Download stocks - McGraw Hill Higher Education

5-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
5-2
Chapter 5
Valuing Stocks
Chapter Outline
Stocks and the Stock Market
 Book Values, Liquidation Values, and
Market Values
 Valuing Common Stocks
 Simplifying the Dividend Discount Model
 Growth Stocks and Income Stocks

copyright © 2003 McGraw Hill Ryerson Limited
5-3
Stocks and the Stock Market
• Definitions
In the last chapter, we learned that
Governments and corporations borrow money
for the long term by issuing and selling
securities which are called bonds.
 Corporations can also raise long term money
by issuing and selling securities which are
called stocks or shares.

 Investors
who purchase these shares are called
stockholders or shareholders.
copyright © 2003 McGraw Hill Ryerson Limited
5-4
Stocks and the Stock Market
• Definitions

Issuing stock is like taking on new
partners.
 Shareholders
become part-owners of the
issuing firm, electing a board of directors to
represent their interests.
 The shareholders are entitled to the firm’s
residual cash flow.
 The residual cash flow is the remaining cash
flow after all employees, suppliers, lenders
and the government have been paid.
copyright © 2003 McGraw Hill Ryerson Limited
5-5
Stocks and the Stock Market
• Definitions
The stockholders, as owners, share in the
fortunes of the firm.
 Shares of stock can be risky investments:

 For
example, the shares of 360networks were first
issued at $21 a share in April 2000.
 By September 2000, they were trading at $35.90.
 Less than a year later, they were worth $0.34 per
share!
No wonder investors want active markets
in which to buy and sell their shares at will!
copyright © 2003 McGraw Hill Ryerson Limited
5-6
Stocks and the Stock Market
• Dividends
Dividends are periodic cash distributions
from the firm to its shareholders.
 Dividends represent that share of the
firm’s profits which are distributed.
 Profits can also be retained in the firm
and reinvested in its operations:

 Profits
which are kept in the firm are called
retained earnings.
copyright © 2003 McGraw Hill Ryerson Limited
5-7
Stocks and the Stock Market
• Dividends
 If you look at Figure 5.2, you will see that
different firms have different dividends:
 Some
firms pay no dividends at all!
 Molson pays an annual dividend of $0.72 per share.
Dividends, unlike coupon payments, are not
fixed -- they represent a share in the profits and
profits can go down …
 Though you hope that profits, and thus the
dividend, will grow with time!

copyright © 2003 McGraw Hill Ryerson Limited
5-8
Stocks and the Stock Market
• Dividends
If you look at Figure 5.2, you will also see, in
the Yield column, the dividend yield.
 The dividend yield is calculated the same way
as the current yield on a bond – divide the
annual income by the price of the security:

Dividend Yield = Dividend Payment
Stock Price
copyright © 2003 McGraw Hill Ryerson Limited
5-9
Stocks and the Stock Market
• Dividends
For Molson, the dividend is $0.72 on a price of
$46.45.
 Thus:

Dividend Yield = Dividend Payment
Stock Price
= $0.72 4
$46.45
= 0.016 = 1.6%
copyright © 2003 McGraw Hill Ryerson Limited
5-10
Stocks and the Stock Market
• Dividends

Note that investors will accept low, or zero,
current yields if they can look forward to:
 Higher
future dividends.
 Rising share prices.

Note also, that like the current yield, the
dividend yield calculation ignores potential
capital gains or losses.
 Therefore,
like the current yield, it is a poor
measure of total return on your investment.
copyright © 2003 McGraw Hill Ryerson Limited
5-11
Stocks and the Stock Market
• Price-Earnings
(P/E) Ratio
 Table 5.6 shows the P/E ratio.
 The
P/E ratio is the price of the stock divided by the
earnings per share (eps).

Thus for Molson:
P/E Ratio
= Stock Price
eps
= $46.45 4
$2.25
= 20.6x
copyright © 2003 McGraw Hill Ryerson Limited
5-12
Stocks and the Stock Market
• Price-Earnings

(P/E) Ratio
The P/E ratio measures how much an investor
would pay for every $1 of eps:
 For
Molson, investors are willing to pay $20.60
for each $1 of earnings the company generates.
 For Methanx, they are willing to pay only $4.30
for each $1 of earnings the company generates.

