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Common Stock Valuation

The document discusses various methods for valuing common stock, including the dividend discount model, free cash flow valuation approaches, and P/E ratio analysis. It provides formulas and examples for calculating stock value under the zero growth, constant growth, and multi-stage growth models using expected future dividends. It also covers estimating value based on free cash flow to equity or the firm and analyzing P/E ratios based on earnings per share and required rates of return.

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Ahsan Iqbal
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107 views40 pages

Common Stock Valuation

The document discusses various methods for valuing common stock, including the dividend discount model, free cash flow valuation approaches, and P/E ratio analysis. It provides formulas and examples for calculating stock value under the zero growth, constant growth, and multi-stage growth models using expected future dividends. It also covers estimating value based on free cash flow to equity or the firm and analyzing P/E ratios based on earnings per share and required rates of return.

Uploaded by

Ahsan Iqbal
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
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INVESTMENT AND

PORTFOLIO MANAGEMENT
PRESENTED TO : DR. UMMARA SAHER
PRESENTED BY:
JAVERIA MUSHTAQ S/2019-1616
MAHAM AYUB S/2019-1626
SYRA KHAN S/2019-1640
COMMON STOCK
VALUATION

Stock valuation is the process of determining


the value of a share of stock in a company.
The holder of one share in a company that has
one million shares outstanding is actually the
owner of one-millionth of the company; the
value of that share should represent that
percentage of the company’s worth.
Common Stock Valuation

 What cash flow will a shareholder receive


when owing share of common stock?
• Future dividends.
• Future sales of common stock shares

Basic Dividend valuation model accounts for


the PV of all future dividends.
Fundamental Analysis
 Value
The regard that something is held to deserve the
importance, worth or usefulness of something.
 Present value approach
 Earlier money on the time is called present
value.
 Future Value:
 Later money on the timeline is called future
value.
Present Value Approach

 Intrinsic value of a security is

 Overvalue + Undervalue

 Estimated intrinsic value compared to


the current market price
 What if market price is different than estimated
intrinsic value?
Dividend Growth pattern
Assumption
 The dividend valuation model requires the forecast of all future
 Dividends. The following Dividend growth rate assumption simplify the
valuation process.
• No Growth
• Constant Growth
• Phases of Growth.
Zero/No Growth Model
 The zero growth model assumes that will grow forever at the rate of contact
rate g=0 Constant Dividend
 Ve=De/Ke (PV pv= R/1)

 D Dividend Paid
 ke investors return
Example

 Stock ABC has an expected growth rate 0%. Each share of stock just
received an amount Dividend Rs/-3.24 per share. The appropriate
discount rate 15%. What is the value of the common stock?

 D= Rs/_ 3.24
 V= De/Ke

 3.24/.15= Rs/ 21.60


Constant Growth Model

 The constant growth model assume that dividend grow forever at


a constant rate. In this growth rate of return is constant.
Dividend Discount Model

 Discount the dividend (Share Price)


 Cost of equity (Expected)

Share price = dividend/Cost of Equities


Dividend Discount Model

 Example:
 Dividend = 3 MKT=30
 Cost of equity = 18% =18
 Share price = 3/18= 16.667

 16.667multiply by 18%= 3 (paying)


30 multiply by 18%=5.4
Dividend Discount Model

 Variable Growth Rate


A dividend valuation approach that allows
for a change in a dividend growth rate.
Types of Variable Growth Rate
Model

There are two further two types of model


a. 2 phase model
b. 3 phase model
2 PHASE MODEL

 A dividend valuation approach that


allows for a change in a dividend
growth rate two times during the life
of stock.
3 PHASE MODEL

 A dividend valuation approach that


allows for a change in dividend
growth rate 3 times during the life of
stock.
Example
Delphi Products corporation currently pays a
dividend of $2 per share, and this dividend is
expected to grow at a 15 percent annual rate for
three years, and then at a 10 percent rate for the
next three year, after which it is expected to grow
at a 5 percent rate forever. What value would you
place on the stock if an 18 percent rate of return
was required?
Phase-I (g1 = 15%p.a)
General Formula: Dn = Dox(1+g)n
Years Dividend Calculations / Answer (1+rd)n Percent Value
0 D0 = $2
1 D1 D1 = 2x(1+0.15)1 = 2.30 (1+0.18)1 = 1.18 $1.95
2 D2 D2 = 2x(1+0.15)2 = 2.65 (1+0.18)2 = 1.39 $1.90
3 D3 D3 = 2x(1+0.15)3 = 3.04 (1+0.18)3 = 1.64 $1.85
Phase-I Total $5.70
Phase-II(g2 = 10%p.a)
General Formula: Dn = Dox(1+g)n
Years Dividend Calculations / Answer (1+rd)n Percent Value

