• What i s the Int r ins ic va lue and how i t i s d ifferent f rom the market pr ice

• How to ca lcu la te the in t r ins ic va lue .

• What are the fundamenta ls o f secur i ty eva luat ion . (RRR, t ime, and s i ze o f CFs)

• The Discount Cash F low mode ls to eva luate common stock

Chapter 8Common Stock Valuation

The Essence of Valuation

One of the main objectives of valuation is to estimate the intrinsic value.

One of the main uses of the intrinsic value is to determine if we are paying the fair value for the security (Common stocks in this case) or its Overvalued (intrinsic value<market price) Undervalued (intrinsic value>market price) Fairly valued (intrinsic value=market price)

What is the Intrinsic Value? And what is the difference between it and the market price?

Intrinsic value: An estimation of the stock “true” value

Not observable hard to estimate subjective. The more info, the better the estimation of the stock true price More info, the better is our estimation.

Its basically the PV of the future cash flows that the asset will generate. These cash flows will be discounted at a required rate of return (rrr) that reflect the riskiness of cash flows to the investor.

Market Price: Is the value of the stock determined by a competitive marketplace.

It is observable, especially for publicly traded firms. but possible incorrect

In equilibrium it is expected that intrinsic value is equal to the market price.

Determining the Intrinsic value and its determinants

N

t rrrCf

rrrf

rrrf

rrrf

rrrf

1t

t

33

22

11

0

)(1

)(1C ...

)(1C

)(1C

)(1C P̂

There are 3 determinants of the value of a security:• The size of the furture CFs (+)• The time of these CF (-)• The discount rate: required rate of return (rrr)

(-)

• The decision made is:Overvalued (intrinsic value<market price)Undervalued (intrinsic value>market price)Fairly valued (intrinsic value=market price)

Determinants of the IV

Timing of the future CFs.

The required rate of return (rrr)?

In case of Bonds: Interest payment Loan Principal.

In Case of Stocks Future Dividends Expected Capital

gain/loss (when the stock is sold at the end of the holding period.

Expected Future CFs

Determining the rrr

rrr: is the minimum return you require to invest in that stock.

It can be determine using CAPM. (shows the relationship between risk and expected retuns)

E(r) = rf + b(Rm-rf)Thus, rrr should at least compensate you for:

The risk-free rate of interest (return from investing in a zero-risk asset) (delaying consumption)

Risk premium b (systematic risk) the relevant risk. It shows the riskiness of the stock

relative to the market portfolio. The higher more risky is the stock. (b>1), (b<1), and (b=0) stock is riskier, less risky, as risky as market. Calculated by regressing the stock return on the market return

(Rm-rf) Market risk premium (MRP). Shows how risk averse are the market participants. The more risk averse, the higher the premium. (see next slide)

Interpretation of Beta

If beta = 1.0, the security is just as risky as the market (stock is as volatile as the market) This implies that the market portfolio has by definition beta of 1

If beta > 1.0, the security is riskier than market (stock is more volatile than the market)

If beta < 1.0, the security is less risky than market (stock is less volatile than the market.

If beta is positive ( + )correlation between the stock and the market. (regression line would slope upward) (most likely to observe that)

If beta is negative ( - )correlation between stock and the market (regression line would slope downward) (2there is a small chance to observe such situation)

• Beta of zero: means the stock have zero correlation with the market. The movement of the stock is independent from the market movement market risk is ZERO

The Concept of Risk-Aversion

(+) Slope indicate risk averse investors Investor 2 is more risk averse than investor 1.

SML1

ri (%) SML2

Risk, bi

B1A2

B2

A1 SML4

Investor 4 is risk neutral (his return will not change regardless of the risk involved).

SML5

Investor 5 is risk lover (he is willing to accept lower return for more risk)

SML3

However investor 3 is extremely risk averse.

How to draw the SML in Excel and Make a Decision regarding the stock fair value

0.00 0.10 0.20 0.30 0.40 0.50 0.600.00%1.00%2.00%3.00%4.00%5.00%6.00%7.00%8.00%9.00%

Rf= 5.00%

RRR= 8.00%

The Security Market Line

Beta

Expe

cted

REt

urn

1 SML and determine fair value

Valuing Common StockAfter we determine the fundamentals of security valuation

(future CF, timing of CFs, and RRR), we know go to how can we use these fundamentals to evaluate common stock.

