Principles of Finance | Topic 3: Stock Prices | Slide 1/36

Principles of Finance

Topic 3: Stock Prices

Dr Yue (Lucy) Liu

University of Edinburgh Business School

Slides are mainly based on Chapter 9 in Berk and DeMarzo (3rd edition)
Principles of Finance | Topic 3: Stock Prices | Slide 2/36

Synopsis

Last time, we learned how to price bonds.

We calculated YTM of bonds.

We talked about the sensitivity of bond prices to different factors.

This time, we will learn how to price stocks.

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Outline

1 The dividend-discount model

2 Applying the dividend-discount model

3 Free cash flow valuation model

4 Valuation based on comparable firms

5 Information, competition, and stock prices

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The dividend-discount model

Outline

1 The dividend-discount model

2 Applying the dividend-discount model

3 Free cash flow valuation model

4 Valuation based on comparable firms

5 Information, competition, and stock prices

Principles of Finance | Topic 3: Stock Prices | Slide 5/36
The dividend-discount model

A one-year investor

Buy the stock for P0 today. Sell it for P1 next year. The stock pays
dividend D1 at the end of year.

Note that P1 and D1 are not known with certainty. They are based on the
investor’s expectations.

Because P1 and D1 are risky, we cannot discount them at the risk-free

interest rate.

We must discount them based on the equity cost of capital rE .

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The dividend-discount model

D1 + P1
Willing to buy, if P0 ≤
1+rE

D1 + P 1
=
Then, the stock price is: Willing to sell, if P0 ≥
1+rE

D1 + P1
P0 =
1+rE

We can rearrange this equation as follows:

D1 P1−P0
rE = +
P0 P0
Total return = Dividend yield + Capital gain rate

Commensurate with the return investors can earn elsewhere while taking the same risk.

If rthis stock > rother securities, same risk , buy this stock P0 ↑↑ dividend yield ↓ ; capital gain ↓

If rthis stock < rother securities, same risk , sell this stock P0 ↓ dividend yield ↑ ; capital gain ↑
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The dividend-discount model

The dividend-discount model equation

A multiyear investor?

We can use the dividend discount model to price a stock:

D1 D2 DN + PN
P0 = + +···+
1+rE (1 + rE )2 (1 + rE )N

See the similarity with the model we used to price a bond:

C C C + FV
P= + +···+
1+r (1 + r )2 (1 + r )N
Principles of Finance | Topic 3: Stock Prices | Slide 8/36
The dividend-discount model

Example: Stock versus bond prices

Calculate the price of: (a) a 5-year government risk-free bond that has a face
value of £100 and that pays annual coupons at a rate of 1%, (b) a stock that
you expect will pay annual dividends of £1 per share and will have a price of
£100 in 5 years. Assume that the risk-free cost of debt is 1% and the cost of
equity for the stock is 2%.

For the bond, there is no uncertainty about cash flows, they are risk-free:
£1 £1 £101
P(bond ) = + +···+ = £100
1.01 (1.01)2 (1.01)5

For the stock, there is uncertainty about cash flows, they are risky:

£1 £1 £101
P(stock ) = + +···+ = £91.02 < £100
1.02 (1.02)2 (1.02)5
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Applying the dividend-discount model

Outline

1 The dividend-discount model

2 Applying the dividend-discount model

3 Free cash flow valuation model

4 Valuation based on comparable firms

5 Information, competition, and stock prices

Principles of Finance | Topic 3: Stock Prices | Slide 10/36
Applying the dividend-discount model

Constant dividend growth

Estimating dividends for the distant future is difficult.

A common assumption: divs will grow at a constant rate, in the long run. (Constant growth perpetuity)

Constant dividend growth model is a special case of the dividend

discount model:
C D1
PV (g.perpetuity ) = P0 =
r −g rE − g

P0 increases as D1 and g increases.

Increasing growth g requires investment.

Money spent on investment cannot be used to pay dividends D1.

