Lecture note 3

Valuation of Stocks
 The Dividend Discount Model

• A One-Year Investor
– Potential Cash Flows
• Dividend
• Sale of Stock
– Timeline for One-Year Investor

– Since the cash flows are risky, we must

discount them at the equity cost of capital.
• A One-Year Investor
 Div1 + P1 
P0 =  
 1 + rE 
– If the current stock price were less than this
amount, expect investors to rush in and buy it,
driving up the stock’s price.
– If the stock price exceeded this amount,
selling it would cause the stock price to
quickly fall.
 Dividend Yields, Capital Gains,
and Total Returns
Div1 + P1 Div1 P1 − P0
rE = − 1 = +
P0 P0 P0
{ {
Dividend Yield Capital Gain Rate

• Dividend Yield
• Capital Gain
– Capital Gain Rate
• Total Return
– Dividend Yield + Capital Gain Rate
 A Multi-Year Investor

• What is the price if we plan on holding the stock

for two years?

𝐷𝑖𝑣2 + 𝑃2
𝐷𝑖𝑣1 + 𝐷𝑖𝑣1 𝐷𝑖𝑣2 + 𝑃2
1 + 𝑟𝐸
𝑃0 = = +
1 + 𝑟𝐸 1 + 𝑟𝐸 (1 + 𝑟𝐸 )2

𝐷𝑖𝑣2 + 𝑃2
∵ 𝑃1 =
1 + 𝑟𝐸
The Dividend-Discount Model Equation

• What is the price if we plan on holding the stock

for N years?

Div1 DivN PN
P0 = + L + +
1 + rE (1 + rE ) N
(1 + rE ) N

– This is known as the Dividend Discount

Model.
 Div1 Div2 Div3
P0 = + + + L
1 + rE (1 + rE ) 2
(1 + rE ) 3


Divn
= 
n =1 (1 + rE ) n

• The price of any stock is equal to the present

value of the expected future dividends it will pay.
Applying the Discount-Dividend Model

• Constant Dividend Growth

– The simplest forecast for the firm’s future
dividends states that they will grow at a
constant rate, g, forever.
• Constant Dividend Growth Model

Div1 Div1
P0 = rE = + g
rE − g P0

• The value of the firm depends on the current

dividend level, the cost of equity, and the growth
rate.
 Dividends Versus Investment and
Growth
• A Simple Model of Growth
– Dividend Payout Ratio
• Fraction of current earnings paid as
dividends
Earningst
Divt =  Dividend Payout Ratet
Shares Outstandingt
1 4 4 4 2 4 4 43
EPSt

Retention Rate
• Fraction of current earnings that the firm
 Growth rate in earnings
= growth rate in dividends
Dividends
<=> Payout ratio = is constant
Earnings

• Formula for a firm’s growth rate:

g = Retention ratio x
Return on new investment (ROE)
• Proof:
Consider a business whose earnings next year
are expected to be the same as earnings this
year unless new investment is made.
New investment = gross investment
– depreciation
=0
=> physical plant is maintained
=> no growth in earnings
New investment > 0 if some earnings are not
paid out as dividends
=> some earnings are retained

New Investment = Earnings  Retention Rate

Change in Earnings
= New Investment  Return on New Investment
Earnings next year
= Earnings this year
+ Retained earnings x Return on new investment
(Net investment)

(Increase in earnings this year)

 Earnings Growth Rate
Change in Earnings
=
Earnings
= Retention Rate  Return on New Investment

g = Retention Rate  Return on New Investment

The discount rate can be broken into two parts:

Div1 Div1
r= +g Q P0 =
P0 r − g

– The dividend yield

– The growth rate, g (in dividend)
• Profitable Growth
– If a firm wants to increase its share price,
should it cut its dividend and invest more, or
should it cut investment and increase its
dividend?
• The answer will depend on the profitability
of the firm’s investments.
 Changing Growth Rates

• We cannot use the constant dividend growth

model to value a stock if the growth rate is not
constant.
– For example, young firms often have very
high initial earnings growth rates. During this
period of high growth, these firms often retain
100% of their earnings to exploit profitable
investment opportunities. As they mature,
their growth slows. At some point, their
earnings exceed their investment needs and
they begin to pay dividends.
• Although we cannot use the constant dividend
growth model directly when growth is not
constant, we can use the general form of the
model to value a firm by applying the constant
growth model to calculate the future share price
of the stock once the expected growth rate
stabilizes.
 DivN + 1
PN =
rE − g
• Dividend-Discount Model with Constant Long-
Term Growth
Div1 DivN 1  DivN + 1 
P0 = + L + + N  
1 + rE (1 + rE ) N
(1 + rE )  rE − g 
 Limitations of the
Dividend-Discount Model
• There is a tremendous amount of uncertainty
associated with forecasting a firm’s dividend
growth rate and future dividends.
• Small changes in the assumed dividend growth
rate can lead to large changes in the estimated
stock price.
 Total Payout and Free Cash Flow
Valuation Models
Share Repurchase
• When the firm uses excess cash to buy
back its own stock
– Implications for the Dividend-Discount Model
• The more cash the firm uses to repurchase
shares, the less it has available to pay
dividends.
• By repurchasing, the firm decreases the
number of shares outstanding, which
increases its earnings and dividends per
share.
 Total Payout Model

