4. Value of Common Stocks

Question 1

What is “common stock”?

Answer 1

Ownership shares in a publicly held corporation

Question 2

What are the 2 ways in which common stocks are traded?

Answer 2

• Electronic communication networks (ECNs)
  -> A number of computer network tock exchanges that connect traders with each other
• Exchange-Traded Funds (ETFs)
  -> Portfolio of stocks that can be bought or solid in a single trade

Question 3

What is the “book value”?

Answer 3

• Net worth of the firm according to the balance sheet

-> useful to know liquidation value (if company would go bankrupt, what you could expect from it)

Question 4

What is the “dividend”?

Answer 4

Periodic cash distribution from the firm to the shareholders

Question 5

What is the “P/E ratio”?

Answer 5

Price per share divided by earnings per share

Question 6

What is the “Market Value Balance Sheet?

Answer 6

Financial statement that uses market value of assets and liabilities

Question 7

How can we value a stock?

Answer 7

The value of any stock is the present value of its future cash flows.
-> dividends = future cash flow of the firm

Question 8

What is the “expected return”?

Answer 8

“The percentage yield that an investor forecasts from a specific investment over a set period of time.”

Question 9

What is the equation for the expected return?

Answer 9

Question 10

example:
If Fledgling Electronics is selling for $100 per share today, and it is expected to sell for $110 in a year from now, what is the expected return if the dividend one year from now is forecasted to be $5?

Answer 10

Question 11

example:
If Fledgling Electronics share will sell for $110 after a year, and the dividend was $5. The return was 15%. What was the original price?

Answer 11

Question 12

What is “market capitalization”?

Answer 12

Market capitalization rate can be estimated using the perpetuity formula, given minor algebraic MANIPULATION
(also called the cost of equity capital)

Question 13

What is the dividend discount model?

Answer 13

Computation of today’s stock, price which states that share values equals the present value of all expected future dividends

Question 14

What is important about “horizon periods”?

Answer 14

As your horizon recedes, the present value of the future price (PV) declines…

BUT the PV of the stream of dividends (unshaded area) increases. Hence, the total PV (price AND dividends) remains the SAME.

Question 15

What is the market cap rate / expected return equation?

Answer 15

The expected RETURN on a stock investment PLUS the expected growth in dividends. Similar to the capitalization rate.

-> DIV / P0 is also called the dividend yield. So expected return is the dividend yield PLUS the growth in dividends (g)

Question 16

How do you find the dividend growth rate (g)?

Answer 16

This is the hard part. One way is to ask analysts. Most wont be able to predict it over the long run, but they can offer a 5 year estimation for the dividend growth rate.

Question 17

What is the one way to calculate dividend growth rate (g)?

Answer 17

ROE * plowback ratio = g

Question 18

What is dangerous about calculating “g” yourself?

Answer 18

the value of g can then be plugged into the expected return formula to estimate r
-> WATCH OUT, estimating r over one stock is dangerous. Should try estimating it across many of the same risk/ industry stocks. But even that may NOT work…

Another thing to watch out for is applying this formula to stocks with high growth rates.
The DCF formula estimates these rates can be sustained indefinitely, but this is unrealistic.

Question 19

What is the equation for valuing non-constant growth?

Answer 19

This model accommodates any pattern of year-by-year horizon period t = H.
Then we may be able to use the capture PV of dividends from periods H + 1 onward.

Question 20

Phoenix produces dividends in 3 consecutive years of 0, .31 and .65. The dividend in y4 grows to .667 and should grow in perpetuity at 4%. At a 10% discount rate, what is the price of the stock?

Answer 20

-> 1 /(1 + 0.1)^3 == Discount Factor
-> By multiplying the horizon price by the discount factor, we calculate the present value of the stock’s future price, allowing us to include it in the present value of the stock overall.

Question 21

What is the difference in goal between income and growth stocks?

Answer 21

• growth stock -> goal of capital gain
• income stock -> goal for near-term earnings and dividends

Question 22

What happens if a firm elects to pay a lower dividend and reinvest their funds?

Answer 22

the stock price may increase because future dividends may be higher

Question 23

What is “payout ratio”?

Answer 23

-> Ratio of dividends to earnings per share

Question 24

What is “plowback ratio”?

Answer 24

-> Fraction of earnings retained by the firm

Question 25

What would the price of the stock be without growth, and with growth?

Answer 25

-> If the company did NOT plow back some earnings, the stock price would remain at $55.56.

-> With the plowback, the price rose to $100.

Question 26

What is the difference between the price of a stock with growth, and without growth?

Answer 26

The difference between these two numbers is called the present value of growth opportunities (PVGO)
-> “Net present value of a firm’s future investments”

Question 27

What is the PVGO in this example?

Answer 27

$44.44

Question 28

How can we value a business or project?

Answer 28

The value of a business or project is usually computed as the discounted value of free cash flows out to a valuation horizon (H).

Question 29

What is the equation to value a business or project?

Answer 29

-> same as DCF, except now you use free cash flows instead of dividends

Question 30

How come the equation for valuing a business or project is the same as the equation to value shares (DCF)?

Answer 30

DCF models work just as well for entire business as for shares of common stock. It doesn’t matter whether you forecast dividends per share or the total free cash flows of a business. Value today always equals future cash flows discounted at the opportunity cost of capital.