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Applying the dividend-discount model

Example 1

What is the price of a stock that is expected to pay a dividend of $1 per share
in the coming year, which will afterwards grow at (a) 3% per year, (b) 4% per
year in the future? This stock’s equity cost of capital is 5%.

For part (a): D1 = $1, rE = 5%, g = 3%, then:

$1
P0 = = $50
0.05 − 0.03

For part (b): D1 = $1, rE = 5%, g = 4%, then:

$1
P0 = = $100
0.05 − 0.04

1% increase in the growth rate doubles the stock price!

What determines the growth rate of divs?

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Applying the dividend-discount model

Dividends versus investment and growth

Payout versus investment:

Divt = Payout ratio × EPSt

I = (1 − Payout ratio) × E

Retention rate
Increase in earnings as a result of investment:

ΔE = ROI × I
ΔE = ROI × (1 − Payout ratio) × E
ΔE = ROI × (1 − Payout ratio)
E

If the payout ratio is kept constant, dividend growth equals earnings

growth: g=
ΔDiv ΔE × Payout ratio
=
ΔE Div E × Payout ratio
g= = ROI × (1 − Payout ratio)
E = ΔE
E
 D1
P0 =
rE − g

Cut divs, invest more?

Depends on ROI.
Cut investment, pay more divs?
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Applying the dividend-discount model

Example 9.3
 D1
P0 =
rE − g

Change the rate to 8%:

P0 = $56.25

Cutting divs to increase investment will raise the stock price if, and only if, the new investments have a +NPV.
 D1
P0 =
rE − g
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Applying the dividend-discount model

Changing growth rates

Successful young firms often have high growth rates initially.

During this period, they retain most of earnings to invest in positive NPV
projects.

As they mature, their growth slows to rates more typical of established

companies.

At that point, their earnings exceed their investment needs and they
begin to pay dividends.
 DivN  1
Terminal (continuation) value PN 
rE  g

Dividend-Discount Model with Constant Long-Term Growth

PN

Div1 Div2 DivN 1  DivN  1 

P0      N  
1  rE (1  rE ) 2 (1  rE ) N
(1  rE )  rE  g 
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Applying the dividend-discount model
0 1 2 3
 Limitations

 Sensitive to g: a small change in g can lead to a large change in P.

Earnings depend on borrowing as interests need to be deducted.-Consider debts

Free Cash Flow Valuation Model
 Management discretion Future shares number See following slides
Therefore, difficult to project dividends. affected by share repurchase
Div payout ratio
Total Payout Model
Total earning
Div = Payout ratio x PV(Future total divs and repurchases)
P0 =
Share number Shares outstanding0
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Free cash flow valuation model

Outline

1 The dividend-discount model

2 Applying the dividend-discount model

3 Free cash flow valuation model

4 Valuation based on comparable firms

5 Information, competition, and stock prices

Principles of Finance | Topic 3: Stock Prices | Slide 19/36
Free cash flow valuation model

The discounted free cash flow model

Enterprise value = the value of the firm’s underlying business

This model first calculates the enterprise value, and then determines the
stock price using the enterprise value:

Enterprise value = Market value of equity + Debt − Cash

V0 = P0 × Shares outstanding0 + Debt0 − Cash0

This yields:
V0 + Cash0 − Debt0
P0 =
Shares outstanding0

We don’t need to explicitly forecast divs, repurchases, borrowings.

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Free cash flow valuation model

Enterprise value V0 is the present value of FCF s discounted at the

weighted average cost of capital rWACC :

FCF1 + FCF2 +···+ FCFN + VN

V0 =
1+rWACC (1 + rWACC )2 (1 + rWACC )N

where VN is the continuation value of the enterprise:

FCFN+1
Constant growing perpetuity VN =
rWACC − gFCF

and gFCF is the long-run growth rate.

