?The McGraw-Hill Companies,Inc.,2001
5- 1
Irwin/McGraw-Hill
Chapter 5Fundamentals of Corporate FinanceThird Edition
Valuing Stocks
Brealey Myers Marcus
slides by Matthew Will
?The McGraw-Hill Companies,Inc.,2001
5- 2
Irwin/McGraw-Hill
Topics Covered
?Stocks and the Stock Market
?Book Values,Liquidation Values and
Market Values
?Valuing Common Stocks
?Simplifying the Dividend Discount Model
?Growth Stocks and Income Stocks
?The McGraw-Hill Companies,Inc.,2001
5- 3
Irwin/McGraw-Hill
Stocks & Stock Market
Primary Market - Place where the sale of new stock
first occurs.
Initial Public Offering (IPO) - First offering of stock
to the general public.
Seasoned Issue - Sale of new shares by a firm that
has already been through an IPO
?The McGraw-Hill Companies,Inc.,2001
5- 4
Irwin/McGraw-Hill
Stocks & Stock Market
Common Stock - Ownership shares in a
publicly held corporation.
Secondary Market - market in which already
issued securities are traded by investors.
Dividend - Periodic cash distribution from the
firm to the shareholders.
P/E Ratio - Price per share divided by
earnings per share.
?The McGraw-Hill Companies,Inc.,2001
5- 5
Irwin/McGraw-Hill
Stocks & Stock Market
5 7 7 7, 6
4 4 8 1, 7
1 9 8 9, 5
1 4 1 4, 1
8 9 6, 1
1 0 6 7, 7
1 3 0 8, 6
5 7 0, 5
222
3 0 5, 2
1 4 3, 2
0
1000
2000
3000
4000
5000
6000
199
7
T
r
ad
i
n
g
Val
u
e
($b
i
l
)
N
Y
S
E
N
a
s
d
a
q
L
o
n
d
o
n
P
a
r
i
s
T
o
k
y
o
G
e
r
m
a
n
T
a
i
w
a
n
Z
u
r
i
c
h
O
s
a
k
a
T
o
r
o
n
t
o
A
m
e
x
Sto ck M ar ket
?The McGraw-Hill Companies,Inc.,2001
5- 6
Irwin/McGraw-Hill
Stocks & Stock Market
Book Value - Net worth of the firm according
to the balance sheet.
Liquidation Value - Net proceeds that would
be realized by selling the firm’s assets and
paying off its creditors.
Market Value Balance Sheet - Financial
statement that uses market value of assets
and liabilities.
?The McGraw-Hill Companies,Inc.,2001
5- 7
Irwin/McGraw-Hill
Valuing Common Stocks
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).
E x p e c t e d R e t u r n ? ?
? ?
r
D i v P P
P
1 1 0
0
?The McGraw-Hill Companies,Inc.,2001
5- 8
Irwin/McGraw-Hill
Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
E x p ec t ed R et u rn ? ? ?
?
r
D i v
P
P P
P
1
0
1 0
0
?The McGraw-Hill Companies,Inc.,2001
5- 9
Irwin/McGraw-Hill
Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equals the
present value of all expected future dividends.
H - Time horizon for your investment.
P
D i v
r
D i v
r
D i v P
r
H H
H0
1
1
2
21 1 1? ? ? ? ? ?
?
?( ) ( )
.,,
( )
?The McGraw-Hill Companies,Inc.,2001
5- 10
Irwin/McGraw-Hill
Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay
dividends of $3,$3.24,and $3.50 over the next
three years,respectively,At the end of three years
you anticipate selling your stock at a market price
of $94.48,What is the price of the stock given a
12% expected return?
?The McGraw-Hill Companies,Inc.,2001
5- 11
Irwin/McGraw-Hill
Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay dividends of $3,$3.24,
and $3.50 over the next three years,respectively,At the end of three
years you anticipate selling your stock at a market price of $94.48,
What is the price of the stock given a 12% expected return?PV
PV
?
?
?
?
?
?
?
?
3 00
1 12
3 24
1 12
3 50 94 48
1 12
00
1 2 3
.
