Equity Valuation

Course 5

Valuation of Preferred Stock

Owner of preferred stock receives a promise to pay a stated dividend, usually quarterly, for perpetuity Dividends are typically fixed at the time of issue and must be paid before common stockholders receive any payment. Since payments are only made after the firm meets its bond interest payments, there is more uncertainty of returns Creditors have prior claim on earnings; interest on debt must be paid before preferred stockholders can receive anything. Tax treatment of dividends paid to corporations (80% tax-exempt) offsets the risk premium.

Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)

Dividend V = kp

Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)

Dividend V = kp
Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent

$8 = $88.89 V = .09

Valuation of Preferred Stock

Given a market price, you can derive its promised yield

Dividend kp = Price
At a market price of $85, this preferred stock yield would be

$8 kp = = .0941 $85.00

Valuation of Preferred Stock - An Example

Suppose an investor is considering the purchase of a preferred stock issue that is expected to pay $3.00 a share in perpetuity. If the investor assigns a required rate of return of 7.5 percent to the issue, whats the maximum amount he/she should be willing to pay?

Valuation of Preferred Stock - Solution

$3.00 P= = $40 / share 0.075

Approaches to the Valuation of Common Stock

Two approaches:
1. Discounted cash-flow valuation
Present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow

2. Relative valuation technique

Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales

Valuation Approaches and Specific Techniques

Approaches to Equity Valuation

Discounted Cash Flow Techniques

Present Value of Dividends (DDM) Present Value of Operating Cash Flow Present Value of Free Cash Flow

Relative Valuation Techniques

Price/Earnings Ratio (PER) Price/Cash flow ratio (P/CF) Price/Book Value Ratio (P/BV) Price/Sales Ratio (P/S)

Which discount rate to use in the Discounted Cash Flow Valuation Approach
The measure of cash flow used: Dividends Cost of equity as the discount rate Operating cash flow (cash flow available to all capital suppliers (debt holders + shareholders) Weighted Average Cost of Capital (WACC) as the discount rate Free cash flow to equity (cash flow available only to equity owners) Cost of equity as the discount rate

1. Discounted Cash-Flow Valuation Techniques

CFt Vj = t t =1 (1 + k )
Where: Vj = value of stock j n = life of the asset CFt = cash flow in period t k = the discount rate
t =n

a. The Dividend Discount Model (DDM)

The value of a share of common stock is the present value of all future dividends
Vj =
n

D3 D1 D2 D + + + ... + (1 + k ) (1 + k ) 2 (1 + k ) 3 (1 + k ) Dt (1 + k ) t

=
t =1

Where: Vj = value of common stock j Dt = dividend during time period t k = required rate of return on stock j

a. The Dividend Discount Model (DDM)

If the stock is not held for an infinite period, a sale at the end of year 2 would imply:

SPj 2 D1 D2 Vj = + + 2 2 (1 + k ) (1 + k ) (1 + k )
Selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation

a. The Dividend Discount Model (DDM)

Stocks with no dividends are expected to start paying dividends at some point, say year three...

D3 D1 D2 D Vj = + + + ... + 2 3 (1 + k ) (1 + k ) (1 + k ) (1 + k )
Where: D1 = 0 D2 = 0

a. The

Gordon growth model

The Gordon growth model assumes a constant growth

rate for future dividends:

D0 (1 + g ) D0 (1 + g ) 2 D0 (1 + g ) n Vj = + + ... + 2 (1 + k ) (1 + k ) (1 + k ) n

Where: Vj = value of stock j D0 = dividend payment in the current period g = the constant growth rate of dividends k = required rate of return on stock j n = the number of periods, which we assume to be infinite

a. The Dividend Discount Model (DDM)

The Gordon growth model can be reduced to:

D1 Vj = kg
(Where D1 is the future period dividend) To find the value V we must: 1. Estimate the required rate of return (k) 2. Estimate the dividend growth rate (g)

Example:
Stock ABC has a current dividend of 1$ per share. You believe that, over the long run, this companys earnings and dividends will grow at 7 percent. If your required rate of return is 11 percent, how much would you be willing to pay for the stock today?

