Finance 331- Chapter 9

Different approaches for estimating the intrinsic value of a common stock

discounted dividend model corporate valuation model P/E multiple approach

The corporate valuation model

is an alternative model used to value a firm, especially one that does not pay dividends or is privately held. This model calculates the firm's free cash flows and then finds their present values at the firms weighted average cost of capital to determine a firms value.

If rRF= 3%, rM= 8% and b=1.2 what is the required rate of return on the firms stock?

rs=rRF+ (rM-rRF)b =3% + (8%-3%)1.2 =9%

Equilibrium

where expected return=required return intrinsic value=market price

constant growth model or Gordon model, named after Myron J. Gordon

who developed and popularized it. There are several conditions that must exist before this equation can be used. First, the required rate of return, rs, must be greater than the long-run growth rate, g. Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almost never holds for start-up firms but it does exist for many mature companies.

Corporate Valuation Model

-also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firms free cash flows -remember free cash flow is the firms after-tax operating income less the net capital investment

Firm multiple method

-analysts often use the following multiples to value stocks: P/E, P/CF, P/Sales -Example: based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.

Issues regarding the corporate valuation model

-often preferred to the discounted dividend model, especially when considering number of firms that dont pay dividends or when dividends are hard to forecast -similar to discounted dividend model, assumes at some point free cash flow will grow at a constant rate -Horizon value (HVN) represents value of firm at the point that growth becomes constant

Intrinsic value and stock price

-outside investors, corporate insiders and analysts use a variety of approaches to estimate a stocks intrinsic value (Po) -In equilibrium we assume that a stocks 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)

Facts about common stock

-represents ownership -ownership implies control -stockholders elect directors -directors elect management -mangements goal: maximize the stock price

Supernormal Growth: What if g=30% for 1 year, 20% for 1 year, and 10% for 1 year before achieving long-run growth of 4%?

Can no longer use just the constant growth model to find stock value however the growth does become constant after 3 years

What happens if g>rs?

If g>rs the constant growth formula leads to a negative stock price, which does not make sense. -the constant growth model can be used only if : rs >g g is expected to be constant forever

If preferred stock with an annual dividend of $5 sells for $100 what is the preferred stocks expected return?

Vp=D/rp $100=$5/rp rp=$5/$100=.05=5%

Preferred stock is

a hybrid--it is similar to a bond in some respects and to common stock in others hybrid nature becomes apparent when we try to classify preferred stock in relation to bonds and common stock Vp= the value of the preferred stock Dp=the preferred dividend rp=the required rate of return

Constant Growth Stock

a stock whose dividends are expected to grow forever at a constant rate, g.

Common stock dividends

are not specified by contract they depend on the firms earnings. Two models are used to estimate a stocks intrinsic value: the discounted dividend model and the corporate valuation model.

The discounted dividend

model values a common stock as the present value of its expected future cash flows at the firms required rate of return on equity. Variations of this model are used to value constant growth stocks, zero growth stocks, and nonconstant growth stocks

The value of a share of common stock depends on

the cash flows it is expected to provide and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price.

There are actually two differences between the discounted dividend and corporate valuation models:

the expected cash flow stream and the discount rate used in the models are different. The discounted dividend model calculates the firm's stock price as the present value of the expected future dividends at the firm's required rate of return on equity, while the corporate valuation model calculates the firm's stock price as the present value of the expected free cash flows at the firm's weighted average cost of equity.

Common stock represents

the ownership position in a firm and is valued as the present value of its expected future dividend stream.

The value of a stock can be calculated as

the present value of an infinite stream of dividends

Market equilibrium occurs when

the stocks price is equal to its intrinsic value. If the stock market is reasonably efficient, differences between the stock price and intrinsic value should not be very large and they should not persist for very long.

When investing in common stocks, an investors goal is

to purchase stocks that are undervalued (the price is below the stocks intrinsic value) and avoid stocks that are overvalued.

Discounted Dividend Model

value of a stock is the present value of the future dividends expected to be generated by the stock