PV (Future Total Dividends and Repurchases)

PV0 =
Shares Outstanding 0

Values all of the firm’s equity, rather than a

single share. You discount total dividends and
share repurchases and use the growth rate of
earnings (rather than earnings per share) when
forecasting the growth of the firm’s total
payouts.
• Expected stock price = $79.26 X 1.085
= $86
• Repurchase = 20% X $860m / $86 = 2m shares
=> shares outstanding = 217m – 2m = 215m
• EPS grows by
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 1.075 × 𝐸𝑃𝑆0 × 217𝑚

𝐸𝑃𝑆1 1.075 × 𝐸𝑃𝑆0 × 217𝑚 1

∴ −1= × −1
𝐸𝑃𝑆0 215𝑚 𝐸𝑃𝑆0
= 8.5%
The Discounted Free Cash Flow Model

• Discounted Free Cash Flow Model

– Determines the value of the firm to all
investors, including both equity and debt
holders
Enterprise Value
= Market Value of Equity + Debt − Cash
– The enterprise value can be interpreted as the
net cost of acquiring the firm’s equity, taking
its cash, paying off all debt, and owning the
unlevered business.
• Valuing the Enterprise

Free Cash Flow

6 4Unlevered
44 7Net4Income
4 48
= EBIT  (1 − c ) + Depreciation
− Capital Expenditures − Increases in Net Working Capital
– Free Cash Flow
• Cash flow available to pay both debt
holders and equity holders
V0 = PV (Future Free Cash Flow of Firm)

– Discounted Free Cash Flow Model

V0 + Cash 0 − Debt 0
P0 =
Shares Outstanding 0
• Implementing the Model
– Since we are discounting cash flows to both
equity holders and debt holders, the free cash
flows should be discounted at the firm’s
weighted average cost of capital, rwacc. If the
firm has no debt, rwacc = rE.
 • Implementing the Model
FCF1 FCF2 FCFN VN
V0 = + + L + +
1 + rwacc (1 + rwacc ) 2
(1 + rwacc ) N
(1 + rwacc ) N

– Often, the terminal value is estimated by

assuming a constant long-run growth rate
gFCF for free cash flows beyond year N, so
that:
FCFN + 1  1 + g FCF 
VN = =    FCFN
rwacc − g FCF  (rwacc − g FCF ) 
• Connection to Capital Budgeting
– The firm’s free cash flow is equal to the sum
of the free cash flows from the firm’s current
and future investments, so we can interpret
the firm’s enterprise value as the total NPV
that the firm will earn from continuing its
existing projects and initiating new ones.
• The NPV of any individual project represents its
contribution to the firm’s enterprise value. To
maximize the firm’s share price, we should accept
projects that have a positive NPV.
A Comparison of Discounted Cash
Flow Models of Stock Valuation
Valuation Based on Comparable Firms

• Method of Comparables (Comps)

– Estimate the value of the firm based on the
value of other, comparable firms or
investments that we expect will generate very
similar cash flows in the future.
 Valuation Multiples

• Valuation Multiple
– A ratio of firm’s value to some measure of the
firm’s scale or cash flow
• The Price-Earnings Ratio
– P/E Ratio
• Share price divided by earnings per share
• Trailing Earnings
– Earnings over the last 12 months
• Trailing P/E
• Forward Earnings
– Expected earnings over the next 12 months
• Forward P/E
 Forward P/E
P0 Div1 / EPS1
= =
EPS1 rE − g
Dividend Payout Rate
=
rE − g
• Firms with high growth rates, and which
generate cash well in excess of their
investment needs so that they can maintain
high payout rates, should have high P/E
multiples.
• Enterprise Value Multiples

V0 FCF1 / EBITDA1
=
EBITDA1 rwacc − g FCF

– This valuation multiple is higher for firms with

high growth rates and low capital
requirements (so that free cash flow is high in
proportion to EBITDA).
• Other Multiples
– Multiple of sales
– Price to book value of equity per share
 Limitations of Multiples

• When valuing a firm using multiples, there is no

clear guidance about how to adjust for
differences in expected future growth rates, risk,
or differences in accounting policies.
• Comparables only provide information regarding
the value of a firm relative to other firms in the
comparison set.
– Using multiples will not help us determine if
an entire industry is overvalued.
 Comparison with Discounted
Cash Flow Methods
• Discounted cash flows methods have the
advantage that they can incorporate specific
information about the firm’s cost of capital or
future growth.
– The discounted cash flow methods have the
potential to be more accurate than the use of
a valuation multiple.
Stock Prices and Multiples for the
Footwear Industry, January 2006
Range of Valuation Methods for KCP Stock Using
Alternative Valuation Methods
 Stock Valuation Techniques:
The Final Word
• No single technique provides a final answer
regarding a stock’s true value. All approaches
require assumptions or forecasts that are too
uncertain to provide a definitive assessment of
the firm’s value.
– Most real-world practitioners use a
combination of these approaches and gain
confidence if the results are consistent across
a variety of methods.