2  

DN (1  g )  (Ke  g )

DN 1 (Ke  g )

21.6(1  .08)  (0.15  0.08)

23.3  333.3 (0.15  0.08)

Note: Value at period 2 is simply the present value of D3, D4, D5, …, D∞ Private and Confidential – Not for Circulation

9

Non-constant growth – Two stage DDM

Bond and Stock Valuation





Two stage DDM 

The DDM assumes that dividends will grow at a constant rate forever, but what if they don’t?



If we assume that growth will eventually be constant, then we can modify DDM



Intrinsic value of the stock is the present value of its future cash flows



Further, we can use the DDM to determine the value of the stock at some future period when growth is constant



If we calculate the present value of that price and the present value of the dividends up to that point, we will have the present value of all of the future cash flows.



D 1  g1  D0 1  g1  1  g 2  V0   0  ( 1  k)t ( 1  k)T k  g 2  t 1 t

T

T

Illustration Example : Calculation of Growth Rate

Check Mate forecasts that its dividend will grow at 15% per year for the next three years before settling down at a constant 8% forever. Dividend (current year) = $20; Expected return = 12%. What is the value of the stock now? 

First, note that we can calculate the value of the stock at the end of period 3 (using D4)



Now, find the present values of the future selling price and D1, D2, and D3 20*1.15 0

1

20*1.15^2 2

g = 15%

20*1.15^3

20*1.15^3*1.08

3

…

V3 

4

g = 8%

V0 

Private and Confidential – Not for Circulation

32.85  821.27 .12  .08

23.00 26.45 30.42  821.27    647.84 1.12 1.12 2 1.123

10

Bond and Stock Valuation

Non-constant growth – Three stage DDM 

One improvement that we can make to the two-stage DDM is to allow the growth rate to change slowly rather than instantaneously



The three-stage DDM is given by: 

First phase: there is a constant dividend growth (g1) or with no dividend



Second phase: there is a gradual dividend decline to the final level



Third phase: there is a constant dividend growth again (g3), i.e. the growth company opportunities are over



N D0 1  g1  Dt DN 1    V0   t t k  g 3 ( 1  k)N ( 1  k) t 1 t T 1 ( 1  k) T

t

Private and Confidential – Not for Circulation

11

Bond and Stock Valuation

Sum Up..

Private and Confidential – Not for Circulation

12