There are several model we can use to estimate the current value of a common stock:

First: Discount CFs Models (DCF)A. Dividend Discount Model (DDM)B. Operating FCF Model (OFCF)C. Free-cash-flow Model to Equity (FCFE)

Second: Relative Valuation Models: Valuing stock relative to other, similar stocks or industry, using valuation ratios such as:

D. P/E1 ratio.E. P/CF1F. P/BV1G. P/Sales1

First: The Discount CF ModelsA. Dividend Discount Model (DDM)

Why use Dividends to determine the stock intrinsic value?

Because dividend is a proxy for the firm’s earnings (net income). Dividends are paid out of earnings. If net income grows, then dividends grow if the firm maintain the

same payout ratio

Expect that dividends to continue in the foreseeable future: Firms that initiate dividends reveal a good sign to investor, if they do

not have any growth opportunities. So a firm that initiate dividend are going to be less likely to

discontinue these dividends because investors will view such action negatively. (dividends are expected to continue in the foreseeable future)

Dividend Discount Model (DDM)

The expected price for a stock that pays dividends at end of year 3 will also depend on future expected dividends. Thus, a general form can be:

)(1 ...

)(1

)(1

)(1 P̂ 3

32

21

10

ssss rD

rD

rD

rD

A stock that pays a dividends. If you are expecting to sell that stock some time in the future (Ex. After 3 years), then the estimate current price should be:𝑷 𝟎=

𝑫𝟏

(𝟏+𝒓 𝒔 )𝟏+

𝑫𝟐

(𝟏+𝒓 𝒔 )𝟐+

𝑫𝟑+𝑷𝟑

(𝟏+𝒓 𝒔 )𝟑

The Constant-Growth DDM This model says that dividend will grow at a constant rate each

year. Thus, knowing the most recent dividend (Do) is equivalent to knowing all future dividends.

The reason for assuming such assumption is that

1. Usually new firms will have low or negative earnings for several years due to high investments in fixed and working capital.

2. However, earnings after that will start to increase rapidly (growth opportunities). Firm could earn return on investments higher than their rrr by retaining more earning are reinvesting it in the firm. Thus, have high growth periods.

3. Then when the firms matures and its earnings stabilized its earnings will grow at a constant rate. If the firm maintain a constant payout ratio, then the constant growth in earning will cause a constant growth in dividends.

The Constant-Growth DDM

Note that for this model to work, it must be rs>g.

Also, g must be constant.

grD

grgD

rgD

rgD

rgD

rgD

rD

rD

rD

rD

ss

ssss

ssss

100

03

30

2

20

1

10

0

33

22

11

0

)1(P̂

)(1)1( ...

)(1)1(

)(1)1(

)(1)1( P̂

)(1 ...

)(1

)(1

)(1 P̂

The Constant-Growth DDM

Rearranging the model we can obtaingr

DgrgD

ss

100

)1(P̂

gDrs 0

1

P̂The required rate of return should be equal to the stock total

return (Dividend yield + capital gain/loss)

This implies that, under the constant-growth DDM, the stock price as well as the dividends will grow at the constant rate g.

If the stock offers a total return>rrr stock is undervaluedIf the stock offers a total return<rrr stock is overvalued

Example 1 (sheet 2)….What is the maximum price you should pay for a stock that has currently paid $2 dividends and such dividend is expected to grow at a constant rate of 6% forever. The rf rate is 7% and the expected market return is 12%, the stock’s beta is 1.2

The required rate of return on the firm’s stock is

rs = rRF + (rM – rRF)b 7% + (12% – 7%)1.2 = 13%

$30.29 0.07

$2.12 0.060.13

$2.12 g r

D P̂s

10

If the current market price of the stock is below (above) this value, then the stock is undervalued (overvalued)

13% 6%$30.29$2.12 g

P̂D E(r)

0

1

If stock offers us a return below (above) the rs, then the stock is overvalued (undervalued)

Also, this means that the stock price next year will growth by 6%. Thus, 30.29(1.06) = 32.11

2 Example 1&2&3&4

Example 2 (Sheet 2)

What is the expected price after 3 years for a stock that has currently paid $2 dividends and such dividend is expected to grow at a constant rate of 6% forever. The required rate of return is 13%

𝑷 𝟑=𝑫𝟒

𝒓 𝒔−𝒈=𝑫𝟎(𝟏+𝟔% )𝟒

𝒓 𝒔−𝒈 =𝟐 (𝟏+𝟔%)𝟒

𝟏𝟑%−𝟔%=𝟐 .𝟓𝟐

𝟕%=𝟑𝟔 .𝟎𝟕𝐨𝐫

𝑷 𝟎=𝑫𝟏

(𝟏+𝒓 𝒔 )𝟏+

𝑫𝟐

(𝟏+𝒓 𝒔 )𝟐+

𝑫𝟑+𝑷𝟑

(𝟏+𝒓 𝒔 )𝟑

𝑷 𝟎=𝟐 .𝟏𝟐

(𝟏+𝟏𝟑% )𝟏+ 𝟐 .𝟐𝟓

(𝟏+𝟏𝟑 %)𝟐+𝟐 .𝟑𝟖+𝟑𝟔 .𝟎𝟕

(𝟏+𝟏𝟑 %)𝟑=𝟑𝟎 .𝟐𝟗

Now, by knowing the estimated price after 3 year, we can do the following:

