70391 - Finance The Valuation of Common...
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70391 - Finance
The Valuation of Common StockWhere do Stock Prices Come From?
70391 – Finance – Fall 2016Tepper School of BusinessCarnegie Mellon Universityc©2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission.10.02.2016 14:14
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Stock Valuation
Future Free Cash Flow (FCF)
Profitability and Efficiency
Profit margins Operating efficiency Capital (asset) efficiency ROIC
Growth Opportunities New customers New products R&D, innovation
Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty
Market Interest Rates
Efficient Markets Market forces will tend to drive market value toward intrinsic value
Risk
Cost of Capital (%)
Investors required rate-of-return
Intrinsic Value of Operations (Discounted FCF)
Market Value of the Firm
Total Debt
Market Value of Equity
Share Price
Number of Shares
Non-Operating Assets (Cash)
Discounted by
Capital Markets Capital Structure (firm’s choice
of debt and equity)
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Game Plan
Where do stock prices come from?
:1: “Multiples of comparables”
:2: Dividend discount model
:3: Dividend discount model with growth and earningsreinvestment
:4: PV the firm, subtract the debt:
Price per Share (PPS) =PV(FCF)−Debt
Number of Shares
Stock Valuation 3
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Multiples of Comparables
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Multiples of Comparables
:: Compare some accounting ratio of the company of interest tosome appropriate (“comparable”) benchmark (e.g., industryaverage, similar companies)
:: Most common: “price-earnings-ratio,” P/E ratio
:: Also: “market-book ratio,” “price-dividend ratio,”EV/EBITDA, etc.
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“Growth Hunt Lifts Tech Stocks”Source: WSJ, July 20 2015
“Already sky high, valuations risk further as NASDAQ Compositesurges to record”
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Toothless Fangs and BatsSource: Toothless, Financial Times, LEX, June 15, 2016
China has a lot of eyeballs, but its internet companies are valued more cheaply than their US counterparts. Concerns about regulation and trustworthiness of service may be factors, as well as a lack of investor familiarity. The country’s top internet companies are all listed outside mainland China
FT graphic Sources: FT Research, Thomson Reuters Datastream; S&P Capital IQ
Internet stocks: sales, profits and capitalisation
0
2
4
6
8
10
12
14
16
0 10 20 30 40 50 60 70 80 90 110100Revenue ($bn)
Market cap ($bn)
US v China stock performance
Alibaba
Tencent
Baidu
Facebook Amazon
Netflix
Google Share price performance since start2015 ($bn)
2015 2016
50
100
150
200
250
GoogleAmazon
BaiduAlibaba
188.3
337.5204.7 325.9
53.6
40.2
497.5
The Financial Times Limited 2016. You may share using our article tools.Please don't cut articles from FT.com and redistribute by email or post to the web.© FT and 'Financial Times' are trademarks of The Financial Times Ltd.
Date: Wednesday June 15, 2016
Page: 14
Region: UK
Edition: 01
Copyright
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From Textbook
Source: Brealey-Myers-Allen, 11th ed., Chapter 4
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Price/Dividend RatioLook at GPS/AEO data online
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Price/Earnings Ratio
P/E ratio: more common multiple.
:: But what is the interpretation? Stockholders get dividends,not earnings.
:: Answer coming soon. First, Comps Spreadsheet
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Recursive Valuation of Dividends(Basis of the “Dividend Discount Model”)
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Conundrum?
(1) “Share prices equal the present value of all future dividends.”
(2) “Investors hope for capital gains, in addition to dividends.”
:: i.e., investors hope to “buy low, sell high”
:: Why doesn’t the share price in (1) depend on capital gains?
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Numerical Examples
:: What is the value of the stock?
:: [risk-free] dividends of
:: $10 per share at year 1,
:: $10 per share at year 2,
:: $10 per share at year 3
:: Zero ($0) per share at year 4, 5, 6 and so on
:: The discount rate, r , is 18%. Constant (simplification).
:: What is the value of the stock?
:: What if you plan to hold the stock for only 1 year?
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Numerical Examples$10 per share at year 1. $10 per share at year 2. $10 per share at year 3. Zero ($0) per share at year 4, 5, 6 and so on. Thediscount rate is 18%.
0 1 2 3 4 ...
0 10 10 10 0 0
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One Year OnlyPrice at date 1 = 15.66 ... price at date 0 = PV of 10 + 15.66
0 1 2 3 4 ...
0 10 10 10 0 0
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Recursive Valuation
General case:
:: What is the value of the stock?
:: Dividends of $dt (riskless)
:: The discount rate is r
:: Does it matter how long you plan on holding the stock?
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Recursive Valuation
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Recursive Valuation: PointDecompose return into capital gain and dividend yield
:: Stock valuations are determined by the value of the cash-flowthat accrues to the owner of the stock.
:: Value of cash flows = present discounted value of sum of thedividends (or “payouts”)
:: Value of cash flows = present discounted value of (tomorrow’sdividend + tomorrow’s price)
Pt =∞∑i=0
E (dt+i )
(1 + r)i
=E (Pt+1 + dt+1)
1 + r
=⇒ 1 + r = EPt+1
Pt+ E
dt+1
Pt
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Recursive Valuation: PointDecompose return into capital gain and dividend yield
:: Stock valuations are determined by the value of the cash-flowthat accrues to the owner of the stock.
