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Stock Valuation

This document discusses stock valuation models and the dividend discount model. It outlines three cases of the dividend discount model: zero growth, constant growth, and variable growth. It provides examples of how to value stocks under each case and practice questions to help understand the concepts. The key stock valuation models discussed are absolute valuation models like the dividend discount model which value stocks based on the present value of expected future cash flows discounted at the appropriate required rate of return.

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Hassaan Nasir
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46 views

Stock Valuation

This document discusses stock valuation models and the dividend discount model. It outlines three cases of the dividend discount model: zero growth, constant growth, and variable growth. It provides examples of how to value stocks under each case and practice questions to help understand the concepts. The key stock valuation models discussed are absolute valuation models like the dividend discount model which value stocks based on the present value of expected future cash flows discounted at the appropriate required rate of return.

Uploaded by

Hassaan Nasir
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 16

Lecture 6:

Stock Valuation

By: Sana Tauseef


Outline
 Types and features of stocks
 Stock valuation models: Absolute and relative
 Simplifying assumptions in Dividend Discount
Model
• Zero growth
• Constant growth
• Variable growth
 Dividend and capital gains yields

2
Types and features of Stocks
Preferred Stocks Common Stocks
 No maturity date.  No maturity date.
 Fixed dividend rate and  No fixed dividend rate.
can be cumulative.  Represents ownership
 Represents liability  Common stock holders
 Preferred stock holders are the residual owners.
are paid before common
stock holders.

3
Stock Valuation Models
1. Relative Valuation Models
 Models that specify an asset’s value relative to that of another asset.
 Similar assets should have similar prices.
 Examples: PE, P/B, P/S, etc.

2. Absolute Valuation Models (fundamental


approach)
 Asset’s intrinsic value is the present value of its expected future
cash flows
 There are different definitions of cash flows from stocks
 Examples: dividends, free cash flow to firm, free cash flow to
equity, etc
4
Practice Question 1
ATTOCK D G KHAN
LUCKY CEMENT BESTWAY CEMENT
  CEMENT PAKISTAN CEMENT COMPANY
EARNINGS PER
SHARE 43.07 30.69 20.83 14.68
SALES PER SHARE 301.64 122.86 88.69 76.38
BOOK VALUE PER
SHARE 336.95 109.90 89.52 174.24
PRICE PER SHARE 434.67 113.2 114.58 98.15

1. Compute the relative value of DG Khan Cement based on the


multiples of given three peers.
2. What dispersion do you observe in DG Khan’s stock value based
on each multiple?

5
Absolute Valuation Models
To value stocks we need to:
• Estimate future cash flows: size (how much)
and timing (when)
• Discount future cash flows at an appropriate
rate

6
Dividend Discount Model
Cash flows from stocks are in form of dividend payments.

Required return is the minimum acceptable return


estimated on the stock, considering both its risk and the
returns available on other investments in market.

Intrinsic value is calculated as:


P0 = D1/(1 + r)1 + D2/(1 + r)2 + D3/(1 + r)3 + . . . forever

7
Simplifying Assumptions in Stock Valuation

But dividends are not necessarily constant over


years in future.

1. No (zero) growth in dividend


2. Constant growth in dividend
3. Non-constant growth in dividends

8
Case 1: Zero Growth in Dividends
(Valid for preferred stocks)

 Assume that dividends will remain at the same


level forever, i.e. D1 = D2 =…=Dt.

 Since future cash flows are constant, the value


of a zero growth stock is the present value of a
perpetuity:
P0 = D / r

9
Practice Question 2
a. Ayden Inc. has an issue of preferred stock
outstanding that pays a $6.5 dividend every year.
The required return is 9 percent and the stock is
selling in the market at $70, should the stock be
bought?

b. Ayden Inc. has an issue of preferred stock


outstanding that pays a $6.5 dividend every year. If
the stock is currently selling in the market at $70,
what is the expected return on the stock?
10
Case 2: Constant Growth in Dividends
(Valid for companies in mature phase)

 Assume that dividends will grow at a constant rate, g, forever, i.


e.,
D1 = D0 x (1+g)
D2 = D1 x (1+g), etc., etc.. and
Dt = D0 x (1+g)t

 Since future cash flows grow at a constant rate forever, the value
of a constant growth stock is the present value of a growing
perpetuity:
P0 = D1 / (r - g)

11
Practice Question 3
a. Great Pumpkin Farms just paid a dividend of $3.50 on its
stock. The growth rate in the stock’s dividend is expected to
remain constant at 5 percent per year. Investors require a
return of 12 percent on their investment. What is the current
fair price?

b. Great Pumpkin Farms just paid a dividend of $3.50 on its


stock. The growth rate in the stock’s dividend is expected to
remain constant at 5 percent per year. Investors require a
return of 14 percent for on their investment for the first 2
years and an 11 percent return thereafter. What is the current
fair price?

12
Case 3: Variable Growth in Dividends
(Applies for most of the companies)
 Assume that dividends will grow at different rates in the
foreseeable future and then will grow at a constant rate thereafter.

 To value a Differential Growth Stock, we need to:


• Divide the life of the stock into variable and constant growth
periods.
• Estimate future dividends in the variable growth period.
• Estimate the future stock price when the stock becomes a
Constant Growth Stock (case 2).
• Compute the total present value of the estimated future
dividends and future stock price at the appropriate discount rate.

13
Practice Question 4
Rizzi Co. is a new fast-growing venture. Dividends are
expected to grow at 25 percent for each of the next three
years, with the growth rate falling to a constant 7 percent
thereafter. If the investors require a return of 13 percent on
their investment, and the company just paid a dividend of
$4, what is the current fair price?

Compute the dividend yield and capital gains yield on stock


for the first and fourth year.

14
Practice Question 5
It is January 1, 2008. Swink Electric Inc. has just developed a solar panel capable of
generating 200% more electricity than any solar panel currently on the market. As a
result, Swink is expected to experience a 15% annual growth rate in the next five
years. When the five year period ends, other companies will have developed
comparable technology and Swink’s growth rate will slow to 5% per year indefinitely.
Stockholders require a return of 12% on Swink’s stock. The firm’s most recent
dividend, paid yesterday, was $1.75 per share.
a. Calculate the value of the stock today.
b. Calculate the expected dividend yield, the capital gains yield expected in 2008 and
the expected total return for 2008. Calculate the same three yields for 2012.
c. Suppose your boss believes that Swink’s annual growth rate will be only 12% during
the next five years and that the firm’s normal growth rate will be only 4%. Explain
the general effect that these growth-rate changes would have on Swink’s stock price.
d. Suppose your boss also regards Swink as being quite risky and believes that the
required rate of return should be 14%, not 12%. Explain how the higher required
rate of return would affect its stock price, its dividend yield and its capital gains
yield.
15
References
 Brigham, E. F. (2007). Financial Management.
 Ross, S. A., Westerfield, R. W., & Jordan, B.
D. (2012). Fundamentals of Corporate Finance.
India: McGraw Hill.

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