There are mainly 2 types of stock:

 Preferred stock
◦ Fixed cash flow stream
◦ Dividend payments as a percentage of par value
◦ Cannot force the firm into bankruptcy
◦ Do not carry the right to vote
◦ Cumulative (cannot pay dividend to regular
bondholders unless it makes up for the unpaid
dividends of preferred stocks)
◦ No fixed maturity date
◦ Similar to a perpetuity
 Preferred stock valuation

Pso= Dividend / required rate of return

Pso= Dp / rp
Example:
Dividend= 9
r=10%
Price=9/0,1= 90
 Common stock valuation
◦ Unspecified
U ifi d cash
h flows
fl
◦ Price = present value of all future dividends
investors expect to receive

◦ Return= (D1+P1) – P0 profit or loss

P0

D1= Dividend at the end of year 1

P1= Price at the end of year 1

P0= Purchase price

◦ P0 = (D1+P1) Equation 1
(1+r)
◦ P1 = (D2+P2)
(1+r)
Substituting P1 in equation 1
1, we have:
◦ P0 = D1+(D2+P2)
(
(1+r)
)
(1+r)
P0 = D1 + (D2+P2)
(1
(1+r)) (1
(1+r))2
 “The price of a stock today equals the present
value of the dividends it will pay over the time
we hold the stock, plus the selling price by
the time we sell the security
security”

P0 = D1 + D2 + …….+ (Dn+Pn)
(1+r) (1+r)2 (1+r)n
 There are two variables that affect a stock
price:
1. Discount rate (firm’s risk)
2. Di id d ((growth)
Dividends h)

 DIVIDEND GROWTH
◦ Zero growth
◦ Constant growth
g
◦ Variable growth
◦ Return= (D1+P1) – P0
◦ P0
◦ From the return formula, we can rearrange terms
◦ and get the price at year zero:

◦ r = (D1+P1) – P0
◦ P0 P0
◦ r = (D1+P1) – 1
◦ P0
◦ P0 = (D1+P1)
◦ (1+r)
 Zero growth

Constant dividend stream

It becomes a perpetuity

P0= D/r
D/
Zero growth
Example:

Dividend= $0,80 per share

Required rate of return= 10%

P0= D/r =0,80/0,1=$8

 Constant Growth (Gordon growth)

Dividends will grow at a constant rate g

Growing perpetuity

P0= D1/r
/ –g

P 0= 4 3/0
4,3 1–0
0,1 03 $61
0,03= 43
$61,43
 Variable growth

Firms go through cycles, thus the growth may

vary
y according
g to each stage
g

Rapid growth (g1) and stable growth (g2)

Price=present value of the dividends at g1 plus

the present value of the price at the end of the
initial period (using the constant growth model)
 PV Dividends in the fast growth phase (g1):

Pg1= D0 (1+g1)1 + D0 (1+g1)2 +…….+ D0 (1+g1)n

(1+r)1 (1+r)2 (1+r)n

 PV Dividends in stable growth phase (g2):

Dn+1= Dn* (1+ g2)

Pn= Dn+1/r – g2

Pg2= Pn/(1+r)n
 Price of a stock using the variable growth model:

P0= Pg1 + Pg2

 Example:
One year from today, investors anticipate that
INTEL stock will pay a dividend of $3.25
per share.
share After that,
that investors believe that the
dividend will grow 20% per year for 3 years
before settling down to a long run growth of 4%.
Th i d rate off return iis 15%
The required 15%. Wh
What iis the
h
current stock price?
 Example:
0 1 2 3 4 5
$3,25 $3,90 $4,68 $5,62 $5,84

1 3,25
2 3
3,25
25 (1
(1,2)
2)1 = 3,90
3 90
3 3,25 (1,2)2 = 4,68
4 3 25
3,25 (1 2)3
(1,2) = 5 62
5,62
5 5,62 (1,0,04)1 = 5,84
 Example:
0 1 2 3 4 5
$3,25 $3,90 $4,68 $5,62 $5,84

Stable growth:
P4 = 5,84
5 84 /0
/0,15
15 – 0,04
0 04 = 53
53,10
10
P0 = 53,10 / (1,15)4 = 30,36
Pg2 = 30 36
30,36
 Example:
0 1 2 3 4 5
$3,25 $3,90 $4,68 $5,62 $5,84

Variable growth:
P0 = 3,25/(1,15)1 + 3,90/(1,15)2 + 4,68/(1,15)3 + 5,62/(1,15)4
Pg1= 12,06