Solution
D1 = D0 (1 + g) = 1$ x 1.07 = 1.07$ V = 1.07/ (0.11 0.07) = 1.07 / 0.04 = 26.75$

Assumptions of The Gordon growth model

Assumptions: 1. Dividends grow at a constant rate (g) 2. The constant growth rate will continue for an infinite period 3. The required rate of return (k) is greater than the infinite growth rate (g)

Valuation with Temporary Supernormal Growth Multistage DDM

Example: The Bourke company has a current dividend (D0) of 2 $ per share and a 14 percent required rate of return for the stock (the companys cost of equity). The following are the expected annual growth rates for dividends: Year 1-3: 4-6: 7-9: 10 on: Dividend Growth Rate 25% 20% 15% 9%

What is the current value of the Bourke stock?

Answer:
2.00 (1.25 ) 2.00 (1.25 ) 2 2.00 (1.25 ) 3 Vi = + + 2 1.14 1.14 1.14 3 2.00 (1.25 ) 3 (1.20 ) 2.00 (1.25 ) 3 (1.20 ) 2 + + 4 1.14 1.14 5 2.00 (1.25 ) 3 (1.20 ) 3 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) + + 6 1.14 1.14 7 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 2 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 3 + + 8 1.14 1.14 9 2.00 (1.25 ) 3 (1.20 ) 3 (1.15 ) 3 (1.09 ) (.14 .09 ) + = 94 .355 $ 9 (1.14 )

The H Model
H-models assume the growth rate starts out high, and then declines linearly over the high-growth stage until it reaches the long-run average growth rate.
D0 (1 + g L ) D0 H ( g S g L ) D0 (1 + g L ) + D0 H ( g S g L ) + = , r gL r gL r gL

V0 =

where : g S initial short term dividend growth rate g L normal long term dividend growth rate H half life in years of the high growth period

The H Model
Example: Bill's Hardware currently pays a dividend of $1.00. The growth rate is 30% and is expected to decline over the next 10 years to a stable rate of 8% thereafter. The required return is 12%. Calculate the current value of Bill's Hardware. Answer:

Answer:

Calculate a required return using the Gordon growth model and the H-model
D0 r = [(1 + g L ) + H ( g S g L )] + g L P 0 Example using the H-model:
Wettster, Inc. pays a current dividend of $1.33, which has been growing at a rate of 12%. This growth rate is expected to decline to 8% over the next five years and then remain at 8% indefinitely. Calculate the implied required return for Wettster's based on the current price of $26.00.

D1 r = +g P 0

Answer

Define, calculate, and interpret the sustainable growth rate (g) of a company and explain the calculations underlying assumptions
The sustainable growth rate (SGR) is the rate at which earnings (and dividends) can continue to grow indefinitely, assuming that the firms debt-to-equity ratio is unchanged and it doesnt issue new equity. SGR is a simple function of the earnings retention ratio and the return on equity:

g = b ROE

Example: Graham Inc., is growing earnings at an annual rate of 8%. It currently pays out dividends equal to 25% of earnings. Graham's ROE is 21%. Calculate its SGR (g).

Answer
Answer: g = (1 0.25) (21%) = 15.75%

Demonstrate the use of the DuPont analysis of return on equity in conjunction with the sustainable growth rate expression.
N etIncom e E quity N etIncom e Sales T otalA sset s R E = O Sales T otalA sset s E quity N etIncom e D ividends N etIncom e Sales g= N etIncom e Sales T otalA sset R E = O

T otalA sset s E quity

This has also been called the PRAT model, where P = profit margin, R = retention rate, A = asset turnover, and T = financial leverage. Example: Halo Construction has been successful in a mature industry. Over the last three years, Halo has averaged a profit margin of 10%, a total asset turnover of 1.8, and a leverage ratio of 1.25. Assuming Halo continues to distribute 40% of its earnings as dividends, calculate its long-term SGR.

