SMU Classification: Restricted
Valuation of Stocks and
Corporations
Features of common stock
Valuing common stock
Valuation of companies
Preferred stock
SMU Classification: Restricted
Stock Valuation
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SMU Classification: Restricted
Corporate Valuation and Stock Valuation
Firm’s debt/equity mix
Weighted average
Free cash flow
cost of capital
(FCF)
(WACC) Cost of debt
Cost of equity: The required
Dividends (D)
return on stock
SMU Classification: Restricted
Determinants of Intrinsic Value and Stock
Prices
Managerial Actions, the Economic Environment,
Taxes, and the Political Climate
“True” Investor “True” “Perceived” Investor “Perceived”
Cash Flows Risk Cash Flows Risk
Stock’s Stock’s
Intrinsic Value Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
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SMU Classification: Restricted
Intrinsic Value and Stock Price
Outside investors, corporate insiders, and
analysts use a variety of approaches to estimate
a stock’s intrinsic value (P0).
In equilibrium we assume that a stock’s price
equals its intrinsic value.
Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell.
Stocks with a price below (above) its intrinsic
value are undervalued (overvalued).
SMU Classification: Restricted
Different Approaches for Estimating
Intrinsic Value of a Common Stock
1. Discounted dividend model (DDM)
2. Corporate valuation model (also known as
DCF or FCFF models)
3. Pricing multiples of comparable firms
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SMU Classification: Restricted
Discounted Dividend Model
Also known as the Discounted Cash Flow or Dividend
Growth valuation models.
Value of a stock is the present value of the future
dividends expected to be generated by the stock.
^ D1 D2 D3 D
P0 ...
(1 rs )1
(1 rs ) 2
(1 rs ) 3
(1 rs )
SMU Classification: Restricted
Constant Growth Stock
A stock whose dividends are expected to grow forever
at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
If g is constant, the dividend growth formula converges
to:
^ D0 (1 g) D
P0 1
rs - g rs - g
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SMU Classification: Restricted
What happens if g > rs?
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
SMU Classification: Restricted
Use the CAPM to Calculate the Required
Rate of Return (rs)
If rF = 7%, rM = 12%, and β = 1.2, what is the
required rate of return on the firm’s stock?
rs = rF + (rM – rF)β
= 7% + (12% – 7%)1.2
= 13%
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SMU Classification: Restricted
Intrinsic Value of Stock
If D0 = $2 and g is a constant 6%, find the intrinsic value of
the stock if the required rate of return is 13%.
Using the constant growth model:
D1 $2.12
P̂0
rs - g 0.13 - 0.06
$2.12
$30.29
0.07
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SMU Classification: Restricted
What is the stock’s expected value, one
year from now?
• D1 will have been paid out already. So,
expected P1 is the present value (as of Year 1) of
D2, D3, D4, etc.
D2 $2.247
P̂1
rs g 0.13 0.06
$32.10
• Could also find expected P1 as:
P̂1 P0 (1.06) $32.10
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SMU Classification: Restricted
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%
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SMU Classification: Restricted
What would be the expected price today if g = 0?
The dividend stream would be a perpetuity.
0 1 2 3
rs = 13%
...
2.00 2.00 2.00
^ P M T $ 2.00
P0 $ 15.38
r 0.13
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SMU Classification: Restricted
Past-year Exam Question:
Constant Growth Model
Which of the following statements is most correct?
A. The constant growth model takes into consideration the
capital gains earned on a stock.
B. It is appropriate to use the constant growth model to
estimate stock value even if the growth rate never
becomes constant.
C. Two firms with the same dividend and growth rate must
also have the same stock price.
D. Statements A and C are correct.
E. All of the statements above are correct.
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SMU Classification: Restricted
Past-year Exam Question:
Constant Growth Model
The North Shore Company is expected to pay a dividend of
$3.00 at the end of the year (that is, D1 = $3.00). The dividend is
expected to grow at a constant rate of 6 percent a year. The
stock currently trades at a price of $50 a share. Assume that the
stock is in equilibrium, that is, the stock’s price equals its intrinsic
value. Which of the following statements is most correct?
