# Which Stocks That Sell for \$2.00 or Less and Pay Dividends by azg15692

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```									            Chapter 9
Stocks and Their Valuation
Topics Covered
 Common and Preferred Stock Properties
 Valuing Preferred Stocks
 Valuing Common Stocks - the Dividend Growth
Model
No growth
Constant growth
Non-constant or supernormal growth
 Valuing the Entire Corporation – Free Cash Flow
Approach
 Stock Market Equilibrium
2

Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Management’s goal: Maximize the stock
price

3
Preferred Stock Characteristics
 Unlike common stock, no ownership interest
 Second to debt holders on claim on company’s
assets in the event of bankruptcy.
 Annual dividend yield as a percentage of par
value
 Preferred dividends must be paid before
common dividends
 If cumulative preferred, all missed past dividends
must be paid before common dividends can be
paid.
4
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).

5
Preferred Stock Valuation
 Promises to pay the same dividend year after
year forever, never matures.
 A perpetuity.
 VP = DP/rP
 Expected Return: rP = DP/P0
 Example: GM preferred stock has a \$25 par
value with a 8% dividend yield. What price
would you pay if your required return is 7%?

6
What do investors in common stock
want?
Periodic cash flows: dividends, and…
To sell the stock in the future at a higher
price
Management to maximize their wealth

7
Stock Valuation: Dividend Growth Model

Stock Value = PV of Future
Expected Dividends

D1       D2       D3                D
P0                             ... 
1  r  1  r  1  r 
1        2        3
1  r 

8
Stock Valuation: Dividend Patterns

For Valuation: we will assume stocks fall
into one of the following dividend growth
patterns.
Constant growth rate in dividends
Zero growth rate in dividends, like preferred
stock
Variable (non-constant) growth rate in dividends

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Stock Valuation Case Study: Doh!
Doughnuts
 We have found the following information for Doh!
Doughnuts:
 current dividend = \$2.00 = Div0
 The current T-bill rate is 5% and investors
demand an 8.5% market risk premium.
 Doh!’s beta = 1.4.

10
Analysts Estimates for Doh! Doughnuts

 NEDFlanders predicts a constant annual growth
rate in dividends and earnings of zero percent
(0%)
 Barton Kruston Simpson predicts a constant
annual growth rate in dividends and earnings of
10 percent (10%).
 Homer Co. expects a dramatic growth phase of
30% annually for each of the next 3 years
followed by a constant 10% growth rate in year 4
and beyond.

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What should be each analyst’s estimated
value of Doh! Doughnuts?

12
Valuing Common Stocks: No Growth

If we forecast no growth, and plan to hold out
stock indefinitely, we will then value the stock as
a PERPETUITY.

Div1    EPS1
Perpetuity  P0       or
r       r
Assumes all earnings are
paid to shareholders.

13
Ned Flanders’ Valuation

D0 = \$2.00, rS = 16.9% or 0.169, g = 0%

14
Constant Growth Valuation Model
 Assumes dividends will grow at a constant rate
(g) that is less than the required return (rS )
 If dividends grow at a constant rate forever, you
can value stock as a growing perpetuity,
denoting next year’s dividend as D1:

D (1 + g ) = D
0              1
P = r -g
0
S     r -gS

Commonly called the Gordon growth model          15
Barton Kruston Simpson’s Valuation

D0 = \$2.00, g = 10%, rS = 16.9%

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Expected Return of Constant Growth
Stocks
Expected Rate of Return = Expected
Dividend Yield + Expected Capital Gains
Yield
D1/P0 = Expected Dividend Yield
g = Expected Capital Gains Yield
r = (D1/P0) + g = (D0(1+g)/P0) + g

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Example

Burns International’s stock sells for \$80
and their expected dividend is \$4. The
market expects a return of 14%.
What constant growth rate is the market
expecting for Burns International?

18
Homer Co. Valuation

Variable (non-constant) growth
Years 1-3 expect 20% growth
After year 3: constant growth of 10%

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Variable Growth Stock Valuation

Framework: Assume Stock has period of
non-constant growth in dividends and
earnings and then eventually settles into a
normal constant growth pattern (gc).
0 g1 1 g2 2 g3 3 gc 4 gc 5 gc ...

