Fin620 Ch7

multisage valuation model

A multistage model is used when the growth rate is nonconstant for several years before becoming constant. In this case, the constant growth model is applied at the end of the forecast horizon when the growth rate has become constant. The total present value of cash flows is the present value of all cash flows in the forecast periods plus the present value of the horizon value:

A bond that pays interest forever and has no maturity date is a perpetual bond, also called a perpetuity or a consol. In what respect is a perpetual bond similar to (1) a no-growth common stock and (2) a share of preferred stock?

A perpetual bond is similar to a no-growth stock and to a share of preferred stock in the following ways: 1. All three derive their values from a series of cash inflows--coupon payments from the perpetual bond, and dividends from both types of stock. 2. All three are assumed to have indefinite lives with no maturity value (M) for the perpetual bond and no capital gains yield for the stocks.

Constant Growth Stock

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

Corporation Valuation 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

classified stock

Classified stock is sometimes created by a firm to meet special needs and circumstances. Generally, when special classifications of stock are used, one type is designated "Class A", another as "Class B", and so on. Class A might be entitled to receive dividends before dividends can be paid on Class B stock. Class B might have the exclusive right to vote.

constant growth model

Constant growth occurs when a firm's earnings, dividends, and free cash flows grow at some constant long-term rate. In this situation, the constant growth model can be used to estimate the present value of the growing cash flows or dividends.

founder's shares

Founders' shares are stock owned by the firm's founders that have sole voting rights but restricted dividends for a specified number of years.

The Free Cash Flow Valuation Model: FCF and WACC

Free cash flow (FCF) is: The cash flow available for distribution to all of a company's investors. Generated by a company's operations. The weighted average cost of capital (WACC) is: The overall rate of return required by all of the company's investors. Used for all companies (paying dividends or not, public/private, divisions, mergers and acquisitions)

proxy fight

If earnings are poor and stockholders are dissatisfied, an outside group may solicit the proxies in an effort to overthrow management and take control of the business

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.

preferred stock

Preferred stock is a hybrid--it is similar to bonds in some respects and to common stock in other respects. Preferred dividends are similar to interest payments on bonds in that they are fixed in amount and generally must be paid before common stock dividends can be paid. If the preferred dividend is not earned, the directors can omit it without throwing the company into bankruptcy. So, although preferred stock has a fixed payment like bonds, a failure to make this payment will not lead to bankruptcy. Most preferred stocks entitle their owners to regular fixed dividend payments.

market price

The market price is the price at which an asset can be sold.

capital gains yield

The capital gains yield results from changing prices and is calculated as (P1 - P0)/P0, where P0 is the beginning-of-period price and P1 is the end-of-period price. For a constant growth stock, the capital gains yield is g, the constant growth rate

Free Cash Flow (FCF)

The cash flow actually available for distribution to all investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations. Defined as net operating profit after taxes (NOPAT) minus the investment in total net operating capital

dividend yields

The dividend yield on a stock can be defined as either the end-of-period dividend divided by the beginning-of-period price, or the ratio of the current dividend to the current price. Valuation formulas use the former definition.

expected rate of return

The expected rate of return, denoted by ^rs, is the rate of return expected on a stockn given its current price and expected future cash flows. If the stock is in equilibrium, the required rate of return will equal the expected rate of return.

expected total return

The expected total return, or expected rate of return, is the expected capital gains yield plus the expected dividend yield on a stock. The expected total return on a bond is the yield to maturity.

Explain how to use the free cash flow valuation model to find the price per share of common equity

The first step is to find the value of operations by discounting all expected future free cash flows at the weighted average cost of capital. The second step is to find the total corporate value by summing the value of operations, the value of nonoperating assets, and the value of growth options. The third step is to find the value of equity by subtracting the value of debt and preferred stock from the total value of the corporation. The last step is to divide the value of equity by the number of shares of common stock.

free cash flow valuation model

The free cash flow model defines the total value of a company as the value of operations plus the value of nonoperating assets.

horizon value

The horizon value is the value all cash flows beyond the horizon date when discounted back to the horizon date. When applied to free cash flows, the horizon value is the value of operations at the end of the explicit forecast period. It is equal to the present value of all free cash flows beyond the forecast period, discounted back to the end of the forecast period at the weighted average cost of capital. Because growth after the horizon is constant, the constant growth model can be applied at the horizon date When applied to dividends, the horizon value is the intrinsic stock price at the end of the explicit forecast period. It is equal to the present value of all dividends beyond the forecast period, discounted back to the end of the forecast period at the required rate of return on stock. Because growth after the horizon is constant, the constant growth model can be applied at the horizon date:

Two investors are evaluating General Electrics stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years and the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for general electics stock. True/False

True. The value of a share of stock is the PV of its expected future dividends. If the two investors expect the same future dividend stream, and they agree on the stock's riskiness, then they should reach similar conclusions as to the stock's value.

Discounted Dividend Model

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

If the stock was expected to have negative growth (g = -4%), would anyone buy the stock, and what is its value?

Yes. Even though the dividends are declining, the stock is still producing cash flows and therefore has positive value.

Dividend Growth Model

formula for the present value of an infinite stream of constantly growing dividends. sometimes called the constant dividend growth model. also called the gordon model (or gordon growth model) due to Myron J Gordon. -constant growth -nonconstant growth

preemptive right

gives the current shareholders the right to purchase any new shares issued in proportion to their current holdings. The preemptive right may or may not be required by state law. When granted, the preemptive right enables current owners to maintain their proportionate share of ownership and control of the business. It also prevents the sale of shares at low prices to new stockholders which would dilute the value of the previously issued shares.

Estimate the value of operations at the horizon year, called the horizon value/terminal value

it is the value of all free cash flows beyond the horizon discounted back to the horizon. In other words, it is how much the operations would be worth if they were sold immediately after receiving the FCF at the horizon date.

Nonoperating assets

nonoperating assets include investments in marketable securities and noncontrolling interests in the stock of other companies, and other financial securities

Free Cash Flow Model

stock valuation method used for firms that do not pay dividends AKA corporate valuation model -constant growth -nonconstant growth

proxy

A proxy is a document giving one person the authority to act for another, typically the power to vote shares of common stock.

horizon date

The horizon date is the last year in a cash flow forecast. Cash flows may grow unevenly during the forecast period, but are assumed to grow at a constant rate for all periods after the horizon date.

preferred stock valuation

dividend per share / required rate of return

estimated value

is the present value of the expected future cash flows.

Sources of Value

1- value of operations 2-nonoperating assets a-short-term investments and other marketable securities (T-Bills, CDs, etc) b-ownership of noncontrolling interest in other company (holding stocks of other companies) -value of nonoperating assets usually is very close to figure that is reported on balance sheets -total intrinsic value = Value of operations + short-term investments -intrinsic value per share: total intrinsic value divided by # of shares outstanding

Value of Operations (Vop)

The present value of all expected future free cash flows when discounted at the weighted average cost of capital.

actual (realized) rate of return

The realized (actual) rate of return, denoted by ̄rs, is the rate of return that was actually realized at the end of some holding period. Although expected and required rates of return must always be positive, realized rates of return over some periods may be negative.

required rate of return

The required rate of return on common stock, denoted by rs, is the minimum acceptable rate of return considering both its riskiness and the returns available on other investments.

value of operations

The value of operations is the present value of all the future expected free cash flows when discounted at the weighted average cost of capital