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
Facts about common stock

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



                                                  9
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.

                                                 11
Our Task: Valuation Estimates

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%




                                     16
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



                                           17
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%




                                        19
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




                               24
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

                                               26
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).
                                            27
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.

                                                  28
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

                                          32
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
                                                         33
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.

                                                34
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
                                                     38

								
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