P0= 30,36 + 12,06 = $42,42

 Among
A other
th factors,
f t growth
th depends
d d mainly
i l
on:
◦ Size of investments (existing and new)
Retention rate (rr): the fraction of the firm’s earning
that it retains to engage in new investments
rr= retained earnings / after tax earnings = %

◦ Rate of return of those investments

ROE: rate of return on equity
ROE= Net income / Shareholder’s equity = %
Net income is for the full fiscal year (before dividends paid
to common stock holders but after dividends to preferred
stock.) Shareholder's equity does not include preferred
shares
h
 Growth formula:
g = rr x ROE

 Example:
A company retains 75% of its earnings. The
firm’s
firm s net income was 44,6
44 6 millions and the
book value of its equity was 297,33 millions.
What is the firm´s
firm s growth rate?
g = 0,75 x 0,15 = 0,1125 = 11,25%
 Free cash flow approach

◦ Values the firm as a whole, not just its shares

◦ Free
F cash
h flow
fl (FCF):the
(FCF) th cashh that
th t the
th firm
fi can
distribute to its investors after meeting all its
obligations
◦ FCF= Total operating cash flow – Funds for
investments (fixed and current)
◦ Discount the FCF at WACC
 Free cash flow approach

◦ WACC = after tax weighted average cost of capital

◦ Sources of firms
firms’ funds:
1. Equity (stocks) E
2. Debt (bonds) D
3. Preferred stocks P

V
V= total market value of the firms’
firms sources of funds
V= E+D+P 100%= E/V+D/V+P/V
 Free cash flow approach

◦ WACC
V total market value of the firms
V= firms’ sources of funds
V= E+D+P 100%= E/V+D/V+P/V
◦ Cost of firms’ funds:
1. Equity (stocks) E RE
2. Debt (bonds) D RD
3
3. Preferred stocks P RP
 Free cash flow approach

◦ WACC FORMULA

WACC= (E/V) ∙ RE + (D/V) ∙ RD + (P/V) ∙ RP (1-TC)

TC= tax rate

 Free cash flow approach

VS =firms’ shares value

VF = tota
total e
enterprise
te p se value
a ue
VD= value of the firms’ debt
VP= value of the firms’ preferred stock

VS= VF – VD – VP
P0= Vs/ number shares outstanding
 Free cash flow approach

Example:
At the beginning of 2001 Disney stocks were traded
at $20 - $25. The company’s
p y debt at the end of
Year 2000 was $66 million, no preferred stocks, and
4,148,002 shares of common shares of common
stock outstanding. Its year 2000 FCF was $4.8
million Disney experienced a 14% annual growth
million.
of FCF from 2000 to 2004 followed by a 7% annual rate
thereafter. WACC is estimated at 11% What is Disney’s stock
price
p at year
y 2001?
 Free cash flow approach

Example:

2000 $4,800,000
2001 $4,800,000 (1,14)1 = $5,472,000
2002 $4 800 000 (1
$4,800,000 (1,14)
14)2 = $6,238,080
$6 238 080
2003 $4,800,000 (1,14)3 = $7,111,411
2004 $4,800,000 (1,14)4 = $8,107,009
2005 $5 472 000 (1
$5,472,000 07)1 =
(1,07) $8 674 499
$8,674,499
 Free cash flow approach

Example:
Stable growth:
g
V2004 = $8,674,499 /0,11 – 0,07 = $216,862,475
V2001 = $216,862,475 / (1,11)4 = $142,854,029
V2001 = $142,854,029
$142 854 029

We estimate the value for the end of year 2000 to forecast the
g g price
beginning p of year
y 2001
 Free cash flow approach

Example:
Variable growth:
V2001 = $5,472,000 / (1,15)1 = $4,929,730
V2001 = + $6,238,080
$6 238 080 / (1
(1,15)
15)2 = $5,062,966
$5 062 966
V2001 = + $7,111,411 / (1,15)3 = $ 5,199,802
V2001 = + $8,107,009 / (1,15)4 = $ 5,340,338
= $ 20,532,836

VE2001= $142,854,029 + $ 20,532,836 = $163,386,865

W i
We estimate h value
the l ffor the
h end
d off year 2000 to fforecast the
h
beginning price of year 2001
 Free cash flow approach

Vs= $163,386,865 - $66,000,000 = $97,386,865

Vs = $97,386,865/4,148,002= $23,48

We estimated d the
h value
l ffor the
h end d off year 2000 to
forecast the beginning price of year 2001, we got:
$23,48. Actual trading range $20 to $25.