A. The required return on the stock is 12 percent.
B. The stock’s expected price 10 years from now is $89.54.
C. The stock’s dividend yield is 6 percent.
D. Statements A and C are correct.
E. All of the statements above are correct.
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SMU Classification: Restricted
Non-constant Growth
What if g = 30% for 3 years before achieving
long-run growth of 6%?
Can no longer use just the constant growth model to
find stock value.
However, the growth does become constant after 3
years.
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SMU Classification: Restricted
Valuing Common Stock with Supernormal
Growth (Non-Constant)
0 r = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P$ 3 $66.54
54.107 = P0
^ 0.13 0.06
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SMU Classification: Restricted
Example of FCF Valuation Model (Cont’d)
D1 D2 D3 + P3
P0 = + +
(1 + rs)1 (1 + r )2s (1 + rs)3
2.60 3.38 4.394 66.54
P0
1 0.13 1 0.13
1 2
1 0.13 3
$54.107
where
D4 4.394(1 0.06) 4.658
P3 66.54
rs - g 0.13 - 0.06 0.07
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SMU Classification: Restricted
Stock Valuation Exercise
Microtech Corp is expanding rapidly, and it currently
needs to retain all of its earnings, hence it does not pay
any dividends. However, investors expect Microtech to
begin paying dividends, with the first dividend of $1.00
coming 3 years from today. The dividend should grow
rapidly – at a rate of 50% per year – during Years 4 and
5. After Year 5, the company should grow at a constant
rate of 8% per year. If the required return on the stock is
15%, what is the value of the stock today?
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SMU Classification: Restricted
Free Cash Flow (FCF) Valuation Model
Recall that Free Cash Flow (FCF) is:
The cash flow available for distribution to all of a
company’s investors.
Generated by a company’s operations.
FCF is the firm’s after-tax operating income less the
net capital investment.
FCF = NOPAT - Net investment in operating capital
Capital
FCF EBIT(1 T) Depreciation Δ NOWC
expenditures
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SMU Classification: Restricted
Total Corporate Value: Sources and
Claims
Equity
Value of Operations
=
ST Pref.
Debt Stk.
Inv
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SMU Classification: Restricted
Value of Firm’s Operations (Vop)
The PV of expected future FCF, discounted at
the WACC, is the value of a company’s
operations (Vop):
The WACC is the overall rate of return
required by all of the company’s investors.
∞
Σ
FCFt
Vop =
t=1 (1 + WACC)t
FCF1 FCF2 FCF3 + HV3
Vop = + + (1 + WACC)3
(1 + WACC)1 (1 + WACC)2
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SMU Classification: Restricted
Claims on Corporate Value
Debtholders have first claim.
Preferred stockholders have the next claim.
Any remaining value belongs to stockholders.
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SMU Classification: Restricted
Applying the Corporate Valuation Model
Find the market value (MV) of the firm by finding
the PV of the firm’s future FCFs.
Add to this any marketable securities (ST
investments, if any) (found within current assets)
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).
