lecture 3: common equity valuation

Question 1

two cash flows provided by stocks

Answer 1

dividends (not always)

the sale price when the stock is sold

Question 2

is the value of a stock equal to

1. The discounted PV of the sum of next period’s dividend plus next period’s stock price, or
2. The discounted PV of all future dividends?

Answer 2

both

Question 3

does a a long-run dividend discount model hold even when investors have short-term time horizon?

why?

Answer 3

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

Question 4

three basic patterns dividends could follow

Answer 4

(1) zero growth
(2) constant growth
(3) differential growth

Question 5

net investment

Answer 5

total investment less depreciation

Question 6

when do we have a net investment of 0?

Answer 6

when the total investment less depreciation is equal to 0ç

–> the firm’s physical plant is maintained, consistent with no growth in earnings

Question 7

what does g define?

Answer 7

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

Question 8

what is the formula to find g?

Answer 8

g = retention ratio · return on retain earnings

Question 9

how can we find r (the discount rate)

Answer 9

r = the dividend yield + growth rate

r = (Div1 / P0) + g

Question 10

what are our assumptions for g

Answer 10

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

Question 11

one should be particularly skeptical of which two polar cases when estimating r for individual securities?

Answer 11

1. 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

2. 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

Question 12

a cash cow company

Answer 12

a company paying their EPS (in perpetuity) as dividends

EPS = Div

Question 13

the value of a cash cow company

Answer 13

EPS/r = Div/r = P0

Question 14

NPVGO

Answer 14

NPV per share of the project as of date 0

net present value (per share) of the growth opportunity.

Question 15

Stock Price after a Firm Commits to a New Project

Answer 15

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

Question 16

Two conditions must be met in order to increase share value when considering NPVGOs

Answer 16

1. Earnings must be retained so that projects can be funded

2. The projects must have positive NPV

Question 17

how can a company still increase its dividend payout ratio but have negative NPVGOs?

Answer 17

if the required rate of return (r) is lower than the growth rate (g)

Question 18

why do we discount dividends instead of earnings to find stock prices?

Answer 18

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

Question 19

why are no-dividend stocks not selling at zero?

Answer 19

Rational shareholders believe that they will either receive dividends at some point or receive something just as good

Question 20

Empirical evidence suggests that firms with high growth rates are likely to pay lower or higher dividends?

why?

Answer 20

lower dividends

because they have so many positive growth opportunities that they need to invest in

Question 21

To value according to the NPVGO model, what do we need?

Answer 21

(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)

Question 22

formula to find NPVGO of various opportunities?

Answer 22

NPVGO0 = NPV1 / (r - g)

Question 23

The comparable approach

Answer 23

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

Question 24

the most common multiple

Answer 24

price–earnings (P/E) multiple, or P/E ratio

Question 25

P/E ratio

Answer 25

the ratio of the stock’s price to its EPS

it is generally assumed that similar firms have similar P/E ratios

Question 26

is the P/E approach better than the others we saw??

Answer 26

depends on the similarity across comparables

Question 27

how does the P/E ratio relate to NPVGO?

Answer 27

1. Price per share = EPS/r + NPVGO

2. Price per share/EPS = 1/r + NPVGO/EPS

Question 28

how does the P/E ratio relate to r?

Answer 28

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

Question 29

firms with conservative accountants usually have high P/E ratios?

true or false

Answer 29

true

Question 30

the P/E ratio is a function of which three different factors?

which factor is the most important

Answer 30

1. growth opportunities
2. level of risk
3. type of accounting

the first factor is the most important

Question 31

considering the three factors that influence the P/E ratio, when is it going to be high?

Answer 31

(1) when the company has many growth opportunities
(2) it has low risk (reflected in a low discount rate)
(3) its accounting is conservative

Question 32

methods to use to value a firm

Answer 32

1. NPVGO if it has gyu growth opportunities
2. discounted cash flows and all
3. P/E