Capital Markets: Stocks

Chapter Eight
 Stock Valuation
Two General Approaches:
1.Discounted Cash Flow (DCF)—Get the present value of
expected future cash flows then determine a share’s claim
on the resulting value.
2.Law of One Price—Similar assets should have similar
prices or arbitrage opportunities exist. Value a share in
terms of the values of similar companies.
 Stock Valuation
From THE MOTLEY FOOL: ASK THE FOOL

•Question: How can novices tell when a stock is

overvalued (and therefore should be avoided). J.M.,
Flagstaff, Ariz.
•Answer: Experienced investors often crunch a lot of
numbers, considering lots of factors. Novices can
learn these skills, but understand that even complex
discounted cash flow analysis calculations are still
based on assumptions and estimates.
 Cash Flows for Stockholders
• If you buy a share of stock, you can receive cash in
two ways.
 The company pays dividends.
 You sell your shares, either to another investor in
the market or back to the company.
• As with bonds, the price of the stock is the present
value of these expected cash flows.
 Cash Flows for Stockholders
0 1 2 3 4 5
|----------|----------|----------|----------|----------|
P0
 Cash Flows for Stockholders
0 1 2 3 4 5
|----------|----------|----------|----------|----------|
P0  D1
P1
 Dividend Discount Model (DDM)
• Continue to push back when you
• You find that the price of the stock is really just the
present value of all expected future

E  D1  E  D2  E  D   E  P 
P0    
1  rE  1  rE  2
1  rE 


• How can we estimate all future dividend payments and

the price today?
 Dividend Discount Model
• Assume all the cash flows are the same.
• That makes a level perpetuity.
• That’s preferred stock.
• Supposed to pay a regular dividend.
 Do Perpetuities Exist?

• $100 × =

• $ .20 ÷ 4 =
 DDM: Preferred Stock
• Stock Price is $25.80 and quarterly dividend is
$1.55, what is the current required return?
D1
PV0 
rp
1.55
25.80 
rp
1.55
rp  0.0
25.80

rp = % per quarter
Present Value of Each Dividend
 Preferred as a Perpetuity: $25.80
• Suppose…
• G-S fails after twenty years.
 PV is $ .56

• G-S misses four dividends ten years from now.

 PV is $ .22

• G-S calls Series B six years from now.

 PV is $ .71
 Common Stock: Dividend Kings
Basic Materials Consumer Staples Industrial
Stepan (SCL) Archer Daniels Midland (ADM) ABM Industries (ABM)
H.B. Fuller (FUL) The Colgate-Palmolive Company (CL) Dover Corporation (DOV)
PPG Industries (PPG) Hormel Foods Corporation (HRL) Emerson Electric (EMR)
Nucor Corp. (NUE) Kimberly-Clark Corporation (KMB) Gorman-Rupp Company (GRC)
RPM International (RPM) The Coca-Cola Company (KO) W.W. Grainger (GWW)
Lancaster Colony (LANC) Illinois Tool Works (ITW)
Consumer Discretionary Altria Group (MO) 3M Company (MMM)
Genuine Parts Company (GPC) PepsiCo (PEP) MSA Safety (MSA)
Leggett & Platt (LEG) Procter & Gamble (PG) Nordson (NDSN)
Lowe’s Companies (LOW) Sysco Corporation (SYY) Parker Hannifin (PH)
Target Corporation (TGT) Stanley Black & Decker (SWK)
Utilities Tootsie Roll Industries (TR) Tennant Company (TNC)
American States Water (AWR) Universal Corporation (UVV) Real Estate
Black Hills Corp. (BKH) Walmart Inc. (WMT) Federal Realty Investment Trust (FRT)
California Water Service (CWT)
Canadian Utilities (CDUAF) Healthcare Communication Services
Consolidated Edison (ED) AbbVie (ABBV) Telephone & Data Systems, Inc. (TDS)
Fortis Inc. (FTS) Abbott Laboratories (ABT)
Middlesex Water Company (MSEX) Becton, Dickinson & Company (BDX) Financial Services
Northwest Natural Gas (NWN) Johnson & Johnson (JNJ) Cincinnati Financial (CINF)
SJW Group (SJW) Kenvue Inc. (KVUE) Farmers & Merchants Bancorp (FMCB)
Commerce Bancshares (CBSH)
Energy S&P Global Inc. (SPGI)
National Fuel Gas (NFG) United Bankshares (UBSI)
 Dividend Growth Model
• Constant dividends is a terrible assumption.
• We need to allow dividends to change.

E  D1  E  D2  E  D3 
P0     
• 1  rinE a way1 we
Allow for growth  model.
2
 rEcan 1  rE 
3

• Growing perpetuity with constant g.

D1 D0 1  g 
P0  
rE  g rE  g
 Dividend Growth Model Example 1

• Suppose Coca-Cola (KO) just paid a dividend of

$1.84. It is expected to increase its dividend by
6.1% per year. If the market requires a return of
9.9% annually on assets of this risk, how much
should the stock be selling for?

