Valuing Stocks Flashcards
The Dividend-Discount Model
since the cash flows are risk, we must discount them at the equity cost of capital
- Pt = price of the stock on date ,t, after the dividend of that date has been paid
- if looking for price on a date before dividend of that date has been paid, adjustments are needed
One year investor price of security
Price of security = (Div1 + P1)/(1+re)
where re = expected return
- if stock price were less than investors would buy it’d drive up the stocks price
Expected return equation
re = (Div1 + P1)/Po -1 = Div1/Po+ P1-Po/Po
where Div1/Po = dividend yield
and P1-Po/Po = capital gain rate
P1 = what the stocks are trading at
Total return
total return = dividend yield + capital gain rate
- the expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk
Multi-year investor holding onto stock for N years
Po = Div1/1+re + Div2/(1+re)^2 +….+Divn/(1+re)^n + Pn/(1+re)^n
- the price of any stock is equal to the present value of the expected future dividends it will pay
Constant dividend growth
the simplest forecast for the firms future dividends states that they will grow at a constant rate, g, forever…
Po = Div1/re - g
re = Div1/Po - g
the value of the firm depends on the current dividend level, the cost of equity and the growth rate
re here = equity cost of capital
e.g company plans to pay $2.60/share in dividends in a year. Equity cost of capital = 6% and dividends expected to grow by 2% per year
Po = 2.60/0.06-0.02 = $65
Changing growth rates
we can use the general form of the dividend discount model to value a firm by applying the constant growth model to calculate the future share price of the stock once the expected growth rate stabilises
Pn = DivN+1/re-g = price of stock at end of period, N
Po = Div1/1+re + Div2/(1+re)^2 +….+Divn/(1+re)^n +
1/(1+re)^n x (Div1/1+re)
Limitations of the dividend-discount model
- tremendous amount of uncertainty associated with forecasting a firms dividend growth rate and future dividends
- small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price
Valuation based on comparable firms
- estimate the value of the firm based on the value of other comparable firms or investments that we expect will generate very similar cash flows in future
Valuation multiples
ratio of firms value to some measure of firms scale of cash flow
- P/E ratio
- Trailing P/E
- Forward earnings - expected earnings over next year
- Forward P/E
Price-earnings ratio (P/E)
share price divided by earnings per share
Forward P/E equation
= Po/EPS1 = (Div1/EPS1)/(re -g) = dividend payout rate/re -g
- firms with high growth rates, and which generate cash well in excess of their investment needs so that they can maintain high payout rates, should have high P/E multiples
estimating share price using P/E as valuation multiple
estimate share price = EPS x P/E of comparable firms
assumes that company will have similar future risk, payout rates and growth rates as the comparable firms
Limitations of multiples
- no clear guidance about how to adjust for differences in expected future growth rates, risks, or differences in accounting policies
- comparables only provide info regarding the value of the firm relative to other firms in the comparison set
- using multiples won’t help us determine if an entire industry is overvalued
Comparison with Discounted cash flow methods
- Discounted cash flow methods have the advantage that they can incorporate specific information about the firms cost of capital or future growth
- discounted cash flow methods usually more accurate than valuation multiples
No single technique provides a final answer regarding a stocks true value. All approaches require assumptions or forecasts that are too uncertain to provide a definitive assessment of the firms value
