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    The Value of Common Stocks: Principles of Corporate Finance

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    principles of corporate finance chapter 4

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    The Value of Common Stocks: Principles of Corporate Finance

    Uploaded by

    chooisin
    68 views27 pages
    principles of corporate finance chapter 4

    Original Title

    Mmi 01 Bma 04 Share Valuation

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    principles of corporate finance chapter 4

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    68 views27 pages

    The Value of Common Stocks: Principles of Corporate Finance

    Uploaded by

    chooisin
    principles of corporate finance chapter 4

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 27

    Chapter 4

    THE VALUE OF COMMON


    STOCKS

    Brealey, Myers, and Allen


    Principles of Corporate Finance
    11th Global Edition
    McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
    4-2 HOW COMMON STOCKS ARE VALUED
    Book Value
    Net worth of firm according to balance sheet
    Dividend
    Periodic cash distribution from firm to the
    shareholders
    P/E Ratio
    Price per share divided by earnings per share
    Market Value Balance Sheet
    Financial statement that uses market value of
    assets and liabilities
    4-2
    4-2 HOW COMMON STOCKS ARE VALUED

    Discounted Cash Flow (DCF) Formula


    Value of a stock = present value of future cash
    flows, i.e. dividends

    PV(stock) PV(expecte d future dividends)

    4-3
    4-2 HOW COMMON STOCKS ARE VALUED

    Expected Return
    Percentage yield forecast from specific
    investment over time period
    Sometimes called market capitalization rate

    4-4
    4-2 HOW COMMON STOCKS ARE VALUED

    Example
    Fledgling Electronics sells for $100 per share
    today; they are expected to sell for $110 in one
    year. What is expected return if dividend in one
    year is forecasted to be $5.00?

    5 110 100
    Expected return .15
    100

    4-5
    4-2 HOW COMMON STOCKS ARE VALUED

    Price of share of stock is present value of


    future cash flows
    For a stock, future cash flows are dividends
    and ultimate sales price

    Div1 P1
    Price P0
    1 r

    4-6
    4-2 HOW COMMON STOCKS ARE VALUED

    Example
    Fledgling Electronics price

    5 110
    Price P0 100
    1.15

    4-7
    4-2 HOW COMMON STOCKS ARE VALUED

    Market Capitalization Rate


    Estimated using perpetuity formula
    Also called cost of equity capital

    Div 1
    Capitaliza tion rate P0
    rg
    Div 1
    r g
    P0
    4-8
    4-2 HOW COMMON STOCKS ARE VALUED

    Dividend Discount Model


    Computation of todays stock price: share value
    equals present value of all expected future
    dividends
    H: Time horizon for investment

    Div1 Div 2 Div H PH


    P0 ...
    (1 r ) (1 r )
    1 2
    (1 r ) H

    4-9
    4-2 HOW COMMON STOCKS ARE VALUED

    Example
    Fledgling Electronics forecasted to pay $5.00
    dividend at end of year 1 and $5.50 dividend at
    end of year 2. End-of-second-year stock will be
    sold for $121. Discount rate is 15%. What is the
    price of stock?

    5.00 5.50 121


    PV
    (1 .15)1
    (1 .15) 2

    PV $100.00
    4-10
    4-2 HOW COMMON STOCKS ARE VALUED

    Example
    XYZ Company will pay dividends of $3, $3.24,
    and $3.50 over next three years. After three
    years, stock sells for $94.48. What is the price
    of stock given 12% expected return?