3 D3 = $3.04

4 D4 D4 = 3.04x(1+0.10)1 =3.35 (1+0.18)4 = 1.94 $1.73

5 D5 D5 = 3.04x(1+0.10)2 =3.68 (1+0.18)5 = 2.29 $1.61

6 D6 D3 = 3.04x(1+0.10)3= 4.05 (1+0.18)6 = 2.70 $1.50

Phase-II Total $4.83


Phase-III
Dividends are expected to grow for indefinite period of time at constant rate

Hence,
   D6 will become Do & D7 will Become D1.
D7 = 4.05x (1+0.05)1 = 4.25

P = 32.69 This is the Value at the 7th year


Further,
   discounting the value at 0th year

Final Step
= 5.70 + 4.83+10.27
= 20.8
  Free Cash Flow Valuation

 Many firms do not currently pay


dividends Theoretically, DDM will
work, but extremely difficult to
estimate when dividends will begin
and what growth rate will be
Alternative to DDM is calculating
present value of Free Cash Flow
Two Approaches:

1. Free Cash Flow to Equity (FCFE)

2. Free Cash Flow to the Firm (FCFF)


Free Cash Flow to Firm

 Free cash flow to firm FCFF


represent the amount of cash flow
from operations available for
distribution after accounting for
depreciation expenses, taxes,
working capital, and investments.
 Free
Cash Flow = Operating Cash
Flow – Capital Expenditure
Free Cash Flow to Firm

FCFF = FCFE + Interest Expense (1-tax rate) + Principal Repayment


- new Debt Issue – Preferred Dividends
Free Cash Flow to Equity

 Free cash flow to equity is a measure


of how much cash is available to the
equity shareholders of the company
after all expenses, reinvestment and
debt are paid.
Free Cash Flow to Equity
FCFE= Net Income + Depreciation – Debt
repayments – capital expenditure – the
change in working capital +new debt
issues
What About Capital Gains?

 Is the dividend discount model only capable


of handling dividends?
 Capital gains are also important
 Price received in future reflects expectations
of dividends from that point forward
 Discounting dividends or a combination of
dividends and price produces same results
Intrinsic Value

 “Fair” value based on the capitalization of


income process
 The objective of fundamental analysis
 If intrinsic value >(<) current market price,
hold or purchase (avoid or sell) because
the asset is undervalued (overvalued)
 Decision will always involve estimates
P/E Ratio or Earnings
Multiplier Approach
 Alternative approach often used by
security analysis
 P/E ratio is the strength with which
investors value earnings as expressed in
stock price
 Divide the current market price of the stock
by the latest 12-month earnings
 Price paid for each $1 of earnings
P/E Ratio

 It is true defined that


 P =E (P /E )
0 0 0 0

Where
P =the current stock price
0

E =the most recent 12 months earning


0

per share (EPS)


Type of P/E Ratio Approach

 Stockprice is the product of two


variables when using this type of
approach
 1.EPS
 2.The P/E multiples
EPS (Earning per Share)

 EPS indicates how much money a company


makes for each share of its stock and is a
widely used metric for estimating corporate
value. A higher EPS indicates greater value
because investors will pay more for a company's
shares if they think the company has higher
profits relative to its share price.

EPS=TOTAL EARNING/NO.OF
SHARES
P/E MULTIPLES

 The P/E ratio measures the relationship


between a company's stock price and
its earnings per issued share. The P/E
ratio is calculated by dividing a
company's current stock price by its
earnings per share (EPS).

P/E Ratio=Stock price/Earning per
share
P/E Ratio Approach

 The higher the payout ratio, the higher the


justified P/E
 Payout ratio is the proportion of earnings that are
paid out as dividends
 The higher the expected growth rate, the
higher the justified P/E
 The higher the required rate of return, k, the
lower the justified P/E
Understanding the P/E Ratio

 Can firms increase payout ratio to increase market


price?
 Will future growth prospects be affected?
 Does rapid growth affect the riskiness of
earnings?
 Will the required return be affected?
 Are some growth factors more desirable than others?
 P/E ratios reflect expected growth and risk
P/E Ratios and Interest Rates

 A P/E ratio reflects investor optimism and


pessimism
 Related to the required rate of return
 As interest rates increase, required rates of
return on all securities generally increase
 P/E ratios and interest rates are indirectly
related
Which Approach Is Best?

 Best estimate is probably the present value of


the (estimated) dividends
 Can future dividends be estimated with
accuracy?
 Investors like to focus on capital gains not
dividends
 P/E multiplier remains popular for its
ease in use and the objections to the
dividend discount model
Other Multiples

 Price-to-book value ratio


 Ratio of share price to stockholder equity as
measured on the balance sheet
 Price paid for each $1 of equity
 Price-to-sales ratio
 Ratio of a company’s total market value (price
times number of shares) divided by sales
 Market valuation of a firm’s revenues

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