𝑷 𝟑=𝟑𝟎 .𝟐𝟗(𝟏+𝟔%)𝟑=𝟑𝟔 .𝟎𝟕

2 Example 1&2&3&4

Example 3 (g=0) (sheet 2)

What is the maximum price you should pay for a stock that has currently paid $2 dividends and such dividend is expected to continue forever. The rf rate is 7% and the expected market return is 12%, the stock’s beta is 1.2

The required rate of return on the firm’s stock is

rs = rRF + (rM – rRF)b= 7% + (12% – 7%)1.2= 13%

38.150.13

0%)$2(1 g r

D P̂s

10

This mean the stock price is not growing and the total return from the stock is from the dividend yield. 2/15.38=13%

2 Example 1&2&3&4

Example 4 (sheet 2)

If the stock was expected to have negative growth (g = -6%s forever), would anyone buy the stock, and what is its value?

Yes. Even though the dividends are declining, the stock is still producing cash flows and therefore has positive value.

$9.89 0.19

$1.88 (-0.06) 0.13(0.94) $2.00

g r)g (1D

g r

D P̂s

0

s

10

2 Example 1&2&3&4

Cont’d Example 4

Find Expected Annual Dividend and Capital Gains Yields?

Capital gains yield = g = -6.00%

Dividend yield= 13.00% – (-6.00%) = 19.00% = 1.88/9.89

Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant.

Dividend yield is sufficiently large (19%) to offset negative capital gains.

Two-Stage Growth DDM

As mentioned before, Usually new firms will have low or negative earnings for

several years due to high investments in fixed and working capital.

After that the firm could experience high growth periods by retaining more earnings if they can earn higher return on investments than its rrr.

Finally, that high growth rate cannot be sustained for ever due to competition and other factors. Thus, earning growth will decline and expect to growth at a lower long-run constant rate.

Thus, the firm could initiate dividends, but that dividend may grow at a fast rate. However, that growth rate is unlikely to continue forever. Thus, the growth rate will start to decline until dividend start to grow at a constant rate.

Examples 5/6 (sheet 3)

Example 5:What is the expected current price for a stock that has currently paid $2 dividends. Dividends will grow at a high rate of 30% for 3 years before achieving the long-run growth rate of 6%. The required rate of return is 13%

Example 6:What is the expected current price for a stock that has currently paid $2 dividends. Dividends will NOT grow (g=0%) for 3 years before achieving the long-run growth rate of 6%. The required rate of return is 13%

Example 5 (sheet 3)

HV refers to horizontal value

rs = 13%

g = 30% g = 30% g = 30% g = 6%

2.3012.6473.045

46.11454.107 =

0 1 2 3 4

4.658

P̂0

$66.54(HV) 06.0 0.13

4.658 P̂3

22.6 3.38 4.39

Example 6 (sheet 3)

HV is the horizontal value

rs = 13%

g = 0% g = 0% g = 0% g = 6%

1.771.571.39

20.9925.72 =

0 1 2 3 4

D0 = 2.00 2.00 2.00 2.00

2.12

P̂0

(HV) $30.29 06.0 0.13

2.12 P̂3

3 Example 5&6

A note on the non-constant growth DDM

If the growth rate of dividend is not constant, then stock will grow at rate that is different from that of dividends Capital gain is NOT going to be equal to g

𝒓 𝒔=𝑫𝟏

𝑷𝟎+𝒈

Example 7 (sheet 4)

From Example 5, we were able to determine = 54.11.

Since dividend will not grow at a constant rate, then CG ≠ g.

Let us examine the stock price for the next 4 years and examine its growth rate.