Answer
g = 0.10 (1 0.4) 1.8 1.25 = 0.135 = 13.5%

b. Present Value of Operating Free Cash Flows

OCFt Vj = t t =1 (1 + WACC j )
Where: Vj = value of firm j n = number of periods assumed to be infinite OCFt = the firms operating free cash flow in period t WACC = firm js weighted average cost of capital

t =n

b. Present Value of Operating Free Cash Flows

Similar to DDM, this model can be used to estimate an infinite period:

OCF1 Vj = WACC j g OCF

Where: OCF1=operating free cash flow in period 1 gOCF = long-term constant growth of operating free cash flow

b. Present Value of Operating Free Cash Flows

Assuming several different rates of growth for OCF, these estimates can be divided into stages as with the supernormal dividend growth model Estimate the rate of growth and the duration of growth for each period

Weighted Average Cost Of Capital WACC

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

WACC exercise
Suppose that B2B, Inc. has a capital structure of 34 percent equity, 14 percent preferred stock, and 52 percent debt. The before-tax cost of equity is 15.3 percent, the before-tax cost of preferred stock is 10.5 percent and the before-tax cost of debt is 8.6 percent. What is B2B's WACC if the firm faces an average tax rate of 30%?

WACC exercise answer:

WACC = Wd * Kd(1-t) + Wp * Kp + We * Ke = 0.52 * 8.6%(1 - 0.30) + 0.14 * 10.5% + 0.34 * 15.3% = 3.130% + 1.47% + 5.202% = 9.802%

c. Present Value of Free Cash Flows to Equity

Free cash flows to equity are derived after operating cash flows have been adjusted for debt payments (interest and principal) The discount rate used is the firms cost of equity (k) rather than WACC

c. Present Value of Free Cash Flows to Equity

FCFEt Vj = t t =1 (1 + k j )
Where: Vj = Value of the stock of firm j n = number of periods assumed to be infinite FCFEt = the firms free cash flow in period t K j = the cost of equity

2. Relative Valuation Techniques

Value can be determined by comparing to similar stocks based on relative ratios Relevant variables include earnings, cash flow, book value, and sales The most popular relative valuation technique is based on price to earnings

a. Earnings Multiplier Model (PER model)

This values the stock based on expected annual earnings The price earnings (P/E) ratio, or Earnings Multiplier equals: PER = P0/EPS1
(leading PER)

a. Earnings Multiplier Model (PER model)

The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio

D1 P0 = kg Dividing both sides by expected earnings during the next 12 months (EPS1)
P 0 ES P D1 / E S P = k g
1

1 b = k g

a. Earnings Multiplier Model (PER model)

Thus, the P/E ratio is determined by 1. Expected dividend payout ratio 2. Required rate of return on the stock (k) 3. Expected growth rate of dividends (g)

P0 D1 / EPS1 1 b = = EPS1 kg kg

a. Earnings Multiplier Model (PER model)

As an example, assume: Dividend payout = 50% Required return = 12% Expected growth = 8% P/E = ?

a. Earnings Multiplier Model (PER model)

.50 P/E = .12 - .08 = .50/.04 = 12.5

Example 2
Retention rate = 70% Required return = 12% Expected growth = 8% P/E = ?

Answer
.30 P/E = .12 - .08 = .30/.04 = 7.5

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the PER D/E = .50; k=.13; g=.08

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = .50/(.13-/.08) = .50/.05 = 10

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10 D/E = .50; k=.12; g=.09

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10 D/E = .50; k=.12; g=.09 P/E = .50/(.12-/.09) = .50/.03 = 16.7

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10 D/E = .50; k=.12; g=.09 P/E = 16.7

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10 D/E = .50; k=.12; g=.09 P/E = 16.7 D/E = .50; k=.11; g=.09

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10 D/E = .50; k=.12; g=.09 P/E = 16.7 D/E = .50; k=.11; g=.09 P/E = .50/(.11-/.09) = .50/.02 = 25

Pi D1 / E1 = E1 kg

a. Earnings Multiplier Model (PER model) A small change in either or both k or g will have a large impact on the multiplier D/E = .50; k=.13; g=.08 P/E = 10 D/E = .50; k=.12; g=.09 P/E = 16.7 D/E = .50; k=.11; g=.09 P/E = 25

Pi D1 / E1 = E1 kg

Example: Earnings Multiplier Model

Given current earnings (EPS0) of $2.00, 50% dividend payout ratio, 12% required return and a growth rate of 9%, what is the estimated current value of the stock?

