Key Concepts and Skills Chapter 8 Stock Valuation Konan Chan Financial Management, Spring 2016 Understand how stock prices depend on future dividends and dividend growth Be able to compute stock prices using the dividend growth model Understand the features of common and preferred stocks Financial Management Konan Chan 2 Topics Covered Dividend discount model Constant growth dividend discount model Valuing common stocks Income stocks vs. growth stocks Common stock and dividend Preferred stock Dividend Discount Model (DDM) Discount future dividends back to present where T is time horizon for your investment Financial Management Konan Chan 3 Financial Management Konan Chan 4 Dividend Discount Model - example Current forecasts for XYZ Company dividends are $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? Types of DDM How to implement in reality? Stock valuations fall into 3 categories Constant growth rate in dividends Zero growth rate in dividends Supernormal (non-constant) growth rate in dividends Financial Management Konan Chan 5 Financial Management Konan Chan 6
Constant Growth DDM A dividend discount model where dividends are assume to grow at a constant rate forever Also called Gordon Growth Model Given any combination of variables in the equation, you can solve for the unknown variable. Constant Growth DDM D 1 = D 0 (1 + g) D 2 = D 1 (1 + g) = D 0 (1 + g) 2 Using geometric series formula Financial Management Konan Chan 7 Financial Management Konan Chan 8 Constant Growth DDM - 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 Same example If the same stock is selling for $100 in the stock market, what might the market assume about the growth in dividends? The market assumes the dividend will grow at 9% per year, indefinitely. Financial Management Konan Chan 9 Financial Management Konan Chan 10 Estimate Expected Return Given constant growth dividend discount model, we can estimate stock return Expected return = expected dividend yield + growth rate Previous example: r = $3/$75 + 8% = 12% Components of Expected Return Expected Return r = total income/ purchase price r = [dividend income + capital gain (or loss)]/price r = expected dividend yield + capital gain yield = D 1 / P 0 + (P 1 P 0 ) / P 0 Financial Management Konan Chan 11 Financial Management Konan Chan 12
Growth in Constant Growth DDM DDM without Growth If we forecast no growth for the stock (i.e., dividends keep constant forever), the stock will become a perpetuity P 1 / P 0 = 1 + g (i.e., the firm will grow constantly) This is exactly the valuation for preferred stocks If firms pay out all earnings as dividends when firms do not grow, then Financial Management Konan Chan 13 Financial Management Konan Chan 14 What if CGDDM Doesn t Apply? Any restriction on constant growth DDM? What does it mean? How to deal with it if this restriction exists? Two-stage or multiple stage of growth Non-constant Growth Model Two stages of growth assume stock has period of non-constant growth in dividend, and then eventually settles into a normal constant growth pattern 3-step Valuation Estimate the dividend during non-constant growth period Estimate 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 Get the present value of the above two values Financial Management Konan Chan 15 Financial Management Konan Chan 16 Supernormal Model - Example The growth rate for firm ABC is expected to be 20% for next two years, and 6% thereafter. The current dividend is $1.60, and the firm s required rate of return is 10%. What s stock worth today? Quiz (two-stage growth model) The growth rate is 20% for the next 4 years, and no growth thereafter. The last dividend was $1.50, and the required rate of return is 18%. What should be the current price? Step 1 g 1 = 20% g 1 = 20% g = 6% D 1 =$1.6(1.2)=$1.92 D 2 =$1.92(1.2)=$2.304 Step 2 Step 3 Financial Management Konan Chan 17 Financial Management Konan Chan 18
Sustainable Growth Rate Payout ratio Fraction of earnings paid out as dividends Plowback (retention) ratio = 1 - payout ratio Fraction of earnings retained by the firm g = return on equity (ROE) * retention ratio Steady rate at which a firm can grow This estimation of growth rate applies to stable firms only Higher or Lower Dividends? The constant growth model suggests to pay higher dividends The higher D 1, the higher current price P 0 How about paying all earnings as dividends? The sustainable growth rate equation suggests that if a firm pays a lower dividend, and reinvest the funds, the stock price MAY increase because future dividends may be higher. Financial Management Konan Chan 19 Financial Management Konan Chan 20 Income Stocks vs. Growth Stocks 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? No growth With growth The difference between these two numbers (75.00-41.67=33.33) is the Present Value of Growth Opportunities (PVGO), which is net present value of a firm s future investments Stock Valuation Using Multiples Another common valuation approach is to multiply a benchmark PE ratio by earnings per share (EPS) to come up with a stock price P t = Benchmark PE ratio * EPS t The benchmark PE ratio is often an industry average or based on a company s own historical values The price-sales ratio and price-book ratio can also be used Financial Management Konan Chan 21 Financial Management Konan Chan 22 Multiples Valuation: Example Suppose a company had earnings per share of $3 over the past year. The industry average PE ratio is 12. Use this information to value this company s stock price. P t = 12 x $3 = $36 per share Common Stock and Dividend Voting right Dividends are not a liability of the firm until a dividend has been declared by the Board Firms cannot go bankrupt for not declaring dividends Dividends and Taxes Dividends are not tax deductible Dividends by individuals are taxed as ordinary income Dividends by corporations can exclude 70% of tax; only 30% will be taxed Financial Management Konan Chan 23 Financial Management Konan Chan 24
Preferred Stock Stated dividend that must be paid before dividends can be paid to common stockholders Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely Most preferred dividends are cumulative any missed preferred dividends have to be paid before common dividends can be paid Preferred stock generally does not carry voting rights Financial Management Konan Chan 25