5.1. Stock Valuation Flashcards
Common stock…
Represents an ownership position in a Plc.
Shareholders are entitled to claim on any cash flows generated.
Shareholders benefit from limited liability, worst case scenario they will lose the money they have invested.
Dealt with last in case of liquidation (after bondholders).
Capital gains and dividends are two ways investors make money:
- Capital gains occur due to capital growth of the share.
- Dividend payments are made on a per-share basis when corporations wish to distribute earnings.
There is no guarantee of capital gains or dividends.
Trading stocks…
Primary market:
- IPOs and seasoned equity offering.
- This is how the sale of shares is organised to the public.
- Underwritten by investment banks, who pay the issuer and then resell for profit.
Secondary market:
- Issued securities are traded on exchanges, such as the LSE or NYSE.
- Individual investors can exchange stocks with one another.
Expected return…
r = Div1 + (P1 - P0) / P0.
Amex is $149.76. It is expected to reach $184.62 one year from today. It is expected to pay $2.40 in dividends.
Expected return = $2.40+(184.62-149.76)/149.76 = 24.88%.
Dividends and capital gains…
Shareholders expect this, but it is not guaranteed.
If a company doesn’t pay, investors will hope for future dividend payments and ongoing capital growth.
Dividend yield = Div1 / P0.
Capital gains rate = P1-P0 / P0.
Amex is $149.76. It is expected to reach $184.62 one year from today. It is expected to pay $2.40 in dividends. Calculate both above.
Today’s price…
P0 = Div1 + P1 / 1 + r
If Amex is expected to be worth $184.62 in one year, earning an expected rate of return of 24.88%. It is expected to pay $2.40 in dividends, today’s value = $149.76.
If Amex was worth $160, the expected return would be less so investors would rush to buy other shares in another risk class, bringing the price of Amex down.
If Amex was worth $130, the expected return would be more so investors would rush to buy Amex shares, driving the price up.
If Discover, Mastercard and Visa offered a 20% return, Amex may be undervalued. If they offered a 30% return, Amex may be overvalued.
Next years price (three equations, plus a general equation, plus a simplified equation)…
P1 = Div2 + P2 / 1 + r
P2 = Div3 + P3 / 1+ r
P3 = Div4 + P4 / 1 + r
Every share price depends on future cash flow and future price:
PN-1 = DivN + PN / 1 + r
P0 = (Div1 / (1+r)) + (Div2 / (1+r)^2) + (Div3 / (1+r)^3) + (Div4 + P4) / (1+r)^4).
Dividend discount…
States that the present value of a stock is equal to the present value of all expected future dividends.
PN-1 = DivN + PN / 1 + r
Chevron is expected to pay dividends of $10, $11 and $12 over the next three years. The shares are then sold for $190 each. Given a 10% return, what is today’s price:
$169.95.
Dividend discount with infinity…
As stocks do not have expiry dates, dividend income can be received forever.
Zero growth: P0 = Div1 / r
Exmar has no growth opportunity and is forecast to pay dividends of just $4 per share, per year. Given a 10% expected return, what is the current price: $40.
Constant growth: P0 = Div1 / r-g
ExxonMobil is expected to pay a dividend of $6.50, expected return is 11.95% and dividends are expected to growth by 6%. What is the P0: $109.24
Canadian Natural Resources have just paid a dividend of $3.25, expected return is 9% and dividends are expected to grow by 8%, what is the current price: $351.00
Five assumptions of the dividend discount model (with infinity)…
All investments are financed from retained earnings.
There is a constant proportion of earnings being retained each time.
The rate of return on the company’s initial assets remains constant over time.
The rate of return on a firm’s investment in new assets is the same in all future time periods.
The life of the firm has no end.
Valuation by comparables…
A method of estimating the value of a firm based on the value of others that we expect to generate a similar cash flow in the future.
The most common valuation multiple is the price earnings ratio.
Price earnings ratio = current market price (P0) / earnings per share.
P/E ratio analysis…
<10: a firm is undervalued or in decline.
10-18: a firm is correctly valued.
18-25: a firm is overvalued or experiencing growth.
>25: a firm has very high future expectations of growth.
Difficult to evaluate on its own and should be evaluated against comparable industry firms.
The P/E ratio is negatively related to a firm’s discount rate.
The P/E ratio is based on expectations and perceptions of the future.