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SMU Classification: Restricted
Example 1: Corporate Valuation with Constant
Growth in FCFs
FCF0 = $24 million
WACC = 11%
FCF is expected to grow at a constant rate of
g = 5%
ST investments= $100 million
Debt = $200 million
Preferred stock = $50 million
Number of shares = n = 10 million
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SMU Classification: Restricted
Constant Growth Formula for Value of
Operations
If FCFs are expected to grow at a constant rate
of g:
FCF1
Vop =
(WACC - g)
FCF0(1+g)
=
(WACC - g)
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SMU Classification: Restricted
Find Value of Operations
FCF0 (1 + g)
Vop =
(WACC - g)
24(1+0.05)
Vop = = 420
(0.11 – 0.05)
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14
SMU Classification: Restricted
Estimated Intrinsic Stock Price per
Share,
Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00
−Debt 200.00
− Preferred Stk. 50.00
VEquity $270.00
÷n 10
0
P $27.00
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SMU Classification: Restricted
Example 2: Corporate Valuation with Non-
Constant Growth in FCFs
Given the firm’s free cash flows and that the long-run g =
6%, and WACC of 10%, use the corporate valuation model
to find the firm’s intrinsic value, where FCF1 = -$5 mil,
FCF2 = $10 mil and FCF3 = $20 mil.
0 r = 10% 1 2 3 4
...
g = 6%
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 HV3 = = 530
0.10 - 0.06
416.942
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SMU Classification: Restricted
Example of FCF Valuation Model (Cont’d)
FCF1 FCF2 FCF3 + V3
Vop = + + (1 + WACC)3
(1 + WACC)1 (1 + WACC)2
-5 10 20 530
V op
1 0.11 1 0.12 1 0.13
$416.94
where
FCF4 20(1 0.06) 21.20
V3 530
WACC - g 0.10 - 0.06 0.04
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SMU Classification: Restricted
Example 2 (cont’d)
If the firm has $40 million in debt and has 10
million shares of stock but no preferred stock
and no short-term investments, what is the
firm’s intrinsic value per share?
MV of equity = MV of firm – MV of debt
= $416.94 - $40
= $376.94 million
Value per share = MV of equity / # of shares
= $376.94 / 10
= $37.69
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SMU Classification: Restricted
Issues Regarding the FCF Valuation Model
Can be used to value any firm.
Useful for stock valuation when firm does not
pay dividends or are hard to forecast.
Similar to dividend growth model in the sense
that it assumes free cash flow will grow at a
constant rate at some point.
Horizon value (HVN) represents value of firm at
the point that growth becomes constant.
Requires forecasted financial statements to
estimate FCF.
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SMU Classification: Restricted
Self-Test Question:
FCF Valuation Model
The current value of Matakana Brewery’s free cash flows is
estimated to be $840 million, based on the Corporate
Valuation Model. Its balance sheet shows $70 million in
accounts receivable, $50 million in inventory, $20 million in
accounts payable, $110 million in notes payable, $90
million in long-term debt, $30 million in preferred stock,
$140 million in retained earnings, and $280 million in total
common equity. If the company has 25 million shares of
stock outstanding, what is your best estimate of the stock's
price per share?
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SMU Classification: Restricted
Pricing Multiples
Analysts often use the following multiples to value
stocks.
P/E (Price to Earnings)
P/CF (Price to Cash Flow)
P/S (Price to 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.
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SMU Classification: Restricted
EPS and PER
Earnings Per Share
EPS = Net Income ÷ # shares outstanding
Price-Earnings Ratio
PER = Stock Price ÷ EPS
Appropriate multiples
Comparable company analysis
Which companies?
Limitations of P/E-based approach
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SMU Classification: Restricted
Example of PER Approach
UOB (31 December 20xx)
P = $19.90
EPS = $1.36
PER = 19.90 ÷ 1.36 = 14.63
DBS (31 December 20xx)
P = $20.70
EPS = $1.44
PER = 20.70 ÷ 1.44 = 14.37
OCBC (31 December 20xx)
P = $8.29
EPS = $0.66
PER = 8.29 ÷ 0.66 = 12.56
Forecasted EPS = $0.68
OCBC’s forecasted stock price based on average PER
= OCBC’s Forecasted EPS x average PER
= $0.68 x 13.85 = $9.42
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SMU Classification: Restricted
Preferred Stock
Hybrid security.
Like bonds, preferred stockholders 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 pushing
the firm into bankruptcy.
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SMU Classification: Restricted
Summary
Questions and Answers
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