Chapter 5. Topics Covered. Debt vs. Equity: Debt. Valuing Stocks

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Chad Harmon
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1 Chapter 5 Valuing Stocks Topics Covered Preferred Stock and Common Stock Properties Valuing Preferred Stocks Valuing Common Stocks - the Dividend Discount Model No growth Constant growth Variable growth Valuing the Enterprise (the Firm) Free Cash Flow Approach Debt vs. Equity: Debt Debt securities represent a legally enforceable claim. Debt securities offer fixed or floating cash flows. Bondholders don t have any control over how the company is run.

2 Debt vs. Equity: Equity Common stockholders are residual claimants. No claim to earnings or assets until all senior claims are paid in full High risk, but historically also high return Stockholders have voting rights on important company decisions. Debt and equity have substantially different marginal benefits and marginal costs. Rights of Common Stockholders Common stockholders voting rights can be exercised in person or by proxy. Most US corporations have majority voting, with one vote attached to each common share. Cumulative voting gives minority shareholders greater chance of electing one or more directors. Shareholders have no legal rights to receive dividends. 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.

3 Preferred Stock Valuation Promises to pay the same dividend year after year forever, never matures. A perpetuity. PS = D P /r P Expected Return: r = D P /PS Example: GM preferred stock has a $5 par value with a 8% dividend yield. What price would you pay if your required return is 7%? The Financial Pages: Common & Preferred Stocks Yld Vol Sym Div % PE s Close GM. 6.5 n/a GM pfg For GM pfg (preferred stock) Dividend: $.8 on $5 par value = 9.% dividend rate. Expected return:.8 / 7. = 8.4%. 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 3

4 Valuing Common Stocks: Expected Return Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR). Expected Return = r = Div P P P Expected Return The formula can be broken into two parts. Dividend Yield Capital Gains Yield Div Expected Return = r = P P P P Example Lisa Simpson buys Grease Gougers stock for $5 per share. In a year she expects the receive $ in dividends and the price of the stock to be $8. What is Lisa s expected return? 4

5 Stock Valuation Stock Value = PV of Future Expected Dividends P = D D... 3 ( r ) ( r) ( r) ( r) D 3 D 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 Stock Valuation Case Study: Doh! Doughnuts We have found the following information for Doh! Doughnuts: current dividend = $.5 = Div Required return = 5% = r 5

6 Analysts Estimates for Doh! Doughnuts NEDFlanders predicts a constant annual growth rate in dividends and earnings of zero percent (%) Barton Kruston Simpson predicts a constant annual growth rate in dividends and earnings of 8 percent (8%). Homer Co. expects a dramatic growth phase of % annually for each of the next 3 years followed by a constant 8% growth rate in year 4 and beyond. Our Task: Valuation Estimates What should be each analyst s estimated value of Doh! Doughnuts? 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. Perpetuity = P = Div or EPS r r Assumes all earnings are paid to shareholders. 6

7 Ned Flanders Valuation Div = $.5, r = 5% or.5, g = % Constant Growth Valuation Model Assumes dividends will grow at a constant rate (g) that is less than the required return (r) If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next year s dividend as D : D D ( g ) P = = r - g r - g Commonly called the Gordon growth model Barton Kruston Simpson s Valuation Div = $.5, g = 8%, r = 5% 7

8 Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield Expected Capital Gains Yield Div /P = Expected Dividend Yield g = Expected Capital Gains Yield R = Div /P g = Div (g)/p g Example Burns International s stock sells for $8 and their expected dividend is $4. The market expects a return of 4%. What constant growth rate is the market expecting for Burns International? Homer Co. Valuation Variable (non-constant) growth Years -3 expect % growth After year 3: constant growth of 8% 8

9 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 (g n ). g g g 3 3 g n 4 g n 5 g n... D D D 3 Non-constant Growth Period Constant Growth 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. Find the PV of non-constant dividends and constant growth price. The total of these PVs = Today s estimated stock value. Back to Homer Co s Valuation: Step 9

10 Homer Co s Valuation: Step Homer Co s Valuation: Step 3 Valuing the Enterprise: Free Cash Flow Valuation Discount estimates of free cash flow that the firm will generate in the future. Use weighted average cost of capital (WACC) to discount the free cash flows. WACC: after-tax weighted average required return on all types of securities that firm issues. We have an estimate of total value of the firm. How can we use this to value the firm s shares?

11 Value of firm s shares V S = V F V D -V P V S = value of firm s common shares V F = total enterprise value V D = value of firm s debt V P = value of firm s preferred stock An example... Morton Restaurant Group (MRG) First quarter of, traded in the $ - $5 range We can use the free cash flow approach to estimate the value of MRG shares. An Example: Best Buy BBY BBYs debt market value is $9 million. No preferred stock 48 million shares outstanding Free cash flow is $775 million. Assume that Best Buy will experience 6% FCF growth for the next 3 years and % annual growth thereafter. Best Buy s WACC is approximately 5%. An Example: Best Buy ($millions) End of Year Growth Status 3 4 Historic Fast Fast Fast Stable Growth Rate (%) Given FCF Calculation $775 $775 x (.6) = $899 $899 x (.6) = $,43 $43 x (.6) = $ $ x (.) = $,33 Use variable growth equation to estimate Best Buy s enterprise value.

12 An Example: Best Buy ($millions) FCF V F = ( r ) FCF N N ( r ) r g ( g ) FCF ( g ) FCF ( g ) ( r )... ( r ) N N V F (. 5 ) = $ 78 = = $ 9 $ 899 (. 5,87 3 ) $ 789 $, 43 (. 5 ). 5 $, 33 $ 796. $, (. 5 ) $ 7, 53 3 An Example: Best Buy ($millions) V F = $9,87 V D = $9 V P = $ V S = $987 - $9 - $ = $8,97 Divide total share value by 48 million shares outstanding to obtain per-share value: P $ 8,97 = 48 = $ Common Stock Valuation Other Options Book value Liquidation value P / E multiples The value shown on the balance sheet of the assets of the firm, net of liabilities shown on the balance sheet Actual net amount per share likely to be realized upon liquidation and payment of liabilities Reflects the amount investors will pay for each dollar of earnings per share P / E multiples differ between and within industries. Especially helpful for privately-held firms.

13 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 PE Ratio x expected EPS PV of all expected future cash flows available to stockholders 3

Chapter 6. Topics Covered. Preferred Stock Characteristics

Chapter 6. Topics Covered. Preferred Stock Characteristics Chapter 6 Valuing Stocks Topics Covered referred Stocks and their valuation Valuing Common Stocks Simplifying the Dividend Discount Model No growth Constant growth Non-constant growth Growth Stocks and