Key questions:
Why does one stock sell for more than another?
How do we value a stock?
copyright © 2003 McGraw Hill Ryerson Limited
5-13
Stocks and the Stock Market
• Book
Value, Liquidation Value, Market Value
 There are three methods used for valuing a
company’s shares:
 Book
Value
 Liquidation Value
 Market Value
copyright © 2003 McGraw Hill Ryerson Limited
5-14
Valuing a Stock
• Book

Value
Book value is the net worth of the firm according to
its balance sheet and records all of the money the
firm has raised
 from
selling shares and
 from retained earnings.

In Table 5.1, you can see a balance sheet dated
March 31, 2001, for Molson:
 Molson
has $3,280.8 million in assets.
 It has liabilities of $2,485.4 million.
 Book Value = $3,280.8 - $2,485.4 = $795.4 million
copyright © 2003 McGraw Hill Ryerson Limited
5-15
Valuing a Stock
• Book
Value
Assume Molson has 59.7 million shares
outstanding.
 That means the book value per share (bvps) for
Molson is:

 $795.4
million / 59.7 million = $13.32 per share
On the same day, its market value per share
was $43.70.
 Thus, we see that investors do not equate book
value and market value.

copyright © 2003 McGraw Hill Ryerson Limited
5-16
Valuing a Stock
• Book
Value
Investors do not equate book value and
market value because they know that
book value is based on the historic cost
of the assets.
 Historic cost is not a good guide to the
value of those assets today.

copyright © 2003 McGraw Hill Ryerson Limited
5-17
Valuing a Stock
• Liquidation
Value
What if we were to liquidate all of the
assets on Molson’s balance sheet and
pay off the liabilities.
 Key Question:

Would the remaining cash per share
equal the market value for Molson shares?
copyright © 2003 McGraw Hill Ryerson Limited
5-18
Valuing a Stock
• Liquidation
Value
NO IT WOULDN’T!
A successful company ought to be worth more
than its liquidation value.
 That is, the difference between liquidation value
and market value may be attributed to what is
known as going concern value.

copyright © 2003 McGraw Hill Ryerson Limited
5-19
Valuing a Stock
• Going

Concern Value
Going concern value means that a well managed,
profitable firm is worth more than the sum of the
value of its assets.
ASSET 1
ASSET 2
ASSET 3
$3 million
$2 million
$6 million
ASSET 2
ASSET 3
$3 million $2 million
$6 million
ASSET 1
Assets sold separately
have liquidation value
of $11 million
The same assets
functioning as a firm have
going concern value of
$15 million
copyright © 2003 McGraw Hill Ryerson Limited
5-20
Valuing a Stock
• Sources
 Extra
of Going Concern Value
earning power.
 If
Molson can use its physical assets more efficiently than
a competitor could, then those assets are worth more than
their resale value (book value).
 Intangible
assets.
 Molson
may have extremely valuable assets, such as
brand names, which do not appear on the balance sheet,
but are reflected in the market value.
 Value
of future investments.
 If
Molson shareholders believe that Molson has
opportunities to invest in lucrative projects which will
increase the company’s future earnings, they will pay
more for the company’s shares today.
copyright © 2003 McGraw Hill Ryerson Limited
5-21
Valuing a Stock
• Market
Value  Book Value or Liquidation
Value
 Stocks rarely sell at either book value or
liquidation value.
 Unlike
market value, book value and liquidation
value do not treat the firm as a going concern.

