Financial Management

Lecture 5: Stock Valuation

Tak-Yuen Wong

Department of Quantitative Finance

National Tsing Hua University
Investing in Stocks

▶ A share of stock represents ownership in a firm; it grants the shareholder

certain rights
▶ Cash-flow rights (residual claimant): shareholders have a claim on all
assets and income left over after all other climants have been paid
▶ Voting rights: shareholders can vote for directors and on certain
issues, such as amendments to the corporate charter and whether
new shares should be issued
▶ Limited liability: shareholders are not liable for corporate’s debts
▶ Cash flows of a stock are uncertain in both magnitude and timing
▶ Cash dividends: cash payments made directly to stockholders,
usually each quarter
▶ Stock dividends: an increase in the amount of shares of a company
with the new shares being given to shareholders
▶ Share repurchases: maturing firms may buy back shares
▶ Liquidating dividends: pro-rata profits from selling the company off
The Dividend Discount Model

▶ A stock pays out a sequence of dividends Dn over time, and the expected
dividends are E(Dn )
▶ The dividend discount model (DDM) states that the stock price is the
present value of expected future dividends
∞
E(D1 ) E(D2 ) E(Dn )
P0 = + 2
+ ... = ∑ n
1 + rE (1 + rE ) n=1 (1 + rE )

where rE is a risk-adjusted discount rate,

rE = "risk-free rate" + "risk premium"

▶ Questions: Can dividends be negative? What happens to the price if a

stock never pays dividend in the past?
Application: Microsoft Corp. (1)

▶ Why did the stock price rise so fast in the 90s?

▶ What dividend policy did Microsoft adopt during that period of time?
Application: Microsoft Corp. (2)

▶ Microsoft started paying dividends in Q4 2004 and gradually increases dividends

over time
Source: https://www.microsoft.com/en-us/Investor/dividends-and-stock-history.aspx
The Gordon Growth Model

▶ Many firms strive to increase their dividends at a constant rate each year.
To model this situation, assume for every period

E(Dn ) =E(D1 ) × (1 + g)n−1

where g is the growth rate of dividends. Then, the DDM price becomes
∞
E(Dn ) E(D1 )
P0 = ∑ n
=
n=1 (1 + rE ) rE − g

▶ Further assume the expected dividend in the next period being

proportional to the most recent dividend D0 in that E(D1 ) = D0 × (1 + g),

E(D1 ) D0 × (1 + g)
P0 = = , rE > g
rE − g rE − g

▶ The pricing formula is known as the Gordon Growth Model

The Gordon Growth Model: Insights (1)

▶ The Gordon Growth Model:

E(D1 ) D0 × (1 + g)
P0 = = , rE > g
rE − g rE − g

1. Firms that pay larger dividends have a higher stock price

2. High growth firms have a higher stock price
▶ Example 1: Dividends are expected to grow at 6% per year and the
current dividend is $1 per share. Given an expected return of 20%, what
should the current stock price be?
1 × 1.06
P0 = = $7.57
0.20 − 0.06
The Gordon Growth Model: Insights (2)

▶ The expected return of holding the stock is

E(D1 )
rE = + g
P0 capital gains rate
dividend yield rate

▶ So, the expected capital gain rate E(P1 )−P0

P0 equals the growth rate of
dividends g
▶ Example 1 (cont.): the decomposition of the expected return is
1 × 1.06
20% = + 6%
7.57
=14% + 6%
DDM with Multiple Growth Stages

▶ In practice, the growth rate is not constant

▶ Growth stage: rapidly expanding sales, high profit margins, high
growth in earnings, many new investment opportunities, low dividend
payout ratio
▶ Transition stage: competition drives lower growth rate and profit
margins, fewer investment opportunities
▶ Mature stage: earnings growths, profit margins, and payout ratio
stabilize for the remaining life of the firm
▶ Example 2 (Two-stage growth): A company pays a current dividend
D0 = $1 and has an expected return rE = 20%. It grows at 6% for the
first 3 years and then the growth rate drops to 2% thereafter. What
should its current price be
3
1 × (1.06)n 1 1 × (1.06)3 × 1.02
P0 = ∑ n
+ 3
= $6.26
n=1 1.20 1.2 0.20 − 0.02
mature stage
growth stage
Using DDM with Growth

An approach to estimating long-run growth rate

▶ Idea: cash spent on investment cannot be used to pay dividends
▶ Earnings per share (EPS): EPSt = Earningst
Shares Outstandingt
▶ Payout ratio= Dividend Per Share
Earnings Per Share
▶ Retention (plowback) ratio= 1 − payout ratio;
▶ Or retained earnings/total earnings
Since earnings can be spent on (1) Investment; (2) Dividends

Earnings growth rate = Plowback ratio × Invest. rate of return

▶ In practice, return from investment can be estimated by return on equity:

Earnings
ROE =
Book Value of Equity
▶ When the firm’s payout ratio is the same in each year

Dividend growth rate g = Earnings growth rate

Using DDM with Growth (1)

Example 3: Suppose firm A expects to have earnings per share of $6 in the

coming year. With these expectations of no growth, A’s current stock price is
$60. Rather than reinvest these earnings and grow, the firm plans to pay out
all of its earnings as a dividend.

Suppose A could cut its dividend payout rate to 75% for the foreseeable future
and use the retained earnings to open new stores. The return on its investment
in these stores is expected to be 12%. Assuming stock’s return 10%, what
effect would this new policy have on A’s stock price?
▶ Compare $60 with new stock price
Using DDM with Growth (2)

Example 3: Finding out new stock price.