FCF s are defined as follows:

FCF = (1 − Tc ) × EBIT − Net Inv . − Increases in NWC

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Free cash flow valuation model

Example 2

A firm at the moment generates FCFs of $100 million every year. It considers
investing in a project. The investment in the project would reduce FCFs by
50%, but in year 6 the FCFs would start to grow by 6%. If the firm’s WACC is
10%, should it take the project? If the firm has $100 million in cash and 100
million shares outstanding, and if its value of debt is $600 million, what is the
firm’s share price with and without the project? Perpetuity without growth:
C
First, calculate the enterprise value without the project: PV =
r

V0(w/o project) = $100 million/0.1 = $1 billion

Perpetuity with constant g:
Next, calculate the enterprise value with the project: PV = C
r −g
$50 million $50million $50 million
V0(w. project) = − + = $1.012 billion
0.1 0.1(1.1)4 (0.1 − 0.06)(1.14)
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Free cash flow valuation model

Note for Example 2

Timelines for constant versus growing perpetuities:

Constant Perpetuity:
C
PV =
r

0 1 2 3 4 5 ...

0 C C C C C
Growing Perpetuity:
PV = C
r −g

0 1 2 3 4 5 ...

0 C C(1 + g) C(1 + g)2 C(1 + g)3 C(1 + g)4

Perpetuity starts Start growing

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Free cash flow valuation model

Note for Example 2 (cont’d)

In Example 2, while the FCFs start growing in year 6, the growing perpetuity
starts in year 4: Perpetuity starts Start growing

0 1 2 3 4 5 6 ...

$50m $50m $50m $50m $50m $50m(1+6%) . . .

Growing perpetuity
Annuity
$50 million $50 million $50 million
− 0.1(1.1)4 0.1−0.06
0.1

÷ (1.1)4
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Free cash flow valuation model

Example 2

A firm at the moment generates FCFs of $100 million every year. It considers
investing in a project. The investment in the project would reduce FCFs by
50%, but in year 6 the FCFs would start to grow by 6%. If the firm’s WACC is
10%, should it take the project? If the firm has $100 million in cash and 100
million shares outstanding, and if its value of debt is $600 million, what is the
firm’s share price with and without the project? Perpetuity without growth:
C
First, calculate the enterprise value without the project: PV =
r

V0(w/o project) = $100 million/0.1 = $1 billion

Perpetuity with constant g:
Next, calculate the enterprise value with the project: PV = C
r −g
$50 million $50million $50 million
V0(w. project) = − + = $1.012 billion
0.1 0.1(1.1)4 (0.1 − 0.06)(1.14)
Principles of Finance | Topic 3: Stock Prices | Slide 22/36
Free cash flow valuation model

V0 + Cash0 − Debt0
P0 =
Shares outstanding0

The share price without the project is:

$1 billion + $0.1 billion − $0.6 billion

P0 = = $5 per share
100 million shares

The share price with the project is:

$1.012 billion + $0.1 billion − $0.6 billion
P0 = = $5.12 per share
100 million shares

The firm should take the project as it increases the firm value.
Principles of Finance | Topic 3: Stock Prices | Slide 25/36
Valuation based on comparable firms

Outline

1 The dividend-discount model

2 Applying the dividend-discount model

3 Free cash flow valuation model

4 Valuation based on comparable firms

5 Information, competition, and stock prices

Principles of Finance | Topic 3: Stock Prices | Slide 26/36
Valuation based on comparable firms

Application of the Law of One Price:

Estimate the value of the firm based on the value of other comparable firms that generate very similar cash flows.

Consider the case of a new firm that is very similar to an existing public
firm.

We can use the value of the existing company to determine the value of
the new firm.

This method is called the method of comparables.

P/E is the most commonly used valuation multiple.

Use multiple to adjusted for differences in scale.

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Valuation based on comparable firms

Example 3: P/E ratio as a valuation multiple

The retail industry has an average P/E of 18. What should be the share price
of a new retail company, if it has similar characteristics with the average firm
in its industry and if it has earnings of $5 per share?