=$ , rounded to the penny

• Actual market price is $

 Dividend Growth Model Example 2
• Johnson & Johnson (JNJ) is expected to pay $4.70
for its next annual dividend. Expected dividend
growth is 6.5% per year. The required return is 9.4%
annually.
• What is the current price?

• Remember that we already have the dividend

expected next year, so we don’t grow the dividend
up a year.
• Actual market price is $
 Dividend Growth Model Example 2
• What is the price expected to be in year 4?
P4 = D1(1 + g)4/(rE – g) = D5/(rE – g)
P4 = 4.70(1+.065)4/(.094 - .065) = .4962706
• What is the implied return given the change in
price during the four-year period?
.4962706 = .0689655(1 + return)
.0689655 PV .4962706 FV 4 N,
CPT I/Y =>
• The price grows at
 Using the DGM to Find rE
• Start with the DGM:

D0 1  g  D1
P0 = or P0 =
rE  g rE  g
• Solve for rE

D0 1  g  D1
rE = +g or rE = +g
P0 P0
 Finding the Required Return
• Suppose a firm’s stock is selling for $10.50. They
just paid a dollar dividend, and dividends are
expected to grow at 5% per year. What is the
required return?
• What is the dividend yield?

• What is the capital gains yield?

g=
• What is the cost of equity?
rE =
 DDM: The Mixed Model
• Supernormal Growth

Transitory Phase Steady State

0 1 t t+1
E[ D 1 ] E [ D t] E[Dt+1]
Not Perpetual Perpetuity
 DDM: The Mixed Model
• Suppose a firm is expected to increase dividends by
20% in one year and by 15% in two years. After that
dividends will increase at a rate of 5% per year
indefinitely. If the last dividend was $1 and the
required return is 20%, what is the price of the stock?
• Remember that we have to find the PV of all
expected future dividends.
 DDM: The Mixed Model
• Compute the dividends until growth levels off:
D1 = 1(1.2) = $1.20
D2 = 1.20(1.15) = $1.
D3 = 1.38(1.05) = $1.

0 1 2 3 4 5

1.20 1. 1.

• Find the expected future price

P2 = D3/(rE – g) =
 The Mixed Model General Approach
1. Put dividends on timeline through the transitory
phase.
2. Note when steady state occurs with constant
growth(maybe zero).
3. Convert constant growth dividends into lump sum 1
period prior to first dividend in constant growth
stream. This is the terminal value.
4. Take all cash flows back to time zero one at a time.
5. Add them up to get price.
 DDM: The Mixed Model

Transitory Phase Steady State

0 1 t t+1
E[ D 1 ] E [ D t] E[Dt+1]
Not Perpetual Perpetuity
Supernormal Growth:
uneven dividends perpetuity
Two-Stage Growth:
growing annuity (g1) perpetuity (g2)
H-Model:
growing annuity (g1) + transition perpetuity (g2)
Three-Stage Growth:
two growing annuities (g1, g2) perpetuity (g3)
 Dividend Discount Model
• Advantages:
 Conceptually
 Prices change with dividend policy.
• Disadvantages:
 Extremely to parameter estimates.
 Only 125 or so, dividend kings and aristocrats out
of 6,000+ stocks on NYSE & NASDAQ.
 of public companies pay dividends.
 Dividend Discount Model in Action
• Anheuser-Busch InBev SA slashed its dividend
Thursday as it reported weaker profit and lower
volumes in several key market..”
• Dividends were cut in half so that cash could be used
to pay down debts.

Wednesday Oct. 24 Thursday Oct. 25

Volume: 2,908,000 Volume: 9,477,200
 Dividend Discount Model

rE g Price KO • KO Growth Rates:

+50 -50 40.48 Maximum 38.11%
+40 -40 42.28 Average 13.51%
+30 -30 44.24
Minimum 3.96%
+20 -20 46.39
+10 -10 48.76 • Cost of Equity 9.90%
9.90% 6.10% 51.37
-10 +10 54.28
-20 +20 57.53
-30 +30 61.18
-40 +40 65.32
-50 +50 70.05
 Other DCF Approaches
• Estimate future expenditures on dividends and
buybacks timeline.
• Determine the present value.
 Divide by the number of shares outstanding.

• Fundamental Analysis
 Estimate a company’s free cash flow timeline.

Cash beyond operating and capital expenditures.

 Determine the present value.
 Divide by the number of shares outstanding.

• All use estimated terminal values.