▶ After dividend cut, payout ratio = 75% ⇒ Plowback ratio = 25%. Invest.
Returns = 12%
▶ Therefore: g = 25% × 12% = 3%;
▶ Under new payout policy, dividend per share = $6 × 0.75% = $4.5
▶ At 10% stock return, new stock price is:

D $4.5
P0 = = = $64.29 > $60
rE − g 10% − 3%

Question: why does the stock price increase?

A Rule of Thumb

Example 3 (Cont.): Suppose now that the return on new investment is 8%

instead of 12%. Everything else equal, what will happen to firm A’s stock
price?
▶ New dividend growth rate g = 25% × 8% = 2%
D $4.5
P0 = = = $56.25
rE − g 10% − 2%
▶ Stock price falls after dividend cut. Why? Think of stock return rE as
“equity cost of capital”: the cost of equity financing
▶ Invest. return = 12% > rE = 10% ⇒ Project net present value
(NPV)>0
▶ Invest. return = 8% < rE = 10% ⇒ Project NPV<0
▶ In general, cutting the firm’s dividend to increase investment will raise the
stock price if and only if the new investments have a positive NPV.
Business Valuation and Discounted Free Cash Flows

▶ DDM: Dividend ⇒ Stock Price

▶ Discounted Free Cash Flows (DFCF) model: FCF ⇒ Business Value
⇒Stock Price
▶ Free Cash Flows (FCF): All cash flows available to investors (debt and
equity) after the firm pays all the necessary taxes, operation costs, and
investment costs.

FCF=EBIT×(1-τc )−Net Invest.−∆NWC

▶ EBIT: Earnings before Interest and Taxes

▶ τc : Corporate Tax Rate
▶ Net Invest. = New Investment - Depreciation
▶ ∆NWC: Change in Net Working Capital (short-term operation
expenses)
▶ Estimate FCF, compute its present value: V0 = PV (Future FCF)
Business Valuation and Discounted Free Cash Flows

▶ Implementation: assume a mature firm’s FCF grows at a constant rate g

after time T , forecast the FCF up to some time T

FCF1 FCF2 FCFT + VT FCFT +1

V0 = + + ... + and VT =
1 + rwacc (1 + rwacc )2 (1 + rwacc )T rwacc − g

where VT = terminal value

▶ Note: the interest rate is rwacc (wacc = Weighted Average Cost of
Capital); it reflects the cost of both debt and equity capital
▶ PV(FCF) approximates the enterprise value of a firm, which is the total
value of its underlying business operations:
▶ Accounting relation:
Enterprise Value=Market Value of Equity + Debt − Cash

▶ Therefore, stock price is P0 = V0 +Cash0 −Debt0

Share Outstanding0
DFCF Model: Example

Example 4: KCP had sales of $518 million in 2005. The expected sales growth
in 2006 is 9%, but that growth rate slows down by 1% per year until 2011.
After that, the free cash flow grows at a long-run rate of 4% per year.
▶ Based on the past records, EBIT is expected to be 9% of sales, increases
in NWC and net invest. are 10% and 8% of any increase in sales
respectively.
▶ Also, KCP has $100 million cash, $3 million in debt, and 21 million shares
outstanding.
▶ Suppose the tax rate is 37%, and rwacc = 11%
What is your estimate of the value of KCP’s stock in early 2006?
DFCF Model: Example

Example 4 (Cont.):

Year 05 06 07 08 09 10 11

Sales 518 564.6 609.8 652.5 691.6 726.2 755.3

Growth (slow down 1% per yr) 9% 8% 7% 6% 5% 4%
EBIT(9% of sales) 50.8 54.9 58.7 62.2 65.4 68.0
(-): Tax (37%) (18.8) (20.3) (21.7) (23.0) (24.2) (25.1)
(-): Net Invest.(8% of ∆Sales) (3.7) (3.6) (3.4) (3.1) (2.8) (2.3)
(-): ∆NWC(10% of ∆Sales) (4.7) (4.5) (4.3) (3.9) (3.5) (2.9)

Free Cash Flows 23.6 26.4 29.3 32.2 35.0 37.6

▶ The terminal date is T = 2011

DFCF Model: Example

Example 4 (Cont.):

Year 05 06 07 08 09 10 11

Free Cash Flows 23.6 26.4 29.3 32.2 35.0 37.6

1.04
▶ Terminal value: V2011 = 0.11−0.04 × 37.6 = $558.6m
▶ KCP’s current enterprise value is the present value of its free cash flows
plus the terminal enterprise value
23.6 26.4 29.3 32.2 35.0 37.6 + 558.6
V0 = + + + + + = $424.8m
1.11 1.112 1.113 1.114 1.115 1.116
▶ The stock price is then
424.8 + 100 − 3
P0 = =$24.85
21
Efficient Market in Finance

▶ Efficient Market Hypothesis (EMH): observed stock prices already

reflect all available information fully and correctly
▶ Some market participants have favorable information about a firm
▶ They rush to trade the stocks of the firm
▶ Stock price will be bid up
▶ Hence the increase in stock price reflects the information
▶ Any predictable information will be incorporated into the stock prices
▶ “Active” portfolio management does not add values: no one can beat the
market
The Challenger Disaster

The Challenger Space Shuttle explodes on Jan 28th, 1986, at 11:39am, 73

seconds after it lift-offed

▶ 11:47 am: “Space Shuttle explodes”

▶ 12:17pm: “Lockheed Has No Immediate Comment”
▶ 12:52pm: “Rockwell Intl Has No Comment”
The Reagan Gov’t Launched an Investigation...
The Market Reaction on Jan 28th

Source: Maloney and Mulherin. “The complexity of price discovery in an efficient

market: the stock market reaction to the Challenger crash” JCF, 2003
6 Months after the investigation

▶ The commission determined that the O-rings, built by Morton-Thiokol, is

responsible of the crash
▶ The market seems super efficient