Use the industry P/E ratio as a valuation multiple:

P0 = 18 × $5 per share = $90 per share

Limitations

 Comparable?

 Differences could be due to: g, profitability, risk, accounting convention, etc. Using multiples can
only capture some, but not all of them.
 Can’t determine if the entire industry is over-valued or under-valued.
Principles of Finance | Topic 3: Stock Prices | Slide 28/36
Valuation based on comparable firms

Stock valuation techniques: the final word

No single valuation technique provides a final answer regarding a stock’s

true value.

All approaches require assumptions or forecasts.

Analysts use a combination of techniques and gain confidence if the

results are consistent across a variety of methods.
Principles of Finance | Topic 3: Stock Prices | Slide 29/36
Information, competition, and stock prices

Outline

1 The dividend-discount model

2 Applying the dividend-discount model

3 Free cash flow valuation model

4 Valuation based on comparable firms

5 Information, competition, and stock prices

Principles of Finance | Topic 3: Stock Prices | Slide 30/36
Information, competition, and stock prices

Information in stock prices

If your valuation model suggests a stock is worth $30 per share

when it is trading for $20 per share in the market, the discrepancy is
equivalent to knowing that thousands of investors - many of them
professionals who have access to the best information - disagree
with your assessment.

You should reconsider the validity of your valuation model or the

accuracy of your estimates of future cash flows and cost of capital.

For a publicly traded firm, the market price provides accurate information
about the true value of shares. Only in the rare case in which an investor
knows something that the market does not know, he or she can
second-guess the market price.
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Information, competition, and stock prices

Example 9.11
Principles of Finance | Topic 3: Stock Prices | Slide 32/36
Information, competition, and stock prices
Principles of Finance | Topic 3: Stock Prices | Slide 33/36
Information, competition, and stock prices

Competition and efficient markets

If information indicates that “buy” has a positive NPV, investors with that information
would buy the stock (driving up the stock price).

The idea that competition among investors works to eliminate all positive
NPV trading opportunities is referred to as the efficient markets
hypothesis.

It implies that the securities will be fairly priced, given all information that
is available to investors.
Principles of Finance | Topic 3: Stock Prices | Slide 34/36
Information, competition, and stock prices

Public, easily interpretable information

The rationale for EMH is the presence of competition.

Competition depends on the number of investors who possess this information.

News reports, financial statements, corporate press releases are public

sources of information.

Stock prices would react almost instantly to news in public sources.

A few lucky investors might be able to trade a small quantity of shares

before the price fully adjusts.

But most investors would find that prices already reflected the news
before they were able to trade on it.
Principles of Finance | Topic 3: Stock Prices | Slide 35/36
Information, competition, and stock prices

Private, difficult-to-interpret information

When a few investors have private information or superior interpretation

of public information, they can profit by trading on their information.

Even though this is an inefficiency in the short-run, the market efficiency

could be preserved in the long-run, because:
1 The trades of informed investors would reveal their information. (Leads the price to move.)
2 If the profits of informed investors are large, other investors would put effort
to acquire the private information of informed investors, which would make
that information less and less private.

From the informed investors’ point of view, they might be able to make profits if :
 Lower trading costs
 Trading opportunity is difficult to replicate
 Strategy (divert attention; attract attention)
Herding
 EMH vs. behavioural finance

 EMH

 Random errors cancel out

 Arbitrage removes errors

The proponents of behavioural finance argue……

People are prone to cognitive biases

 Cost of arbitrage

42
Toast Illusion

43
Confused Washing Machine

44
45
Principles of Finance | Topic 3: Stock Prices | Slide 36/36
Information, competition, and stock prices

Summary

There are many different valuation models that can be used to value a
firm’s stock:
1 The dividend-discount model
2 The total payout model
3 The discounted FCF model
4 Method of comparables

When you use a valuation model to price a stock, if you find that the
price is different than the market price, it is more likely that the market
price is the true price, and not the other way around.

You should then reconsider either your valuation model or the inputs to
your model.