 Law of One Price
• Snap’s dividend policy:
• “We have never declared or paid cash dividends on
our capital stock. We intend to retain all available
funds and future earnings, if any, to fund the
development and expansion of our business, and we
do not anticipate paying any cash dividends in the
foreseeable future. The terms of our outstanding
credit facility also restrict our ability to pay dividends,
and we may also enter into credit agreements or
other borrowing arrangements in the future that will
restrict our ability to declare or pay cash dividends on
our capital stock.”
 LoOP: Comparables
• For example, determine the price of a house.
1. Comparables analysis: get the price per square foot
of similar houses.
2. Multiply price per square foot of comparable houses
by the square feet of the target house, e.g.,
$ 2
Pt  feet

per foot 2 target
   
benchmark

$ 16
Pt  2
600
per foot
    target
benchmark

3. Use a set of houses. The comp set.

 LoOP: Stock Valuation
• Apply the law of one price to pricing stocks, similar
stocks should have similar prices.
• When firms are comparable in some sense, we can
use the multiples approach to determine the value
of the target firm based on the value of another
benchmark firm, as we did in getting the price of a
house.
• Use multiples such as Price/Earnings and
Price/Sales ratios to compare firms.
 Valuation Using Multiples

1. Ptarget PE Ratiobenchmark  EPStarget

Price per share

Ptarget  Earnings per share
Earnings per share     target
   
        
benchmark

2. Ptarget PS Ratiobenchmark  SPStarget

Price per share
Ptarget  Sales per share
Sales per share    target
   
      
benchmark

3. Any other comparable that makes sense.

 Valuation Using Multiples

• Boeing & Caterpillar

$ = 6.9CAT_PET × 5.96BA_EPS

$ = 4.13CAT_PEF ×5.96BA_EPS

Actual price of Boeing is $

• Zynga & Electronic Arts

$ = .77EA_PS × 0.84ZNGA_SPS

Actual price of Zynga is $

 Valuation Using Multiples

• Enterprise Value:
EV = Value of E + Value of D - Cash & Equivalents
• EV-to-EBITDA ratio (billions)
Ford 159.33 ÷ .82 = .48
GM 141.78 ÷ .78 = .98
Tesla 538.90 ÷ .56 = .74
• Suppose Kwik Trip was just purchased by KKR for
fifteen times EBITDA.
• If Race Trac has EBITDA of $ million, what’s its
market value?
 Valuation: Bonds versus Stocks

 1  (11r )t  FV
Bond Value C  
 1  r 
t
 r

D1
Share Value 
rE  g

Share Value PE Ratiobenchmark  EPStarget

 Capital Providers

Priority Risk
Highest Least
Fixed Income: Senior Debt
Junior Debt
Equity: Preferred Stock
Common Stock Lowest Most
Capital Providers
 Capital Providers
DEBT EQUITY

Bonds Preferred Common

face value yes yes no
fixed payment yes yes no
callable maybe maybe no
sinking fund maybe maybe no
credit ratings yes yes no
voting rights no no* yes
obligation to pay yes no no
 Dividends
• Dividends are not a liability of the firm until declared
by the Board.
 Consequently, all-equity firms cannot go bankrupt.
 Each share type gets same dividend.

• Preferreds must be paid before common shares.

 Priority in liquidation too.

• Missed dividends: Arrears

 Cumulative and non-cumulative shares.

• Executive Summary:
 Preferreds have superior cash flow rights.
 Common has superior voting rights.
 Taxes
• Interest is a business expense—deductible.
• Dividends are not—not deductible.
1. Individuals pay tax on dividends received.
2. Results in the double taxation we know and love.
3. Dividends received by corporations have a minimum
70% exclusion from taxable income.
We would rather purchase businesses than stocks. There is a powerful
reason behind that preference, and that has to do with taxes. The
tax code makes Berkshire’s owning 80% or more of a business far
more profitable for us than owning a smaller share. When a
company we own earns $1 million after-tax and upstreams it to us,
Berkshire owes no tax on the dividend.
 Common Stock & Voting
• Typically, one share, one vote.
• Issues:
 Board of directors
 Auditor
 Merger & Acquisitions
 Change bylaws
 And more…
• Proxy voting
 Don’t have to be present at annual meeting.
 Can assign votes to others, e.g. Carl Icahn.
“Our Board believes that we and our shareholders are best served by having
Brian L. Roberts serve as Chairman and Chief Executive Officer…Our Board
believes that Mr. Roberts, in his capacities as Chairman and Chief Executive
Officer, serves as an effective bridge between the Board and management
and provides critical leadership for carrying out our strategic initiatives and
confronting our challenges. In addition, our Board does not believe it should
be constrained by an inflexible, formal requirement that the offices of
Chairman and Chief Executive Officer be separated.”

Corporate Governance
Institutional Shareholder Services (ISS) Governance Quality Score:

A decile score of 1 indicates lower governance risk.

A 10 indicates higher governance risk.

Comcast’s score?
Shareholder Services
Analysts Recommendations?
 Common Stock & Voting
Snap:
Class A Class B Class
C
Votes per share:
Shares Floated: m 0 0
m m m
m m m
Prodigy Communications:
Class A Class B
Votes per share: 1
Shares: 70m