    3.00 3.24 3.50 94.48


    PV
    (1 .12) (1 .12)
    1 2
    (1 .12) 3

    PV $75.00
    4-11
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Dividend Yield
    Expected return on stock investment plus
    expected dividend growth
    Similar to capitalization rate
    Div1
    Price P0
    rg
    Div1
    Dividend yield r g
    P0
    4-12
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Example
    Northwest Natural Gas shares sold for $47.30
    at start of 2012. Dividend payments for 2013
    were $1.86 a share with no growth. What is
    dividend yield?
    Dividend Yield r
    1.86
    r
    47.30
    r .039
    4-13
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Example
    Northwest Natural Gas shares sold for $47.30 at
    start of 2012. Dividend payments for 2013 were
    $1.86 a share with 4.6% growth. What is dividend
    yield?
    Dividend yield r
    1.86
    r .046
    47.30
    r .085

    4-14
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Return Measurements

    Div1
    Dividend yield
    P0

    Return on Equity ROE


    EPS
    ROE
    Book equity per share

    4-15
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Dividend Growth Rate


    Derived by applying return on equity to
    percentage of earnings reinvested in operations
    g = return on equity plowback ratio

    4-16
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Valuing Non-Constant Growth

    Div1 Div 2 Div H PH


    PV ...
    (1 r ) (1 r )
    1 2
    (1 r ) H
    (1 r ) H

    Div H 1
    PH
    rg

    4-17
    4-3 ESTIMATING COST OF EQUITY CAPITAL

    Example
    Phoenix pays dividends in three consecutive
    years of 0, .31, and .65. Year-4 dividend is
    estimated at .67 with perpetuity growth at 4%.
    With 10% discount rate, what is stock price?

    0 .31 .65 1 .67


    PV
    3

    (1 .1) (1 .1) (1 .1) (1 .1) (.10 .04)
    1 2 3

    9.13

    4-18
    4-4 STOCK PRICE AND EARNINGS PER SHARE

    If firm pays lower dividend and reinvests


    funds, stock price may increase due to
    higher future dividends
    Payout Ratio
    Fraction of earnings paid out as dividends
    Plowback Ratio
    Fraction of earnings retained by firm

    4-19
    4-4 STOCK PRICE AND EARNINGS PER SHARE

    Example
    Company plans $8.33 dividend next year (100%
    of earnings). Investors required return is 15%.
    Then the company decides to plow back 40% of
    earnings at firms current ROE of 25%. What is
    the stock value before and after plowback
    decision?

    4-20
    4-4 STOCK PRICE AND EARNINGS PER SHARE

    Example, continued
    No Growth

    8.33
    P0 $55.56
    .15
    With Growth

    g .25 .40 .10


    5.00
    P0 $100.00
    .15 .10

    4-21
    4-4 STOCK PRICE AND EARNINGS PER SHARE

    Example, continued
    Stock price remains at $55.56 with no earnings
    plowed back
    With plowback, price is $100.00
    Difference is called present value of growth
    opportunities (PVGO)

    PVGO 100.00 55.56 $44.44

    4-22
    4-4 STOCK PRICE AND EARNINGS PER SHARE

    Present Value of Growth Opportunities


    (PVGO) is the net present value of firms
    future investments
    Sustainable Growth Rate is the steady rate
    at which firm can grow: plowback ratio x
    return on equity

    4-23
    4-5 VALUING A BUSINESS

    Valuing a Business or Project


    Usually computed as discounted value of FCF
    to valuation horizon (H)
    Valuation horizon sometimes called terminal
    value and calculated like PVGO

    4-24
    4-5 VALUING A BUSINESS

    Valuing a Business or Project

    FCF1 FCF2 FCFH PVH


    PV ...
    (1 r ) (1 r )
    1 2
    (1 r ) H
    (1 r ) H

    PV (free cash flows) PV (horizon value)

    4-25
    4-5 VALUING A BUSINESS

    Example
    Given cash flows for Concatenator
    Manufacturing Division, calculate PV of near-
    term cash flows, PV (horizon value), and total
    value of firm; r = 10% and g = 6%

    4-26
    4-5 VALUING A BUSINESS

    Example, Continued
    .80 .96 1.15 1.39 .20 .23
    PV(FCF)
    1.1 1.12 1.13 1.14 1.15 1.16
    3.6

    1 1.59
    PV(horizon value) 6 22.4
    1.1 .10 .06
    PV(busines s) PV(FCF) PV(horizon value)
    -3.6 22.4
    $18.8
    4-27

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