D1      D2      D3

Non-constant Growth Period    Constant Growth   20
Variable Growth Valuation Process
3 Step Process
 Estimate Dividends during non-constant growth
period.
 Estimate Price, which is the PV of the constant
growth dividends, at the end of non-constant
growth period which is also the beginning of
the constant growth period. This is called the
horizon or terminal value.
 Find the PV of non-constant dividends and
horizon value. The total of these PVs =
Today’s estimated stock value.                21
Back to Homer Co’s Valuation: Step 1

D0 = \$2.00, g = 20% or 0.2 for next 3
years

22
Homer Co’s Valuation: Step 2

23
Homer Co’s Valuation: Step 3

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Homer Co’s Valuation: Step 3
Valuing common stock with nonconstant growth

0 r = 16.9% 1             2               3              4
s
...
g = 20%       g = 20%       g = 20%         gc = 10%
D0 = 2.00        2.400         2.880         3.456        3.802
2.053
2.107
2.163
3.802
34.491                          \$
P3                    \$55.10
^                        0.169 - 0.10
40.814    = P0                                                    25
Corporate value model

Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s free
cash flows.
Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
FCF = NOPAT – Net capital investment

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Applying the corporate value model

Find the market value (MV) of the firm, by
finding the PV of the firm’s future FCFs at
the company’s weighted average cost of
capital, WACC.
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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Issues regarding the corporate value
model
 Often preferred to the dividend growth model,
especially when considering number of firms
that don’t pay dividends or when dividends are
hard to forecast.
 Similar to dividend growth model, assumes at
some point free cash flow will grow at a constant
rate.
 Terminal value (TVN) represents value of firm at
the point that growth becomes constant.

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An Example: Advanced Micro Devices (AMD)

• AMD’s debt market value is \$692
million.
• No preferred stock
AMD            • 486 million shares outstanding
• Current free cash flow is \$286
million.

Assume that AMD will experience 21% year 1, 19%
year 2 and 18% FCF growth in year 3 and 11%
constant annual growth thereafter.

AMD’s WACC is approximately 17%.               29
An Example: AMD Projected FCFs(\$millions)

End of Year Growth    Growth     FCF Calculation
Status    Rate (%)

1      Variable      21      \$286(1.21) = \$346.1

2      Variable      19      \$346.1 x (1.19) = \$411.8

3      Variable      18      \$411.8 x (1.18) = \$485.9

4      Constant      11      \$485.9 x (1.11) = \$539.4

Use nonconstant growth to estimate AMD!s
corporate value.                               30
AMD’s FCF Corporate Valuation
(\$millions)

0 WACC       1         2             3              4
=17%                                              ...
gc = 10%
346.1        411.8        485.9        539.4
295.8
300.8
303.4
539.4
5613.0                       \$
TV                  8989.8
3
^                       0.17 - 0.11
6513.0   = Firm Value                                       31
AMD’s Stock Value per share

MV of firm = \$6513 million
MV of debt = \$692 million
MV of equity (stock) = \$6513 - \$692 =
\$5821 million
486 million shares outstanding
P0 = MV of equity/shares = \$5821/486 =
\$11.98

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Stock Market Equilibrium
 In equilibrium, stock prices are stable and
there is no general tendency for people to buy
versus to sell.
 In equilibrium, two conditions hold:
The current market stock price equals its intrinsic
value (P0 = P0).
^
Expected returns must equal required returns.

^   D1
rs     g            rs  rRF  (rM - rRF )b
P0
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How is market equilibrium established?

If price is below intrinsic value …
The current price (P0) is “too low” and
offers a bargain.
Buy orders will be greater than sell
orders.
P0 will be bid up until expected return
equals required return.

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Doh! In equilibrium?

Doh! Doughnuts current stock price is \$30.
Required return = 5% + 8.5%(1.4) =
16.9%
Let’s assume the 2nd analyst is correct
and Doh! Has a constant growth rate of
10% and its current dividend is \$2.
Is Doh! Doughnuts’ current stock price in
equilibrium?
35
Expected Return of Constant Growth
Stocks
 Expected Rate of Return = Expected Dividend
Yield + Expected Capital Gains Yield
 D1/P0 = D0(1+g)/P0 = Expected Dividend Yield
 g = Expected Capital Gains Yield
 From our example, D1=\$2(1.10) = 2.20, P0=\$30,
g = 10% or 0.1
^   D1     \$2.20
rs    g        10%  7.3%  10%  17.3%
P0      \$30

DOH! Doh! Doughnuts                       36
The Effect On the Stock Price
20%
15%
10%
5%
0%
0   0.2   0.4   0.6   0.8   1   1.2   1.4   1.6

 Expected Return needs to fall to the required
return of 16.9%. This means the stock price
must rise to the the equilibrium price which
yields the required return of 16.9%
 New Price = D1/(rs- g)=\$2.20/(.169 - .1)= \$31.88
37
Stock Valuation Summary
Looked at Dividend Discount Model:
Value = PV of future expected dividends.
All else equal:
Higher interest rates yields lower stock prices
(inverse relationship)
Higher growth rate yields higher stock price.
Other Stock Valuation Methods
“Multiples” Method: P/E, P/CF, P/S
For example: Price Estimate = PE Ratio x
expected EPS
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