CHAPTER 9 STOCK VALUATION Business Finance 3220 Discounted Dividend Model Estimating Dividends: 3 Cases 1. Constant fixed dividend (g=0): The firm will pay a constant dividend forever This is like preferred stock: 0 = 1 2. Constant dividend growth: The firm will increase the dividend by a constant percent every period: 0 = 1 3. Supernormal growth: Dividend growth is not consistent initially, but settles down to constant growth eventually Estimating g g = growth rate = (1 – payout rate)ROE = (retention rate)ROE ROE = Return on Invested Capital = Net Earnings/Equity The more a company retains/reinvests, the higher g will be. Retention/Reinvestment only good as long as ROE > Equity Cost of Capital (rS) Shareholders will be satisfied with foregoing dividends if the company is able to reinvest at a higher rate of return than the shareholders are demanding If rs = 15%, but a new project has an expected return on invested capital (ROE) of 20%, shareholders will be willing to let the company invest in the new project rather than giving the shareholders the cash. Stock Price Sensitivity to Dividend Growth, g 0 50 100 150 200 250 0 0.05 0.1 0.15 0.2 St oc k Pr ic e Growth Rate D1 = $2; rs = 20% Using the Discounted Dividend Model to find rs Start with the Discounted Dividend Model: 1 = 0(1+g) Rearrange and solve for : = 10 + = Dividend yield + Cap Gains Yield 0 = 1 Finding the Required Return – Example Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return 1 = 0(1+g) = $1(1+.05) = $1.05 rs = [1.05/10.50] + .05 = 15% What is the dividend yield 1.05/ 10.50 = 10% What is the capital gains yield g =5% Constant growth Problem Laurel Enterprises expects earnings next year of $4/share and has a 60% payout rate, which it plans to keep constant. Its equity cost of capital is 10%, which is also its ROE. Its earnings are expected to grow forever at a rate of 4%/year. If its next dividend is due in one year, what do you estimate the firm’s current stock price to be To retain more or less XTRA Corp. expects earnings next year of $12/share, and it plans to pay a $3 dividend/share. XTRA will retain $9/share to reinvest in new projects that have an expected return of 12%/year (ROE). Suppose XTRA will maintain the same payout rate and ROE. A. Solve for g, the growth rate in earnings B. If the cost of equity capital is 15%, what is the stock price C. Suppose they decided to pay a $6 dividend and retain only $6/share, and maintain this payout ratio indefinitely. Is this a good policy or not Supernormal growth McGraw Hill expects to pay a dividend of $4.50/share one year from today. The growth rate of dividends is expected to be 9% for the next three years, then 4% thereafter. If McGraw Hill’s equity cost of capital is 10.5%/year and its dividend payout ratio re
mains constant, compute McGraw Hill’s stock price. Three steps: 1. Find the PV of the dividends during the non-constant growth period (3 years, in this case) 2. Find the “terminal value” to cover the remaining cash flows on the timeline (years 4-infinity, in this case). Use the growing perpetuity formula. Remember that if your first cash flow in your growing perpetuity formula is from year 4, that means you are solving for the terminal value as of the end of year 3. 3. Discount terminal value back to time 0 and add to your value from step 1. What if the company doesn’t pay dividends Many small and/or young companies do not pay dividends—what then Dividend discount models are out, unless you can anticipate when the company will pay a dividend in the future (good luck). If the company does share repurchases, the value of the repurchase is effectively the same as a cash dividend. Since dividends are a proxy for equity cash flows, we can substitute another estimate, such as free cash flow This is what is commonly done in the industry, but requires much more information and expertise to forecast. Intuition is the same, however. Corporate Valuation Model Firm finances with debt, preferred stock and common stock WACC is the weighted average cost of capital used to discount the cash flows FCF is the cash generated before any payments are made to any investors; so it must be used to compensate common stockholders, preferred stockholders and bondholders Rearrange: MV(Equity) 0 = V0 – Debt0 – Preferred Stock0 P0 = (V0 – Debt0 – Preferred Stock0) / Shares Outstanding0 Corporate Valuation Example Allied Inc. expects to have the following Free Cash Flows (in millions) over the next 5 years: Year 1 2 3 4 5 FCF ($M) 124 122 137 168 182 After that, the free cash flows are expected to grow by 3%/year. If the WACC is 17%, estimate the Total Corporate Value of the firm. If Allied has $100 million in preferred stock, debt of $650 million and 75 million shares outstanding, estimate its share price. Valuation based on “comps” Compare firms by valuation multiples: 1. Price-to-Earnings (P/E): Use firm’s EPS and multiply it by industry P/E to get estimated price. Assumes firm should be at industry average P/E. Forward P/E: use E1. Trailing P/E: use E0 2. Enterprise Multiple: = () Overall, comps are a shortcut. Gives us a ballpark estimate. But need to note the differences between firms. Industry average may not be applicable to the firm in question. Comps Example After researching the competitors of Merck, you determine that most comparable firms have the following valuation ratios: Merck has EPS of $2, EBITDA of $16 billion, $18 billion in preferred stock, $27 billion in debt, and 3 billion shares outstanding. What range of prices is consistent with both sets of multiples GlaxoSmithKline Novartis AstraZeneca EV/EBITDA 11 12 9 P/E 19 23 26