Lecture 2(Ch7) - NCBA&E

7/31/2019 Lecture 2(Ch7) - NCBA&E

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Financial Management-2

Winter Semester 2011

NCBA&E

Instructor: Jamal Nasir Khan


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Equity Markets & Stock Valuation

Learning Objectives

Common Stock Valuation

Dividend Growth model

Zero Growth

Constant Growth

Multiple/Variable Growth

Components of Required Return

Features of Stocks

Stock Markets


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Capital Market Securities

Fixed Income (Bonds)

Treasuries

Agencies

Municipals

Corporate

Equities

Preferred Stock

Common Stock


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Stocks

It is an equity ownership in a corporation, initiallyissued to raise capital

Points to keep in mind (vs Bonds)

C/Fs are NOT known in advance

Life of stocks is forever no maturityDifficult to observe required rate of return for

discounting


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Stocks

How do we come up with the Price of a Stock?

PV of all future expected C/Fs?

Assumptions will be needed!

Assume a dividend the stock will pay.

Assume a selling price at the end of 1 year.

Come up with a required rate of return.


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Stocks Valuation

Assumptions will be needed!

Assume a dividend the stock will pay.

Assume a selling price at the end of 1 year.

Come up with a required rate of return.

Example: At the end of 1 year

Stock selling price is $70

Stock dividend will be $10

U need a 25% return

PV will be 80/(1.25) = $64 (u should pay today)


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Stocks Valuation

Example: For 1 year

Stock selling price is $70 (P1)Stock dividend will be $10 (D1)

U need a 25% return (R)

PV will be 80/(1.25) = $64 (Po) (u should pay today)

Therefore we can write:

Po = (D1+P1) / (1+R)

NOTE: coming up with a stock price @ end year is not easy!!


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Stocks Valuation

Example: For 1 year

P1 @ t1, would be found the same way byassuming the year 2 price & dividend:

P1 = (D2+P2) / (1+R)

Here then P1 really equals the P1 we used at Po.

Thus we can substitute:


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Stocks Valuation

Example: For 1 year

substituting P1 in Po equation:

Po = (D1+ (D2+P2)/1+R) / (1+R)

= D1/(1+R)^1 + D2/(1+R)^2 + P2/(1+R)^2

If u repeat this forever, the P2 ultimately has a PV of almost ZERO!!


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Stocks Valuation

Formula:

Po = E Dn / (1+R)^n

PV of all future dividends

as a general valuation framework.

Dividends to infinity are still a problem at this stage!


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Stocks Valuation

The problem of NO dividends.

This formula assumes the company will paysomething at some point in its life to itsshareholders.

A Corp where money goes in but nothingcomes out doesnt exist. Or shouldnt exist!


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Stocks Valuation

Special Cases. of dividends

Zero-growth:Here the dividend is constant, D1=D2=D

So, the value of the stock is a Perpetuity (ordinary),

Po = D/R same as PV = C/r


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Stocks Valuation

Example zero-growth

Suppose a company pays Rs. 10 dividend always.

If this policy is forever,

Whats the stock price if the required return is20%?


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Stocks Valuation

Example zero-growth

Suppose a company pays Rs. 10 dividend always.

If this policy is forever,

Whats the stock price if the required return is20%?

Po = 10 / 0.2 = Rs 50 per share


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Stocks Valuation

Special Cases. of dividends

Constant Growth Model:

Suppose the dividend grows at a constant rate g.

If dividend just paid is Do, then the next D1 is:

D1 = Do x (1+g)

& for 2 periods is:

D2 = Do x (1+g)^2 (FV formula)

D2 = (Do x (1+g)) x (1+g)


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Stocks Valuation

Growing Perpetuity:

An asset where the C/Fs grow at a constant rate forever.

Putting these dividends in the formula:

Po = Do(1+g)^1/(1+R)^1 + Do(1+g)^2/(1+R)^2

we can write this simply as:

Po = Do x (1+g) / R-g OR D1 / R - g


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Stocks Valuation

Dividend Growth Model:

Determines the Stock Price with constant growthdividends.

Po = Do x (1+g) / R-g

OR

D1 / R - g (g


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Example:

Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share?

Stocks Valuation


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Example:

Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share?

D1 / R - g (g


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Stocks Valuation

Note:

You can use this to find the stock price at anypoint in time!

Just find the D for that year,

grow it at (1+g)

& then divide by R-g


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Stocks Valuation

Example:

Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share in 5 years?

D6 / R - g (g


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Stocks Valuation

Example:

Suppose Do = 2.30, R=13%, g=5%.


Formula is:

Dt+1 / R - g (g


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Stocks Valuation

Example:

Suppose Do = 2.30, R=13%, g=5%.


D6 / R - g (g


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Example:

Suppose Company Ts next dividend will be $4.Required return is 16%.

Dividend increases by 6% every year.

Whats the price per share today?

& in 4 years?

Stocks Valuation


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Stocks Valuation

Example:

Suppose next dividend will be $4. Required return is 16%. Dividendincreases by 6% every year.

