Principles of
Corporate Chapter 4
Finance
The Value of Common Stocks
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Slides by
Matthew Will
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Topics Covered
How Common Stocks are Traded
How To Value Common Stock
Capitalization Rates
Stock Prices and EPS
Discounted Cash Flows and the Value of a
Business
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Stocks & Stock Market
Common Stock - Ownership shares in a
publicly held corporation.
Secondary Market - market in which already
issued securities are traded by investors.
Dividend - Periodic cash distribution from the
firm to the shareholders.
P/E Ratio - Price per share divided by earnings
per share.
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Stocks & Stock Market
Book Value - Net worth of the firm according
to the balance sheet.
Liquidation Value - Net proceeds that would be
realized by selling the firm’s assets and
paying off its creditors.
Market Value Balance Sheet - Financial
statement that uses market value of assets and
liabilities.
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Valuing Common Stocks
Expected Return - The percentage yield that an
investor forecasts from a specific investment over a
set period of time. Sometimes called the market
capitalization rate.
Div1 P1 P0
Expected Return r
P0
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Valuing Common Stocks
Example: If Fledgling Electronics is selling for $100
per share today and is expected to sell for $110 one
year from now, what is the expected return if the
dividend one year from now is forecasted to be
$5.00?
5 110 100
Expected Return .15
100
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Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
Div1 P1 P0
Expected Return r
P0 P0
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Valuing Common Stocks
Capitalization Rate can be estimated using the
perpetuity formula, given minor algebraic
manipulation.
Div1
Capitalization Rate P0
rg
Div1
r g
P0
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Valuing Common Stocks
Return Measurements
Div1
Dividend Yield
P0
Return on Equity ROE
EPS
ROE
Book Equity Per Share
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Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equals the
present value of all expected future dividends.
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Valuing Common Stocks
Dividend Discount Model - Computation of today’s
stock price which states that share value equals the
present value of all expected future dividends.
Div1 Div2 Div H PH
P0 ...
(1 r ) (1 r )
1 2
(1 r ) H
H - Time horizon for your investment.
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Valuing Common Stocks
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Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the next three
years, respectively. At the end of three years you
anticipate selling your stock at a market price of
$94.48. What is the price of the stock given a 12%
expected return?
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Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24,
and $3.50 over the next three years, respectively. At the end of three
years you anticipate selling your stock at a market price of $94.48. What
is the price of the stock given a 12% expected return?
3.00 3.24 . 94.48
350
PV
(1.12) (1.12)
1 2
(1.12) 3
PV $75.00
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Valuing Common Stocks
If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.
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Valuing Common Stocks
If we forecast no growth, and plan to hold out stock
indefinitely, we will then value the stock as a
PERPETUITY.
Div1 EPS1
Perpetuity P0 or
r r
Assumes all earnings are
paid to shareholders.
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Valuing Common Stocks
Constant Growth DDM - A version of the dividend
growth model in which dividends grow at a constant
rate (Gordon Growth Model).
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Valuing Common Stocks
Example- continued
If the same stock is selling for $100 in the stock
market, what might the market be assuming about
the growth in dividends?
$3.00 Answer
$100
.12 g The market is
assuming the dividend
g .09 will grow at 9% per
year, indefinitely.
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Valuing Common Stocks
If a firm elects to pay a lower dividend, and reinvest
the funds, the stock price may increase because
future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as
dividends
Plowback Ratio - Fraction of earnings retained by the
firm.
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Valuing Common Stocks
Growth can be derived from applying the
return on equity to the percentage of earnings
plowed back into operations.
g = return on equity X plowback ratio
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Valuing Common Stocks
Example
Our company forecasts to pay a $5.00
dividend next year, which represents
100% of its earnings. This will provide
investors with a 12% expected return.
Instead, we decide to plow back 40% of
the earnings at the firm’s current return
on equity of 20%. What is the value of
the stock before and after the plowback
decision?
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Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a 12%
expected return. Instead, we decide to blow back 40% of the earnings at
the firm’s current return on equity of 20%. What is the value of the stock
before and after the plowback decision?
No Growth With Growth
5
P0 $41.67
.12
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Valuing Common Stocks
Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a 12%
expected return. Instead, we decide to blow back 40% of the earnings at
the firm’s current return on equity of 20%. What is the value of the stock
before and after the plowback decision?
No Growth With Growth
5 g .20.40 .08
P0 $41.67
.12
3
P0 $75.00
.12 .08
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Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, the
stock price would remain at $41.67. With the
plowback, the price rose to $75.00.
The difference between these two numbers (75.00-
41.67=33.33) is called the Present Value of Growth
Opportunities (PVGO).
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Valuing Common Stocks
Present Value of Growth Opportunities (PVGO)
- Net present value of a firm’s future
investments.
Sustainable Growth Rate - Steady rate at which
a firm can grow: plowback ratio X return on
equity.
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FCF and PV
Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
FCF is a more accurate measurement of PV
than either Div or EPS.
The market price does not always reflect the
PV of FCF.
When valuing a business for purchase, always
use FCF.
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FCF and PV
Valuing a Business
The value of a business is usually computed as the
discounted value of FCF out to a valuation horizon
(H).
The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.
FCF1 FCF2 FCFH PVH
PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H
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FCF and PV
Valuing a Business
FCF1 FCF2 FCFH PVH
PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H
PV (free cash flows) PV (horizon value)
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FCF and PV
Example
Given the cash flows for Concatenator Manufacturing
Division, calculate the PV of near term cash flows, PV
(horizon value), and the total value of the firm. r=10% and
g= 6%
Year
1 2 3 4 5 6 7 8 9 10
Asset Value 10.00 12.00 14.40 17.28 20.74 23.43 26.47 28.05 29.73 31.51
Earnings 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.36 3.57 3.78
Investment 2.00 2.40 2.88 3.46 2.69 3.04 1.59 1.68 1.78 1.89
Free Cash Flow - .80 - .96 - 1.15 - 1.39 - .20 - .23 1.59 1.68 1.79 1.89
.EPS growth (%) 20 20 20 20 20 13 13 6 6 6
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FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate
the PV of near term cash flows, PV (horizon value), and the total value of
the firm. r=10% and g= 6%
.
1 1.59
PV(horizon value) 6 22.4
1.1 .10 .06
.80 .96 1.15 1.39 .20 .23
PV(FCF) -
1.1 1.1 2
1.1 1.1 1.1 1.1 6
3 4 5
3.6
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FCF and PV
Example - continued
Given the cash flows for Concatenator Manufacturing Division, calculate
the PV of near term cash flows, PV (horizon value), and the total value of
the firm. r=10% and g= 6%
.
PV(busines s) PV(FCF) PV(horizon value)
-3.6 22.4
$18.8
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