Cont’d Example 7 (sheet 4)

For the first year ……. DY = D1/P0 = 2.60/54.11

For the Second year……DY = D2/P1 = 3.38/58.54

For the third year……. DY = D3/P2 = 4.39/62.77

For the fourth year…….. DY = D4/P3 = 4.66/66.54

rs - DY = CG Thus, stock P end 1Y [E(P1)]13% - 4.81% = 8.19% 54.11 * (1+8.19%) = 58.54

rs - DY = CG Thus, stock P end 2Y [E(P2)]13% - 5.77% = 7.23% 58.54 * (1+7.23%) = 62.77

rs - DY = CG Thus, stock P end 3Y [E(P3)]13% - 7.00% = 6.00% 62.77 * (1+6.00%) = 66.54

rs - DY = CG Thus, stock P end 4Y [E(P4)]13% - 7.00% = 6.00% 66.54 * (1+6.00%) = 70.53

4 Example 7

First: Discount CF (DCF) ModelsB. Operating FCF Model

Non-operating assets such as marketable securities

SHO

Then

AssetsOperatingNongWACC

OFCFgWACCgOFCF

AssetsOperatingNonWACC

gOFCFWACC

gOFCFWACC

gOFCF

AssetsOperatingNonWACCOFCF

WACCOFCF

WACCOFCF

CS0

CSPSDF

10F

02

20

1

10

F

22

11

F

VP

VVVV,

,__)1(V

__)(1)1( ...

)(1)1(

)(1)1( V

__)(1

... )(1

)(1

V

Operating FCF Model

OFCF: is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.

It’s the operating cash flow after taxes less the reinvestments in fixed assets (capital expenditure) and operating working capital (which is essential to maintain ongoing operation and positive growth) Thus, OFCF shows the cash available to all investors (capital providers:

debt-holders, preferred stock holders, and common stock holders).

Thus, the higher that FCF, the more valuable become the firms (intrinsic stock value will increase).

30

Earning before interest and taxes

(1 − Tax rate)

Net operating profit after taxes

X

Operating current assets

Operating current liabilities

Net operating working capital

−

Total net operating capital

Net Operating long-term assets

+

Net operating working capital

Free cash flow

−Net investment in operating capital

Net operating profit after taxes

−

Total net operating capital this yearTotal net operating capital last yearNet investment in operating capital

Calculating Free Cash Flow in 5 Easy StepsStep 1 Step 2

Step 3

Step 4Step 5

Calculating OFCF (Gross of Dep.)

𝑶𝑭𝑪𝑭=𝑵𝑶𝑷𝑨𝑻 +𝑫𝒆𝒑 .∧𝑨𝒎𝒐𝒓𝒕 .−∆𝑻𝒐𝒕𝒂𝒍 𝑮𝒓𝒐𝒔𝒔 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊𝒏𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝑻𝒐𝒕𝒂𝒍 𝑮𝒓𝒐𝒔𝒔 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊𝒏𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍=𝑵𝑶𝑾𝑪+𝑮𝒓𝒐𝒔𝒔𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒍𝒐𝒏𝒈𝑻𝒆𝒓𝒎 𝑨𝒔𝒔𝒆𝒕𝒔𝑵𝑶𝑾𝑪=𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔−𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔=𝑪𝒂𝒔𝒉+𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 +𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔= 𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑷𝒂𝒚𝒂𝒃𝒍𝒆+ 𝑨𝒄𝒄𝒓𝒖𝒂𝒍𝒔+𝑰𝒏𝒄𝒐𝒎𝒆𝑻𝒂𝒙 𝑷𝒂𝒚𝒂𝒃𝒍𝒆

𝑵𝑶𝑷𝑨𝑻=𝑬𝑩𝑰𝑻 (𝟏−𝑻 )

Alternative Method (Net of depreciation)

𝑶𝑭𝑪𝑭=𝑵𝑶𝑷𝑨𝑻 −∆𝑻𝒐𝒕𝒂𝒍 𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊𝒏𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍

𝑻𝒐𝒕𝒂𝒍 𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊𝒏𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍=𝑵𝑶𝑾𝑪+𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈𝒍𝒐𝒏𝒈𝑻𝒆𝒓𝒎 𝑨𝒔𝒔𝒆𝒕𝒔𝑵𝑶𝑾𝑪=𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔−𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔=𝑪𝒂𝒔𝒉+𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 +𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔= 𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑷𝒂𝒚𝒂𝒃𝒍𝒆+ 𝑨𝒄𝒄𝒓𝒖𝒂𝒍𝒔+𝑰𝒏𝒄𝒐𝒎𝒆𝑻𝒂𝒙 𝑷𝒂𝒚𝒂𝒃𝒍𝒆

𝑵𝑶𝑷𝑨𝑻=𝑬𝑩𝑰𝑻 (𝟏−𝑻 )

Alternative Method to Calculating OFCF

CAPEX is the additional investment in long-term operating assets. These investments are essential for growth and ongoing operations. These investment goes from renovating a roof of a building all the way to buying buildings, equipment, machinery