D1 = 4 , R=16%, g=6%. (since D1 is given, dont need to grow by g)


Po = D1 / R - g (g


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Stocks Valuation

Notice here:

P4 = Po (1+g)^4

50.50 = 40 x (1.06)^4

So, Stock price grows at the same constant rate as the Dividend!

P4 is simply D5/(R-g)


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Lets break down the R, discount rate which weused in the Dividend Growth Model or DDM

Po = D1 / (R-g)if we rearrange to solve for R.

then

R-g = D1/PoR = D1/ Po + g


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R = D1/ Po + g

This means TR has 2 components:

D1/Po = Dividend Yield

g = same rate as the increase in stock price

= Capital gains yield


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EXAMPLE

R = D1/ Po + g

If a stock is selling for $20 per share. Next

dividend will be $1 per share. Dividend willgrow by 10% per year forever.

What is the return on this stock?


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EXAMPLE

R = D1/ Po + g

If a stock is selling for $20 per share. Next dividend willbe $1 per share. Dividend will grow by 10% per year

forever.What is the return on this stock?

R = Div yield + Cap gains yield

= 1/20 + 10%

= 5% + 10% = 15%


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Stocks Valuation

Multiple Growth Model

Company grows at a certain high rate first, then slows down

to grow at a constant sustainable rate.

illustrate concept


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Stocks Valuation

Multiple Growth Model

Company grows at a certain high rate first, thenslows down to grow at a constant sustainable rate.

Value = PV of dividends + PV of terminal price

= E Do(1+g)^t / (1+k) + Dn(1+g)/(k-g).1/1+k^n

illustrate concept


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Stocks Valuation

Intrinsic Value & Market Price

If IV > Mkt Price = under/over-valued?

IV < Mkt Px = under/over valued?


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Stocks ValuationMultiple growth

Example:

MCB is expanding and is expected to grow at a rate of 20% per year forthe next three years. Current dividend is Rs. 2 per share. After thisrapid growth, the company is likely to slow down to a normal growth of7% for the foreseeable future. Required return on this stock is 22%.

D1 = 2*(1.20) = 2.40 , R=22%, G1= 20%, g=7%.


Solution in Excel MCB
http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/http://stock%20intrinsic%20value%281%29.xls/


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Relative Valuation Techniques

Making Valuations through comparisons

P/E = Price to Earnings ratio

so if comparable stocks are trading at x15.

& Earnings for a stock are equal to: $3

What should be the stock price? 45Forward P/E = Po/E1


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P/E = Payback period!

P/E = 15, EPS= $3, Px=45

So P/E of 15= 15 years payback!

Also:

1/15 = 6.66% yield indicating low pay-off for investors!


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P/BV = Price to Book Value (S.Equity) ratio


& BV for a stock is equal to: $5

What should be the stock price?50


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P/S = Price to Sales ratio


& Sales for a stock is equal to: $5

What should be the stock price?5


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Cash Flows between the Firm and the Financial Markets

Total Value of

Firms Assets

Total Value of the Firmto Investors in

the Financial Markets

B. Firminvests inassets

CurrentAssetsFixedAssets

C. Cash flow fromfirms assets

D. Government

E. Retained cash flows

A. Firm issues securities

F. Dividends and

debt payments

FinancialMarkets

Short-term debtLong-term debtEquity shares


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Major Types of Financial Assets

ORGANIZATION

DIRECT INVESTING

Non-Marketablesecurities

Money Markets

Capital Markets

Derivatives Markets

INDIRECT INVESTING

Investment Companies

Mutual Funds Stock, Bond Funds

Unit Investment Trusts

Wh t M j T f Fi i l A t ?


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What are Major Types of Financial Assets?

Direct Investing

Capital Market Securities

Fixed Income (Bonds)

Treasuries

Agencies

Municipals

Corporate

Equities

Preferred Stock Common Stock

Wh M j T f Fi i l A ?


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Direct InvestingEquity Securities

Equity Security:

Preferred Stock:

Common Stock:

Voting Rights:



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Equity Security:Represents an ownership interest in a corporation. Afterpayment of all obligations to fixed-income claims, provides residual claim.

Preferred Stock:Hybrid security: Pays dividends known in advance & fallsb/w Bonds & common stocks. However, dividends may be deferred.

Common Stock: Represents ownership interest of corporations or Equity ofstock holders (also called Equity securities)

Example: 100 shares of common stock represents 100/n% ownership interest in thecorp (n=outstanding shares).

Voting Rights: Gives C.S. Holders legal control of the Corp. Elect the boardof Directors as their reps. To run the corp.

Wh t M j T f Fi i l A t ?


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Common Stock Characteristics

Par Value:

Book Value:

Limited Liability:

Market Value (Cap):

Dividends:

Dividend Yield:

Payout Ratio:

Retention Ratio:



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Common Stock Characteristics Par Value:Not a significant economic variable. Any number can be chosen. New

stock usually sells for more than PAR.

Book Value:The accounting value of the equity as shown on the Balance Sheet.Sum of Stock Outstanding, Capital in excess of Par & Retained Earnings.

Limited Liability:Investors cannot lose more than their investment. Creditorshave access only to the assets of the corp.