Market value is the amount investors are willing
to pay today for the shares of the firm.
 This
depends on the earning power of the existing
assets and the expected profitability of future
investments.
copyright © 2003 McGraw Hill Ryerson Limited
5-22
Valuing a Stock
• Market

Value
The key question is:
HOW DO WE MEASURE MARKET VALUE?
copyright © 2003 McGraw Hill Ryerson Limited
5-23
Valuing Common Stocks
• Expected

Return
In Chapter 4, you learned how to calculate the
expected return on a security:
Expected Return = income + price change
investment
= D 1 + P 1 – P0
P0
Assuming that:
The
current price of the shares is P0.
The expected price a year from now is P1.
The expected dividend a year from now is D1.
copyright © 2003 McGraw Hill Ryerson Limited
5-24
Valuing Common Stocks
• Expected

Return
Note that expected return can be divided into
two parts:
Expected return = Dividend Yield + Capital Gain
= D1 + P1 – P0
P0
P0
copyright © 2003 McGraw Hill Ryerson Limited
5-25
Valuing Common Stocks
• Expected

Return
Assume that for Blue Sky shares:



The current price of the shares is $75.
The expected price a year from now is $81.
The expected dividend a year from now is
$3.
What is Blue Sky’s expected return?
copyright © 2003 McGraw Hill Ryerson Limited
5-26
Valuing Common Stocks
• Expected

Return
Blue Sky’s expected return is:
Expected Return = D1 + P1 – P0
P0
= $3 + 81 – 75
$75
= 0.12 = 12%

Note that this expected return can be decomposed into
two parts:
The expected dividend yield.
 The expected capital gain.

copyright © 2003 McGraw Hill Ryerson Limited
5-27
Valuing Common Stocks
• Expected

Return
For Blue Sky:
Expected return = Dividend Yield + Capital Gain
= D1 + P1 – P0
P0
P0
= $3 + $81 - $75
$75
$75
= 0.04 + 0.08
= 4% + 8%
= 12%
copyright © 2003 McGraw Hill Ryerson Limited
5-28
Valuing Common Stocks
• Expected Return vs Actual Return
 Expected return is a forecast of what the return
would be if your predictions about the price and the
dividend are correct.
 However, the actual return on a stock could be
more or less than what you expect!
 Calculate how well you did as versus the 12%
expected return if the following occurs to Blue Sky
stock:
 The actual price a year from now is $61.
 The actual dividend a year from now is $3.
copyright © 2003 McGraw Hill Ryerson Limited
5-29
Valuing Common Stocks
• Dividend
Discount Model (DDM)
Like any other security, we can calculate the
value of a common stock by getting the PV of
all its future cash flows.
 For stocks we can make a simplifying
assumption that the firm will pay dividends
(cash flows) in perpetuity.
 In Chapter 3, you learned that there are two
kinds of perpetuity:

 Perpetuities
which grow at a constant rate.
 Constant value perpetuities (no growth).
copyright © 2003 McGraw Hill Ryerson Limited
5-30
Valuing Common Stocks
• Dividend

Discount Model (DDM)
The PV of a growing perpetuity is calculated
by dividing the cash payment (the dividend) by
the discount rate less the growth rate:
PV of a perpetuity =
=
=
C
r-g
Dividend1
Discount Rate – Growth Rate
Div 1
r-g
copyright © 2003 McGraw Hill Ryerson Limited
5-31
Valuing Common Stocks
• Dividend

Discount Model (DDM)
What would be the price of Blue Sky shares
if:
 Next year’s dividend (D1) will be $3.
 Dividends grow at 8% in perpetuity.
 The discount rate is 12%.
Div 1
PV of a perpetuity =
=
=
r-g
$3.00
0.12 – 0.08
$75.00
copyright © 2003 McGraw Hill Ryerson Limited
5-32
Valuing Common Stocks
• Dividend
Discount Model (DDM)
The PV of a constant value perpetuity is
calculated by dividing the cash payment (the
dividend) by the discount rate.
 That is, the growth rate is zero and drops out!

PV of a perpetuity =
=
C
=
r-g
Div1
r-0
Dividend1
Discount Rate – Growth Rate
=
Div1
r
copyright © 2003 McGraw Hill Ryerson Limited
5-33
Valuing Common Stocks
• Dividend

Discount Model (DDM)
What would be the price of Blue Sky shares if:
future dividends (D1, D2, D3, …) will be $3 (i.e.,
dividends are constant at $3 and do not grow).
 The discount rate is 12%.
 All
Div 1
PV of a perpetuity =
=
=
r
$3.00
0.12
$25.00
copyright © 2003 McGraw Hill Ryerson Limited
5-34
Valuing Common Stocks
• DDM vs Expected Rate of Return
 The DDM can be rearranged so that we can
calculate the expected rate of return on the
stock:
r =

