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This 5 page Class Notes was uploaded by Jamie Frami on Wednesday September 23, 2015. The Class Notes belongs to FIN 6515 at University of South Florida taught by Staff in Fall. Since its upload, it has received 30 views. For similar materials see /class/212615/fin-6515-university-of-south-florida in Finance at University of South Florida.
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Date Created: 09/23/15
EQUITY VLAUATION Uses of Stock Valuation Models 0 Assessing investment opportunities I stock selection I risk management 0 Valuing stockivaluing privately held companies is important 0 Estimating discount ratesiinvestors required rate of return versus the rm s cost of capital Valuation Models 0 book valueibased on nancial statements historical cost liquidation valueiamount for which the rm can be sold if it is broken up replacement costiwhat it would cost to replicate the rm Tobin s Q market pricereplacement value Intrinsic value present value of the futures cash ows the rm is expected to provide investors thus the value of any asset can be stated as follows A A A n CF Value CFI m t 1k1 1k2 1k t11kt This equation shows that the value of any assetireal or nancialiis based on 1 the A cash ows that the asset is expected to generate during its life CFL and 2 the rate of return that investors require to put up their money to purchase the investment asset k 0 dividend discount models DDM7the cash ows received by investors in common stock are called dividends and assuming the rm is a going concern the lifetime associated with these dividends is in nite Thus the valuation of common stock is based on the present value of the expected future dividends I general model D D 00D 120 t Z 1k1 1k2 1k t11kt D V0 where D represents the dividend that is expected to be paid in period t Most investors do not hold a stock for an in nite time period so it appears the DDM given above is not appropriate Consider an investor who purchases a stock with the intention of holding it for 10 years and then selling it to another investor It is obvious that the cash ows this investor will receive include the annual dividend payments plus the price expected in the tenth year Thus the value of the stock to this investor can be written V0 D1 1k1 1k2 1k10 1k10 Notice that the value of the stock for this investor depends on the price of the stock in Year 10 To determine the value of the stock in Year 10 we can apply the DDM as follows X i Doc tglliDt 391k O 101kt D11 12 1k1 I 1k2 D V10 Plugging the equation for V10 into the computation for V0 we end up right back where we startedithe DDM Consequently it does not matter what the investment horizon is at least in theory the general DDM is an appropriate method to determine the value of stock It is important to recognize that valuation is based on the characteristics of the asset eg life and cash ows not the investor eg investment horizonithat is it is the cash ow stream associated with the asset that is important for valuation 0 Application of the DDM Constant normal dividend growthiif dividends grow at a constant rate g which is less than the required return k then the DDM simpli es to the following Normal dividend growth often is defined to be the same as the growth associated with a normal economy73 percent to 5 percent The constant dividend growth model sometimes referred to as the Gordon model can be used to estimate the return required by investorsijust solve for k D1 k g P0 Zero dividend growthiif a firm pays all of its earnings out as dividends then presumably it will experience zero growth because there are no funds retained to invest in growth opportunities When the growth rate associated with a firm is zero the dividends paid each period in the future are equal and g 0 in the constant dividend growth model Consequently the value of a zerogrowth stock can be written D1 D1 Po a T Supemormal nonconstant dividend growthifrrms that have many positive NPV opportunities generally experience higher than normal growth in operations thus dividends often do not grow at a constant rate When this happens the constant dividend growth model cannot be usediat least not until constant growth begins or because g 0 nonconstant growth ends Because nonconstant growth does not end until some future date the constant dividend growth model cannot be applied until that time to determine the value of the stock at that future date Application of the constant dividend growth model at a future period is written as follows D P 1 D2 P 11 P n Dn1 1k1 I1k2 I I1k where P n 1 kn 39 gnorm where gnorm represents the normal or constant growth rate that the dividends reach at some period in the future 0 Application of the DDMiExample of nonconstant growth A company just paid a 1 dividend During the next three years the company is expected to grow at rates equal to 30 percent 20 percent and 10 percent In year 4 and every year thereafter the growth rate will be 4 percent Investors in similar risk investments require a return of 14 percent What is the current market price of the company39s stock According to the situation presented here we have the following information g1 g2 g3 g4 k d0 30 20 10 g5 14 1 g gn4 Therefore the dividends expected in the future are d1 100130 d2 130120 d3 156110 d4 1716104 d5 1785104 d100 171610497 1300 1560 1716 0 1141 1142 1143 1300 I 1560 I 1716 1300 1560 1716 1785 1856 77046 1785 1144 P3 1141T1142 T1143 T1143 o073 77046 m 39 114100 114 P3 1716104 1785 1785 014 004 010 1300 1560 17161785 1554 0 11411142 1143 Does the current price depend on the investment horizon of the investor who buys the stock NO If an investor purchased the stock today and then sold it one year later the cash ows received would be the dividend in Year 1 130 and the selling price at the end of the year The selling price at the end of the year would be 1560 17161785 1642 1 1141 1142 The present value of these two cash ows is 130 1642 11401 1554 0 If an investor purchased the stock today and then sold it ve years later the cash ows received would include ve dividend payments and the selling price ve years from today The selling price in ve years is D6 17161043 P 5 kgmmI 014004 1930 1300 I 1560 I 1716 I 1785 I 18561930 0 T 1141 T 1142 T 1143 T 1144 T 1145 1554 The stock will have the same current value regardless of the intentions of the investori each speci c nancial asset must sell at one price for every investor otherwise arbitrage exists 0 Determining dividend growth rates I Use historical ex post data to estimate future growth I If a rm has constant normal growth in earnings and dividends the dividend payout ratio will be constant and the growth rate can be approximated as g ROE X l payout ratio o PriceEamings PE ratio I Use of the PE ratio to make investment decisionsisome investors believe they can earn higher returns by investing in stocks with low PE ratios but often they fail to consider the risk involved with such stocks I Use of the PE ratio to value stockithere is a perception that rms have quotnormalquot P E multiples if so it can be determined whether a stock is mispriced by applying its quotnormalquot PE value
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