Market Value: Market Capitalization: Price of Stock x Shares outstanding

Dividends: Cash Payments declared & paid to stockholders

Dividend Yield: 12 month dividend / current stock price

Payout Ratio: Dividends / Earnings (indicates % of a firms earnings paid out)

Retention Ratio: 1 Payout Ratio (% of firms earnings retained)



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Stock Example

Coca-Colas 2002 EPS = $1.23. Paid annual dividend DPS of

$0.8. If price of KO is $45, calculate the following. DY?

Payout ratio?

If the company reported $11.8 Billion in Stockholder Equity &

the outstanding shares are 2.478 Billion, whats the BVS?



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Stock Example

Coca-Colas 2002 EPS = $1.23. Paid annual dividend DPS of$0.8. If price of KO is $45, calculate the following.

Dividend Yield: 0.8/45 = 1.8%

Payout Ratio: 0.8/1.23 = 65%

If the company reported $11.8 Billion in Stockholder Equity &the outstanding shares are 2.478 Billion, whats the BVS?

BVS = 11.8 / 2.478 = $4.76



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More Common Stock Characteristics

Stock Dividend:

Stock Split:

P/E Ratio:



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Stock Dividend:Payment of a dividend in the form of stock (instead of cash)

Stock Split:Issuance of stock in proportion to shares outstanding

P/E Ratio: Stock Price/ EPS (what investors are paying per dollar of earnings)

Example: Price of X = $25, EPS = 1.5

P/E = 25/1.5 = ?



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Stock Dividend:Payment of a dividend in the form of stock (instead of cash)

Stock Split:Issuance of stock in proportion to shares outstanding

P/E Ratio: Stock Price/ EPS (what investors are paying per dollar of earnings)

Example: Price of X = $25, EPS = 1.5

P/E = 25/1.5 = 16.6


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Financial Markets?

US Securities Markets for Equities

Dow Jones Industrial Average

Standard & Poors (S&P 500)

Nasdaq

Pakistani Securities Markets for Equities

KSE (Karachi Stock Exchange)


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Financial Markets?

US Securities Markets for Equities

Dow Jones Industrial Average

30 Blue chip stocks stock price weighted average

Standard & Poors (S&P 500)

500 stock composite

Nasdaq

100 Large cap companies

The Dow Jones Industrial Average consists of the following 30companies:

3M Co (NYSE: MMM) (conglomerates "manufacturing") H ll I i l I S HON


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3M Co. (NYSE: MMM) (conglomerates, manufacturing ) ALCOA Inc. (NYSE:AA) (aluminium) Altria Group, Inc. (NYSE: MO) (tobacco, foods) American International Group, Inc. (NYSE:AIG) (property

& casualty insurance) American Express Co. (NYSE:AXP) (credit services) AT&T Inc. (NYSE: T) (telecoms) Boeing Co., The (NYSE: BA) (aerospace/defense) Caterpillar, Inc. (NYSE: CAT) (farm & construction

equipment) Citigroup, Inc. (NYSE: C) (money center banks) Coca-Cola Co. (NYSE: KO) (beverages) E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals) Exxon Mobil Corp. (NYSE:XOM) (major integrated oil & gas) General Electric Co. (NYSE: GE) (conglomerates, media)

General Motors Corporation (NYSE: GM) (automanufacturers) Hewlett-Packard Co. (NYSE: HPQ) (diversified computer

systems) Home Depot, Inc. (NYSE: HD) (home improvement stores)

Honeywell International, Inc. (NYSE: HON)(conglomerates)

Intel Corp. (NYSE: INTC) (semiconductors)

International Business Machines Corp. (NYSE: IBM)(diversified computer systems)

JPMorgan Chase and Co. (NYSE: JPM) (money centebanks)

Johnson & Johnson Inc. (NYSE: JNJ) (consumer andhealth care products conglomerate)

McDonald's Corp. (NYSE: MCD) (restaurant franchise

Merck & Co., Inc. (NYSE: MRK) (drug manufacturers)

Microsoft Corp. (NYSE: MSFT) (software)

Pfizer, Inc. (NYSE: PFE) (drug manufacturers)

Procter & Gamble Co. (NYSE: PG) (consumer goods)

United Technologies Corp. (NYSE: UTX) (conglomera

Verizon Communications (NYSE: VZ) (telecoms)

Wal-Mart Stores, Inc. (NYSE: WMT) (discount, varietystores)

Walt Disney Co., The (NYSE: DIS) (entertainment)


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T f O d


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Types of Orders

Market Order Limit Order

Stock Order

Clearing Procedures (T+3)


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Types of Orders

Market OrderBest price on the floor ENSURES EXECUTION NOT PX

Limit Orderspecified or better price ENSURES PX NOT EXECUTION

Stop Order

Automatic execution at specified price BUY STOP PROTECTS PROFITS

SELL STOPS PROTECT LOSSES

Clearing Procedures (T+3)Trade Day plus 3 business days


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Short Sales

Being Long Being Short

Short Sale

Short Interest Ratio


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Lecture 2(Ch7) - NCBA&E

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