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    NOTES On Finma Mod 3 Stocks and Their Valuation

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    Leyanna Pauleen Villanueva
    1) Common stock represents ownership in a company and entitles stockholders to elect directors who appoint management to maximize stock price. 2) There are several approaches to estimate a stock's intrinsic value such as discounted dividend, corporate valuation, multiples, and EVA models. 3) The constant growth discounted dividend model values a stock based on the present value of expected future dividends growing at a constant rate, but the model only works if the growth rate is below the required rate of return.

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    NOTES On Finma Mod 3 Stocks and Their Valuation

    Uploaded by

    Leyanna Pauleen Villanueva
    51 views4 pages
    1) Common stock represents ownership in a company and entitles stockholders to elect directors who appoint management to maximize stock price. 2) There are several approaches to estimate a stock's intrinsic value such as discounted dividend, corporate valuation, multiples, and EVA models. 3) The constant growth discounted dividend model values a stock based on the present value of expected future dividends growing at a constant rate, but the model only works if the growth rate is below the required rate of return.

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    NOTES on Finma Mod 3 Stocks and Their Valuation

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    1) Common stock represents ownership in a company and entitles stockholders to elect directors who appoint management to maximize stock price. 2) There are several approaches to estimate a stock's intrinsic value such as discounted dividend, corporate valuation, multiples, and EVA models. 3) The constant growth discounted dividend model values a stock based on the present value of expected future dividends growing at a constant rate, but the model only works if the growth rate is below the required rate of return.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    51 views4 pages

    NOTES On Finma Mod 3 Stocks and Their Valuation

    Uploaded by

    Leyanna Pauleen Villanueva
    1) Common stock represents ownership in a company and entitles stockholders to elect directors who appoint management to maximize stock price. 2) There are several approaches to estimate a stock's intrinsic value such as discounted dividend, corporate valuation, multiples, and EVA models. 3) The constant growth discounted dividend model values a stock based on the present value of expected future dividends growing at a constant rate, but the model only works if the growth rate is below the required rate of return.

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    of 4

    STOCKS AND THEIR VALUATION

    Facts About Common Stock


    • Represents ownership
    • Ownership implies control
    • Stockholders elect directors
    • Directors elect management
    • Management’s goal: Maximize the stock price

    Intrinsic Value and Stock Price


    • Estimating a stock’s intrinsic value (P0) will help determine which stocks are attractive to buy and/or sell
    • In equilibrium we assume that a stock’s price equals its intrinsic value.
    • Stocks with a price below (above) its intrinsic value are undervalued (overvalued

    Determinants of Intrinsic Value and Stock Prices

    Different Approaches for Estimating the Intrinsic Value of a Common Stock


    • Discounted dividend model
    • Corporate valuation model
    • P/E (Price/Earnings) multiple approach
    • EVA (Economic Value Added) approach

    A. Constant Growth Stock (Discounted Dividend Model)


    - Value of a stock is the present value of the future dividends expected to be generated by the stock.

    - If a stock whose dividends are expected to grow forever at a constant rate (g), the discounted dividend
    formula converges to:

     Future Dividends and Their Present Values


    ~ As time progresses, in a constant growth stock:
     the value of the dividends given increases
     but the present value of such dividends
    also decreases due to time value effect
     What happens if g > rs?
    ~ The constant growth formula leads to a
    negative stock price, which does not make sense.
    ~ The constant growth model can only be used if:
     rs > g
     g is expected to be constant forever
     Example
     Use the SML to Calculate the Required Rate of Return (rs)

    If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firm’s stock?
    rs = rRF + (rM – rRF)b = 13%

     Find the Expected Dividend Stream for the Next 3 Years and Their PVs
    D0 = $2 and g is a constant 6%.

     What is the stock’s intrinsic value?

     What is the stock’s expected value, one year from now?

    OR

     Find Expected Dividend Yield, Capital Gains Yield, and Total Return During First Year
    • Dividend yield = D1/P0 = $2.12/$30.29 = 7.0%
    • Capital gains yield = (P1 – P0)/P0 = ($32.10 – $30.29)/$30.29 = 6.0%
    • Total return (rs) = Dividend yield + Capital gains yield = 7.0% + 6.0% = 13.0%
     What would the expected price today be, if g = 0?

     Non-constant growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
    • Can no longer use just the constant growth model to find stock value.
    • However, the growth does become constant after 3 years.
    • Find Expected Dividend and Capital Gains Yields During the First and Fourth Years
    • Dividend yield (first year) = $2.6/$54.11 = 4.81%
    • Capital gains yield (first year) = 13.00% – 4.81% = 8.19%
    • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield =
    6%.
    …During non-constant growth, dividend yield and capital gains yield are not constant, and capital
    gains yield ≠ g…
     If the stock was expected to have negative growth (g = -6%), 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.

    • Find Expected Annual Dividend and Capital Gains Yields


    • Capital gains yield = g = -6.00% OR 13% - 19% = -6%
    • Dividend yield = 13.00% – (-6.00%) = 19.00% OR $1.88/$9.89 = 19%
    …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…

    B. Corporation Valuation Model (free cash flow method)


    - Suggests the value of the entire firm equals the present value of the firm’s free cash flows.
    - Free cash flow is the firm’s after-tax operating income less the net capital investment.

     Applying the Corporate Valuation Model


    • Find the market value (MV) of the firm by finding the PV of the firm’s future FCFs.
    • Subtract MV of firm’s debt and preferred stock to get MV of common stock.
    • Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).
     Issues Regarding the Corporate Valuation Model
    • Often preferred to the discounted dividend model, especially when considering number of firms that
    don’t pay dividends or when dividends are hard to forecast
    • Similar to discounted dividend model, assumes at some point FCF will grow at a constant rate
    • Horizon value (HVN) represents value of firm at the point that growth becomes constant
     Use the Corporate Valuation Model to find the Firm’s Intrinsic Value

     What is the firm’s intrinsic value per share?


    The firm has $40 million total in debt and preferred stock
    and has 10 million shares of common stock.
    C. Firm Multiples Method
    - Analysts often use the following multiples to value stocks.
     P/E
     P/CF
     P/Sales
    - EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected
    earnings to back out an estimate of the stock price.

    D. EVA Approach
    EVA = Equity capital (ROE – Cost of equity)
    MVEquity = BVEquity + PV of all future EVAs
    Value per share = MVEquity / # of shares

    Preferred Stock
    • Hybrid security.
    • Receive a fixed dividend that must be paid before dividends are paid to common stockholders.
    • However, companies can omit preferred dividend payments without fear of bankruptcy.
    • If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return?

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