Solution:
EPS1 = EPS0 (1 + g) = 2 x 1.09 = $2.18 P/E = 0.5/0.03 =16.7$ Then we have: P/2.18 = 16.7 P = 2.18 x 16.7 = 36.41$ Compare this estimated value to market price to decide if you should invest in it.

b. The Price-Cash Flow Ratio

Companies can manipulate earnings Cash-flow is less prone to manipulation Cash-flow is important for fundamental valuation and in credit analysis

Pt P / CFi = CFt +1
Where: P/CFj = the price/cash flow ratio for firm j Pt = the price of the stock in period t CFt+1 = expected cash low per share for firm j

c. The Price-Book Value Ratio

Pt P / BV j = BVt +1
Where: P/BVj = the price/book value for firm j Pt = the end of year stock price for firm j BVt+1 = the estimated end of year book value per share for firm j

d. The Price-Sales Ratio

Pt P = S S t +1
Pj Sj
Where:

= price to sales ratio for firm j

Pt = end of year stock price for firm j St +1 = annual sales per share for firm j during Year t

Taxes and International Investments

Calculate the impact of different national taxes on the return of an international investment
Example: Suppose a U.S. investor buys 100 shares of SAP Systems (SAP) listed in Germany on the XETRA, quoted at EUR 14.5 per share (including commissions) for a total trade cost of EUR1,450. The exchange rate is one EUR = USD 0.90. The U.S. currency cost is USD 1,305 for the entire trade, including commissions charged by the U.S. broker. Three months later a one-euro dividend is paid for each share owned. Dividends are subject to a 15% withholding tax in Germany, and 28% tax on short-term capital gains and dividends in the U.S. At this point, the investor decides to sell the 100 shares of SAP now worth EUR 16. The current exchange rate is now one EUR = USD 0.95. Calculate the impact of taxes on the total return.

Answer

Stock Dividends and Stock Splits

Stock Dividends and Stock Splits

Stock dividend: payment of additional shares of stock to common stockholders. Example: Citizens Bancorporation of Maryland announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another 5 shares. Does the shareholders wealth increase?

Stock Dividends and Stock Splits

Stock Split: the firm increases the number of shares outstanding and reduces the price of each share. Example: Joule, Inc. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive another 50 shares. Does this increase shareholder wealth? Are a stock dividend and a stock split the same?

Stock Dividends and Stock Splits

Stock Splits and Stock Dividends are economically the same: the number of shares outstanding increases and the price of each share drops. The value of the firm does not change. Example: A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.

Stock Dividends and Stock Splits

Effects on Shareholder Wealth:

Stock Dividends and Stock Splits

Effects on Shareholder Wealth: these will cut the company pie into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 halfsized pieces for each full-sized piece they previously owned.

Stock Dividends and Stock Splits

Effects on Shareholder Wealth: these will cut the company pie into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned. For example, this would double the number of shares, but would cause a $60 stock price to fall to $30.

Stock Dividends and Stock Splits

Why bother? Proponents argue that these are used to reduce high stock prices to a more popular trading range (generally $15 to $70 per share). Opponents argue that most stocks are purchased by institutional investors who have millions of dollars to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!

Stock Dividend Example

shares outstanding: 1,000,000 net income = $6,000,000; P/E = 10 25% stock dividend. An investor has 120 shares. Does the value of the investors shares change?

Before the 25% stock dividend: EPS = 6,000,000/1,000,000 = $6 P/E = P/6 = 10, so P = $60 per share. Value = $60 x 120 shares = $7,200 After the 25% stock dividend: # shares = 1,000,000 x 1.25 = 1,250,000. EPS = 6,000,000/1,250,000 = $4.80 P/E = P/4.80 = 10, so P = $48 per share. Investor now has 120 x 1.25 = 150 shares. Value = $48 x 150 = $7,200

Stock Dividends
In-class Problem

shares outstanding: 250,000 net income = $750,000; stock price = $84 50% stock dividend. What is the new stock price?

Hint:

P/E =

stock price net income # shares

Before the 50% stock dividend: EPS = 750,000 / 250,000 = $3 P/E = 84 / 3 = 28. After the 50% stock dividend: # shares = 250,000 x 1.50 = 375,000. EPS = 750,000 / 375,000 = $2 P/E = P / 2 = 28, so P = $56 per share. (a 50% stock dividend is equivalent to a 3-for-2 stock split)