Chapter 7: Common Stock Valuation

Question 1

L01. The basic dividend discount model.

Answer 1

7.1 Security Analysis: Be careful out there.
The basic idea is to identify both undervalued or cheap stocks to buy and overvalued or rich stocks to sell. A good analyst is cautious and is wiling to probe further/deeper before committing to an investment.
*Fundamental Analysis: Examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock.
Fundamentals refers to numbers such as earnings per share, cash flow, book equity value, and sales.
Be cautious when applying fundamental analysis, the simpler the technique the more caution is required. Too-simple techniques that rely on available information are not likely to yield systematically superior investment returns, and they could actually lead to unnecessarily risky investment decisions.

7.2 The Dividend Discount Model
A fundamental principle of finance holds that the economic value of a security is properly measured by the sum of its future cash flows, where the cash flows are adjusted for risk and the TVM.
*Dividend Discount Model (DDM): Method of estimating the value of a share of stock as the present value of all expected future dividend payments.
*Constant Perpetual Growth Model: Version (simple) of the DDM in which dividends grow forever at a constant rate, and the growth rate is strictly less than the discount model.
*Historical Growth Rates:
1. Geometric Average Dividend Growth Rate: A dividend growth rate based on a geometric average of historical dividends.
2. Arithmetic Average Dividend Growth Rate: A dividend growth rate based on an arithmetic average of historical dividends.
Having arithmetic average growth rate close to the geometric average growth rate is usually the case for dividend growth rates, but not always. A large difference means that the dividend grew erratically, which makes the use of the constant growth formula questionable. Sometimes, the arithmetic and geometric growth rate averages can yield different results. Analysts prefer to use a geometric average when calculating average historical dividend growth rate. In any case, a historical average growth rate may or not be a reasonable estimate of future dividend growth.
*Sustainable Growth Rate: A dividend growth rate that can be sustained by a company’s earnings.
When using perpetual growth rate it is necessary to come up with and estimate of g (growth rate in dividend). There are 3 ways of estimating g: 1. using company’s historical average growth rate, 2. using industry median/average growth rate, 3. using sustainable growth rate.
Sustainable growth rate has the problem that they are sensitive to year to year fluctuations in earnings; as a result, security analysts often adjust sustainable growth rate estimates to smooth out the effects of earnings variations.
A limitation of the constant perpetual growth model is that it should only be used with companies with stable dividend and earnings growth.
A company’s earnings can be paid out as dividends to stockholders or kept as retained earnings to finance future growth.
->Retained Earnings: Earnings retained within the firm to finance growth.
->Payout ratio: Proportion of earnings paid out as dividends.
->Retention Ratio: Proportion of earnings retained for investment.

Question 2

L02. The 2 stage dividend growth model.

Answer 2

7.3 The 2-stage Dividend Growth Model
*2-Stage Dividend Growth Model: Dividend model that assumes a firm will temporarily grow at a rate different from its long-term growth rate.
The two-stage growth formula requires that the second-stage growth rate be strictly less than the discount rate. However, the first-stage growth rate can be smaller, equal or greater to the discount rate. If the first-stage growth rate is equal to the discount rate, the two-stage formula reduces (**see formula in page 206).
*The H-Model: This model assumes a linear growth rate declines overtime.
*Discount rates for Dividend Discount Models: Capital Asset Pricing Model (CAPM), based on CAPM the discount rate for a stock can be estimated using the Discount Rate Formula.
The return expected on a risky asset has 2 parts: 1. “wait” component which is the TVM, and 2. “worry” component which is the risk premium (the greater the risk the greater the risk premium).
->Stock’s Beta: Measure of a stock’s risk relative to the stock market average. The market average beta is 1.0, a beta of 1.5 indicates that the stock has 50% more risk than the average stock, so its risk premium is 50% higher.
* Observations on Dividend Discount Models:
->3 Dividend Discount Models: 1. Constant Perpetual Growth, 2. 2-Stage Dividend Growth, 3. Non-constant growth.
->Advantage of Constant Perpetual is that it is simple to compute
->Disadvantages of Constant Perpetual: 1. not usable for firms paying dividends. 2. not usable when growth rate is greater than discount rate. 3. sensitive to choice of growth rate and discount rate. 4. difficult to estimate discount/growth rates. 5. often an unrealistic assumption.
->Advantages of 2-Stage Discount: 1. more realistic than constant perpetual because it accounts for low, high, or zero growth (in first stage) followed by constant long term growth in the second stage. 2. usable when a first stage growth rate is higher than discount rate (2-stage model is sensitive to choice of discount/growth rate, and is not useful for companies that don’t pay dividends).

Question 3

L03. The residual income and free cash flow models.

Answer 3

7.4 The Residual Income Model: Used for firms that don’t pay dividends.
The difference between actual earnings “EPS” and required earnings “REPS” during a period is called “Residual Income”, Residual Income is also called “Economic Value Added” or “Abnormal Earnings”, it is the excess of actual earnings over required earnings, think of it as the value created by a firm in the period (t).
->Economic Value Added (EVA): Financial performance measured based on the difference between a firm’s actual earnings and required earnings.
->Residual Income Model (RIM): Method for valuing stock in a company that doesn’t pay dividends.
->Clear Surplus Relationship (CSR): An accounting relationship in which earnings minus dividends equals change in book value per share.
RIM and Constant Growth are really the same but RIM is more flexible because is applicable to any stock, not just dividend payers.

7.5 The Free Cash Flow Model
The residual income model allows to value companies that do not pay dividends. But when using residual income model it is assumed that the company had positive earnings. Some companies do not pay dividends and have negative earnings. Even though a company has negative earnings, it may have positive cash flows and positive value.
The key to understanding how a company can have negative earnings and positive cash flows is depreciation (the writing down of assets). Depreciation reduces earnings but impacts cash flows positively because depreciation is counted as an expense. Higher expenses mean lower taxes paid, all else equal.
->Free Cash Flow (FCF): Converts reported earnings into cash flow by adjusting for items that impact earnings and cash flows differently.
Most Analysts agree that in examining a company’s financial performance, cash flow can be more informative than net income.
Resume in page 216