Finance Ch 9
Issues Regarding the Corporate Valuation Model
Often preferred to the discounted dividend model, especially when considering number of firms that don't 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
P0
Constant Growth Stock
A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0(1 + g)1 D2 = D0(1 + g)2 Dt = D0(1 + g)t If g is constant, the discounted dividend formula converges to: P0=D1/(r-g)
Corporate 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. FCF=[EBIT(1-T)+Depr. and amort]-[Capital expenditure+averageNOWC]
Firm Multiples 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.
Supernormal Growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
Can no longer use just the constant growth model to find stock value. However, the growth does become constant after 3 years.
Different Approaches for Estimating the Intrinsic Value of a Common Stock
Discounted dividend model Corporate valuation model P/E multiple approach
Find Expected Dividend Yield, Capital Gains Yield, and Total Return During First Year
Dividend yield = D1/P0 = $2.12/$30.29 = 7.0% Capital gains yield = (P1 - P0)/P0 = ($32.10 - $30.29)/$30.29 = 6.0% Total return (rs) = Dividend yield + Capital gains yield = 7.0% + 6.0% = 13.0%
Applying the Corporate Valuation Model
Find the market value (MV) of the firm, by finding the PV of the firm's future FCFs. 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).
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 only be used if: rs > g. g is expected to be constant forever.
Use the SML to Calculate the Required Rate of Return (rs)
If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firm's stock? rs = rRF + (rM - rRF)b = 7% + (12% - 7%)1.2 = 13%
Market Equilibrium
Intrinsic value=stock price
Facts about Common Stock
Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management's goal: Maximize the stock price
What would the expected price today be, if g = 0?
The dividend stream would be a perpetuity. p0=PMT/r=$2.00/.13=15.38
What is the firm's intrinsic value per share?
The firm has $40 million total in debt and preferred stock and has 10 million shares of stock. MV of equity=MV of firm-MV of debt and preferred 416.94-40=376.94 million Value per share=MV of equity/# of shares 376.94/10=37.69
Discounted Dividend Model
Value of a stock is the present value of the future dividends expected to be generated by the stock. P0=D1/(1+rs)^1 + D2/(1+rs)^2 +... Dinfinity/(1+rs)^infinity
If the stock was expected to have negative growth (g = -6%), 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.
During nonconstant growth,
dividend yield and capital gains yield are not constant, and capital gains yield ≠ g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.