(, )
.
(, )
.,
(, )
$75,
?The McGraw-Hill Companies,Inc.,2001
5- 12
Irwin/McGraw-Hill
Valuing Common Stocks
If we forecast no growth,and plan to hold out
stock indefinitely,we will then value the stock as
a PERPETUITY.
P er p et u i t y P D i v
r
or EPS
r
? ?0 1 1
Assumes all earnings are
paid to shareholders.
?The McGraw-Hill Companies,Inc.,2001
5- 13
Irwin/McGraw-Hill
Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a
constant rate (Gordon Growth Model).
Given any combination of variables in the
equation,you can solve for the unknown variable,
P
D i v
r g0
1?
?
?The McGraw-Hill Companies,Inc.,2001
5- 14
Irwin/McGraw-Hill
Valuing Common Stocks
Example
What is the value of a stock that expects to pay a
$3.00 dividend next year,and then increase the
dividend at a rate of 8% per year,indefinitely?
Assume a 12% expected return.
P
D i v
r g0
1 00
12 08
00?
?
?
?
?
$3,
.,
$75,
?The McGraw-Hill Companies,Inc.,2001
5- 15
Irwin/McGraw-Hill
Valuing Common Stocks
Example- continued
If the same stock is selling for $100 in the stock
market,what might the market be assuming about
the growth in dividends?
$100
$3,
.
.
?
?
?
00
12
09
g
g
Answer
The market is
assuming the dividend
will grow at 9% per
year,indefinitely.
?The McGraw-Hill Companies,Inc.,2001
5- 16
Irwin/McGraw-Hill
Valuing Common Stocks
?If a firm elects to pay a lower dividend,and
reinvest the funds,the stock price may increase
because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as
dividends
Plowback Ratio - Fraction of earnings retained by
the firm.
?The McGraw-Hill Companies,Inc.,2001
5- 17
Irwin/McGraw-Hill
Valuing Common Stocks
Growth can be derived from applying the
return on equity to the percentage of
earnings plowed back into operations.
g = return on equity X plowback ratio
?The McGraw-Hill Companies,Inc.,2001
5- 18
Irwin/McGraw-Hill
Valuing Common Stocks
Example
Our company forecasts to pay a $5.00
dividend next year,which represents
100% of its earnings,This will
provide investors with a 12%
expected return,Instead,we decide to
plow back 40% of the earnings at the
firm’s current return on equity of
20%,What is the value of the stock
before and after the plowback
decision?
?The McGraw-Hill Companies,Inc.,2001
5- 19
Irwin/McGraw-Hill
Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year,which
represents 100% of its earnings,This will provide investors with a
12% expected return,Instead,we decide to blow back 40% of the
earnings at the firm’s current return on equity of 20%,What is the
value of the stock before and after the plowback decision?
P 0 512 67? ?,$41,
No Growth With Growthg
P
? ? ?
?
?
?
.,,
.,
$75,
20 40 08
3
12 08
000
?The McGraw-Hill Companies,Inc.,2001
5- 20
Irwin/McGraw-Hill
Valuing Common Stocks
Example - continued
If the company did not plowback some earnings,
the stock price would remain at $41.67,With the
plowback,the price rose to $75.00,
The difference between these two numbers (75.00-
41.67=33.33) is called the Present Value of
Growth Opportunities (PVGO).
?The McGraw-Hill Companies,Inc.,2001
5- 21
Irwin/McGraw-Hill
Valuing Common Stocks
Present Value of Growth Opportunities
(PVGO) - Net present value of a firm’s
future investments.
Sustainable Growth Rate - Steady rate at
which a firm can grow,plowback ratio X
return on equity,
?The McGraw-Hill Companies,Inc.,2001
5- 22
Irwin/McGraw-Hill
Web Resources
www.ganesha.org/invest/index.html
www.nasdaq.com
www.nyse.com
www.fool.com/School/HowtoValueStocks.htm
www.zacks.com
Investools.com
www.morningstar.net
www.brill.com
Click to access web sites
Internet connection required