lecture 3: common equity valuation Flashcards
two cash flows provided by stocks
dividends (not always)
the sale price when the stock is sold
is the value of a stock equal to
- The discounted PV of the sum of next period’s dividend plus next period’s stock price, or
- The discounted PV of all future dividends?
both
does a a long-run dividend discount model hold even when investors have short-term time horizon?
why?
ye
Although an investor may want to cash out early, he or she must find another investor who is willing to buy
–> The price this second investor pays depends on dividends after the date of purchase
three basic patterns dividends could follow
(1) zero growth
(2) constant growth
(3) differential growth
net investment
total investment less depreciation
when do we have a net investment of 0?
when the total investment less depreciation is equal to 0ç
–> the firm’s physical plant is maintained, consistent with no growth in earnings
what does g define?
a firm’s growth rate
–> based on a number of assumptions
the change between the earnings next year and the earnings this year
(earnings next year)/(earnings this year) = 1 + g
what is the formula to find g?
g = retention ratio · return on retain earnings
how can we find r (the discount rate)
r = the dividend yield + growth rate
r = (Div1 / P0) + g
what are our assumptions for g
we assume that the return on reinvestment of future retained earnings is equal to the firm’s past ROE
We assume that the future retention ratio is equal to the past retention ratio
one should be particularly skeptical of which two polar cases when estimating r for individual securities?
- a firm currently paying no dividend
–> The stock price will be above zero because investors believe that the firm may initiate a dividend at some point or the firm may be acquired at some point
–> However, when a firm goes from no dividend to a positive number of dividends, the implied growth rate is infinite
- the value of the firm is infinite when g is equal to r
–> Because prices for stocks do not grow infinitely, an analyst whose estimate of g for a particular firm is equal to or greater than r must have made a mistake
–> Most likely, the analyst’s high estimate for g is correct for the next few years. However, firms simply cannot maintain an abnormally high growth rate forever
–> The analyst’s error was to use a short-run estimate of g in a model requiring a perpetual growth rate
a cash cow company
a company paying their EPS (in perpetuity) as dividends
EPS = Div
the value of a cash cow company
EPS/r = Div/r = P0
NPVGO
NPV per share of the project as of date 0
net present value (per share) of the growth opportunity.
Stock Price after a Firm Commits to a New Project
EPS/r + NPVGO
The first term (EPS/r) is the value of the firm if it rested on its laurels, that is, if it simply distributed all earnings to the shareholders
The second term is the additional value if the firm retained earnings in order to fund new projects
Two conditions must be met in order to increase share value when considering NPVGOs
- Earnings must be retained so that projects can be funded
2. The projects must have positive NPV
how can a company still increase its dividend payout ratio but have negative NPVGOs?
if the required rate of return (r) is lower than the growth rate (g)
why do we discount dividends instead of earnings to find stock prices?
The calculated stock price would be too high were earnings to be discounted instead of dividends
To discount earnings instead of dividends would be to ignore the investment that a firm must make today in order to generate future returns
why are no-dividend stocks not selling at zero?
Rational shareholders believe that they will either receive dividends at some point or receive something just as good
Empirical evidence suggests that firms with high growth rates are likely to pay lower or higher dividends?
why?
lower dividends
because they have so many positive growth opportunities that they need to invest in
To value according to the NPVGO model, what do we need?
(1) the NPV of a single growth opportunity
(2) the NPV of all growth opportunities
(3) the stock price if the firm acts as a cash cow
the value of a share is (2) + (3)
formula to find NPVGO of various opportunities?
NPVGO0 = NPV1 / (r - g)
The comparable approach
similar to valuation in real estate
–> If your neighbour’s home just sold for $400,000 and it has similar size and amenities to your home, your home is probably worth around $400,000 also
–> In the stock market, comparable firms are assumed to have similar multiples
the most common multiple
price–earnings (P/E) multiple, or P/E ratio
P/E ratio
the ratio of the stock’s price to its EPS
it is generally assumed that similar firms have similar P/E ratios
is the P/E approach better than the others we saw??
depends on the similarity across comparables
how does the P/E ratio relate to NPVGO?
- Price per share = EPS/r + NPVGO
2. Price per share/EPS = 1/r + NPVGO/EPS
how does the P/E ratio relate to r?
the P/E ratio is negatively related to the firm’s discount rate
–> the discount rate is positively linked to the stock’s risk or variability
–> the P/E ratio is negatively related to the stock’s risk
firms with conservative accountants usually have high P/E ratios?
true or false
true
the P/E ratio is a function of which three different factors?
which factor is the most important
- growth opportunities
- level of risk
- type of accounting
the first factor is the most important
considering the three factors that influence the P/E ratio, when is it going to be high?
(1) when the company has many growth opportunities
(2) it has low risk (reflected in a low discount rate)
(3) its accounting is conservative
methods to use to value a firm
- NPVGO if it has gyu growth opportunities
- discounted cash flows and all
- P/E