D1
+ g =
P0
Dividend Yield + Growth Rate
What is the expected return for Blue Sky if:



Next year’s dividend (D1) will be $3.
Dividends grow at 8% in perpetuity.
The current price is $75.
copyright © 2003 McGraw Hill Ryerson Limited
5-35
Valuing Common Stocks
• DDM vs Expected Rate of Return
 The expected rate of return on Blue Sky would
be:
r =
D1
P0
=
$3
$75
+ g =
Dividend Yield + Growth Rate
+ .08
= .04 + .08
= 4% + 8% =
12%
copyright © 2003 McGraw Hill Ryerson Limited
5-36
Valuing Common Stocks
• Calculating

“g” (growth rate)
How fast a firm grows depends on how much of
its profits are reinvested in operations:
 The
fraction of earnings retained by the firm is
called the plowback ratio.
 The fraction of earnings a company pays out in
dividends is called the payout ratio.

What is Blue Sky’s payout ratio and plowback
ratio if:
 It
has eps of $5.
 It pays a dividend of $3 and retains the balance.
copyright © 2003 McGraw Hill Ryerson Limited
5-37
Valuing Common Stocks
• Calculating

“g” (growth rate)
What is the payout ratio? The plowback
ratio?
Payout ratio
= Dividend/ eps
= $3/ $5
= 0.60 = 60%
Plowback ratio
= 1 – payout ratio
= 1 – 0.60
= 0.40 = 40%
copyright © 2003 McGraw Hill Ryerson Limited
5-38
Valuing Common Stocks
• Calculating

“g” (growth rate)
Assume that Blue Sky can earn a 20% return
on new equity investments.
 If
all of its earnings were reinvested, Blue Sky
would grow at 20% per year.
 If all of its earnings were paid out as dividends –
i.e., none of the earnings were reinvested – then
Blue Sky would forgo any growth (growth = 0%).
 If part of its earnings were reinvested, then Blue
Sky would grow at between 0% and 20% per year.
You should see that the higher the
plowback rate, the higher the growth rate.
copyright © 2003 McGraw Hill Ryerson Limited
5-39
Valuing Common Stocks
• Calculating

You can calculate the growth rate for a
company by multiplying the return on equity by
the plowback ratio:
g

“g” (growth rate)
= roe x plowback ratio
For Blue Sky, the growth rate would be:
g = roe x plowback ratio
= 20% x 40%
= 8%
copyright © 2003 McGraw Hill Ryerson Limited
5-40
Valuing Common Stocks
• Calculating

Growth rates calculated this way:
g

“g” (growth rate)
= roe x plowback ratio
are known as sustainable growth rates.
Sustainable Growth Rates
copyright © 2003 McGraw Hill Ryerson Limited
5-41
Valuing Common Stocks
• Growth


Stocks vs Income Stocks
Let’s try a few problems with Blue Sky
and see what we can learn about growth
and stock value.
In all cases, assume that Blue Sky has:


Expected eps of $5 next year.
A discount rate of 12%.
copyright © 2003 McGraw Hill Ryerson Limited
5-42
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
Problem 1:

Assume that Blue Sky has:
 A payout
ratio of 100%.
What is the value of Blue Sky stock?
Problem 2:

Assume now that Blue Sky has:
 A payout ratio of 60%.
 The roe on new investment is 10%.
What is the value of Blue Sky stock?
copyright © 2003 McGraw Hill Ryerson Limited
5-43
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
Problem 3:

Assume now that Blue Sky has:
 A payout ratio of 60%.
 The roe on new investment is 12%.
What is the value of Blue Sky stock?
Problem 4:

Assume now that Blue Sky has:
 A payout ratio of 60%.
 The roe on new investment is 20%.
What is the value of Blue Sky stock?
copyright © 2003 McGraw Hill Ryerson Limited
5-44
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
You should get the following results:
g
Prob. #
Plowback
Ratio
1
0%
**
0.0%
$5.00
$41.67
2
40%
10%
4.0%
$3.00
$37.50
3
40%
12%
4.8%
$3.00
$41.67
4
40%
20%
8.0%
$3.00
$75.00
ROE
(Sustainable
growth rate)
Div1
P0
* Since the plowback ratio = 0%, sustainable growth rate will
equal 0% regardless of the ROE. Thus, ROE is irrelevant.
copyright © 2003 McGraw Hill Ryerson Limited
5-45
Valuing Common Stocks
• Growth