𝑶𝑭𝑪𝑭=𝑵𝑶𝑷𝑨𝑻 +𝑫𝒆𝒑 .∧𝑨𝒎𝒐𝒓𝒕 .−∆𝑵𝑶𝑾𝑪−𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 (𝑪𝑨𝑷𝑬𝑿 )

𝑶𝑭𝑪𝑭=𝑵𝑶𝑷𝑨𝑻 −∆𝑵𝑶𝑾𝑪−𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 ( 𝑪𝑨𝑷𝑬𝑿 )−𝑫𝒆𝒑 .∧𝑨𝒎𝒐𝒓𝒕 .𝑪𝑨𝑷𝑬𝑿=∆𝑻𝒐𝒕𝒂𝒍 𝑮𝒓𝒐𝒔𝒔 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒐𝒏𝒈𝑻𝒆𝒓𝒎 𝑨𝒔𝒔𝒆𝒕𝒔

Interpretation of OFCF

+ FCF: shows that the firms generates more than enough cash from its operations to finance its current investments in fixed assets and working capital.

- FCF: the firm have insufficient internal funds to finance its investments in fixed assets ands working capital. Need to raise additional funds to pay for these investments.

Is negative free cash flow always a bad sign? NO if the firm is growing.

For such firms, the needed investments in fixed assets and working capital always exceed the cash flows from existing operation. This is not bad as long as these investments are profitable in the future and generate future CFs.

OFCF

Usually there are 3 ways firms are financed: Common stock (rs) Debt (rd) Preferred stock (rsp) : hybrid between common stock and equity, where it

guarantees the amount of dividends, but the firm can omit such dividends without exposing the firm to bankruptcy.

Thus, when discounting OFCF to obtain the value of the firm, we must used the weighted average of the minimum acceptable return each investor requires. It is called the weighted average cost of capital (WACC).

To the firm, WACC is the cost of obtained capital

We do not use required rate of return rs

Example 8 (sheet 5)

If WACC = 10%, calculate the firm’s intrinsic value (expected value of the stock) if OFCFs for Y1= -5, Y2=10, Y3=20 then OFCFs will keep on growing a the long-run rate of 6%. Also, the firm has 40 million in total debt and preferred stock and has 10 million shares common stock outstanding.

Note, that for the first 3 years OFCF grows at a non-constant rate Thus, cannot use the constant growth model.

After the 3Y, OFCF will grow at the long-run growth rate of 6% can use the constant growth model.

Thus, we must use a 2 stage method.

Cont’d Example 8 (sheet 5)

3HV 06.0 0.1021.20 530

WACC

= 10% g =

6%

-4.5458.264

15.026398.197416.942

0 1 2 3 4

-5 21.2010 20

�̂�0=𝑉 𝐶𝑆

𝑆𝐻𝑂=376 .94 𝑀  10 𝑀 =$37 .69

+ + = 40M +

5 Example 8

Preferred Stock Evaluation

Hybrid security.

Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. Thus, g=0

However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s

expected return?

10% 0.10$50$5 r̂

r$5$50

rD V

p

p

pp

Debt, Preferred stock, and Common Stock.

From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds.

However, from a corporate issuer's standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky. The cheapest form of capital is RE.

Important Note on the DCF models (whether using the Dividend or OFCF)

An important factor in the evaluation process is determining the level of growth (g)-how fast the firm should grow. The value of the firm depends on future growth in earnings, cash

flows, and dividends.

Growth depends on two main issues: The amount that the firm retains and reinvests in the firm. This is

measured by the retention ratio (RR) RR= (1-payout ratio) = Net income –(Dividends/Net income)

Payout ratio = Dividend/ Net income The rate of return earned on the reinvested funds.

Can be measured by ROE and ROIC.

Growth Analysis

g here is called the sustainable growth because it

represent the maximum level of growth in sales that can be achieved without any external financing (raising debt or equity).

Note the firm cannot achieve the sustainable growth rate unless there are growth opportunities. Thus, it not uncommon to see firms growth at a rate lower than g.

Second: Relative Valuation Models:

Second: Relative Valuation Models: Valuing stock relative to other, similar stocks or industry, using valuation ratios such as:

A. P/E1 ratio. , A. Higher PE ratio should be justified by lower risk

(decrease in rs, increase in growth (increase in g), or both.

B. P/CF1C. P/BV1D. P/Sales1

Practical Examples

How to Calculate OFCF and sustainable growth Look Sheet 6 (Example 9)

The full evaluation process: See the Walgreen Evaluation Excel file Calculating stock and market return. Estimating the required rate of return of common stocks Estimating the sustainable growth Performing the Dividend discount model (DDM) Performing the OFCF Model

This is part of what is expected from your term projects