Stocks vs Income Stocks
You should see the following in your
calculations:
Problem 1
o
If Blue Sky does not reinvest any of its earnings,
then its stock price would be $41.67.
This price represents the
value of earnings from
assets which are already in place.
copyright © 2003 McGraw Hill Ryerson Limited
5-46
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
Problem 2
o If Blue Sky invests in projects which generate a return
less than its discount rate, then its stock price would
drop to $37.50.
o With zero growth, Blue Sky stock was worth $41.67.
o The share price is $4.17 lower because of investing in
projects with an unattractive rate of return!
Lesson from Problem 2:
o Successful financial managers do not invest in
projects which earn less than the discount rate – it
would reduce the value of the company’s shares!
copyright © 2003 McGraw Hill Ryerson Limited
5-47
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
Problem 3
o
o
If Blue Sky invests in projects with a return equal to
its discount rate, then its stock price would be
$41.67.
But, this is the same price as for zero growth … why
didn’t growth translate into a higher share price?
Lesson from Problem 3:
 Successful
financial managers know that plowing
earnings back into a company does not add value
unless investors believe the reinvested earnings
will earn more than the discount rate.
copyright © 2003 McGraw Hill Ryerson Limited
5-48
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
Problem 4
o
o
o
If Blue Sky invests in projects with a return which is
greater than its discount rate, then its stock price
would rise to $75.
We know from Problem 1, that $41.67 is the value of
the earnings from assets which are already in place.
Thus, $33.33 ($75 - $41.67) represents the value to
investors of the superior return on future
investments.
Lesson from Problem 4:
o
This superior return is know as the Present Value
Of Growth Opportunities (PVGO)
copyright © 2003 McGraw Hill Ryerson Limited
5-49
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
The earnings potential of Blue Sky will be
reflected in its Price-Earnings ratio.
 Blue Sky has expected earnings of $5.
 With high growth prospects, its price is $75:

 Its

P/E ratio = P/eps = $75 / $5 = 15x15.0 x
With no growth prospects, its price is
$41.67:
 Its
P/E ratio = P/eps = $41.67 / $5 = 8.3X8.3 x
copyright © 2003 McGraw Hill Ryerson Limited
5-50
Valuing Common Stocks
• Price

Earnings Ratio and Growth
Successful financial managers know that
to justify a high P/E ratio on their
company’s stock, they must deliver …
… lots of growth opportunities!
copyright © 2003 McGraw Hill Ryerson Limited
5-51
Summary of Chapter 5
Firms which wish to raise long-term capital
may issue bonds (borrow money) or
equity.
 Issuing equity is like taking on new
partners.
 Equity may be called shares or stocks.
 Information on stocks is regularly reported
in the financial pages of newspapers and
online financial services.

copyright © 2003 McGraw Hill Ryerson Limited
5-52
Summary of Chapter 5

Calculate the value of a stock by working out the
PV of the stock’s future dividends.
 This
model is called the Dividend Discount Model
(DDM).

If dividends are expected to grow forever at a
constant rate “g”, then the value of the stock is
equal to:
 P0

= Div1 / (r – g)
The expected return on the stock under these
conditions will be equal to:
 The
dividend yield (Div1 / P0) plus
 The expected growth rate (g)
copyright © 2003 McGraw Hill Ryerson Limited
5-53
Summary of Chapter 5

You can think of a share’s value as the sum
of two parts:
 The
value of the assets in place plus
 The Present Value of Growth Opportunities
(PVGO).
The PVGO represents the firm’s future ability
to invest in high-return projects.
 The firm’s P/E ratio will reflect the market’s
assessment of the firm’s PVGO.
 The higher the PVGO, the higher the firm’s
P/E ratio will be.

copyright © 2003 McGraw Hill Ryerson Limited