:: Value of cash flows = present discounted value of sum of thedividends (or “payouts”)
:: Value of cash flows = present discounted value of (tomorrow’sdividend + tomorrow’s price)
Pt =∞∑i=0
E (dt+i )
(1 + r)i
=E (Pt+1 + dt+1)
1 + r
=⇒ 1 + r = EPt+1
Pt+ E
dt+1
Pt
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Earnings, Growth and Reinvestment(The Link Between Earnings and Dividends)
(Understanding the P/E Ratio)
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Dividends
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Understanding the P/E Ratio
Motivation
:1: Earnings, not dividends?
:2: P/E ratio is most common “valuation ratio.”
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Problem
Stock valuation
Pt =∞∑i=0
Et [d̃t+i ]
(1 + E [r ])i
But wait ... some firms don’t pay dividends?
:: Can we stick in earnings? No. Earnings are not the paymentsto stockholders.
:: Two approaches1. Model how earnings affects dividends2. V = D + E : Value the firm’s FCF, subtract the debt, divide by
shares outstanding.
:: Key thing::: Dividend policy (“payout policy”) is a financial decision.
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Problem
Stock valuation
Pt =∞∑i=0
Et [d̃t+i ]
(1 + E [r ])i
But wait ... some firms don’t pay dividends?
:: Can we stick in earnings?
No. Earnings are not the paymentsto stockholders.
:: Two approaches1. Model how earnings affects dividends2. V = D + E : Value the firm’s FCF, subtract the debt, divide by
shares outstanding.
:: Key thing::: Dividend policy (“payout policy”) is a financial decision.
Stock Valuation 22
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Problem
Stock valuation
Pt =∞∑i=0
Et [d̃t+i ]
(1 + E [r ])i
But wait ... some firms don’t pay dividends?
:: Can we stick in earnings? No. Earnings are not the paymentsto stockholders.
:: Two approaches1. Model how earnings affects dividends2. V = D + E : Value the firm’s FCF, subtract the debt, divide by
shares outstanding.
:: Key thing::: Dividend policy (“payout policy”) is a financial decision.
Stock Valuation 22
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Problem
Stock valuation
Pt =∞∑i=0
Et [d̃t+i ]
(1 + E [r ])i
But wait ... some firms don’t pay dividends?
:: Can we stick in earnings? No. Earnings are not the paymentsto stockholders.
:: Two approaches1. Model how earnings affects dividends2. V = D + E : Value the firm’s FCF, subtract the debt, divide by
shares outstanding.
:: Key thing::: Dividend policy (“payout policy”) is a financial decision.
Stock Valuation 22
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Problem
Stock valuation
Pt =∞∑i=0
Et [d̃t+i ]
(1 + E [r ])i
But wait ... some firms don’t pay dividends?
:: Can we stick in earnings? No. Earnings are not the paymentsto stockholders.
:: Two approaches1. Model how earnings affects dividends2. V = D + E : Value the firm’s FCF, subtract the debt, divide by
shares outstanding.
:: Key thing::: Dividend policy (“payout policy”) is a financial decision.
Stock Valuation 22
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Why?[Source: google.com but lots (lots!) of places have this information.]
Why the differences in P/E?
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Accounting Definitions
Most variables are “per share” in Year t.
:: Pt ex-dividend price per share.
:: EPSt = DIVt + REt
:: BVEt = book-value of equity, at the beginning of Year t.
:: Return on Equity: ROE = EPStBVEt
.
:: Plowback ratio: PLOW = REtEPSt
:: Payout ratio: PAY = DIVtEPSt
= 1− PLOW
Stock Valuation 24
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Accounting Definitions
Most variables are “per share” in Year t.
:: Pt ex-dividend price per share.
:: EPSt = DIVt + REt
:: BVEt = book-value of equity, at the beginning of Year t.
:: Return on Equity: ROE = EPStBVEt
.
:: Plowback ratio: PLOW = REtEPSt
:: Payout ratio: PAY = DIVtEPSt
= 1− PLOW
Stock Valuation 24
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Accounting Definitions
Most variables are “per share” in Year t.
:: Pt ex-dividend price per share.
:: EPSt = DIVt + REt
:: BVEt = book-value of equity, at the beginning of Year t.
:: Return on Equity: ROE = EPStBVEt
.
:: Plowback ratio: PLOW = REtEPSt
:: Payout ratio: PAY = DIVtEPSt
= 1− PLOW
Stock Valuation 24
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Accounting Definitions
Most variables are “per share” in Year t.
:: Pt ex-dividend price per share.
:: EPSt = DIVt + REt
:: BVEt = book-value of equity, at the beginning of Year t.
:: Return on Equity: ROE = EPStBVEt
.
:: Plowback ratio: PLOW = REtEPSt
:: Payout ratio: PAY = DIVtEPSt
= 1− PLOW
Stock Valuation 24
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Accounting Definitions
Most variables are “per share” in Year t.
:: Pt ex-dividend price per share.
:: EPSt = DIVt + REt
:: BVEt = book-value of equity, at the beginning of Year t.
:: Return on Equity: ROE = EPStBVEt
.
:: Plowback ratio: PLOW = REtEPSt
:: Payout ratio: PAY = DIVtEPSt
= 1− PLOW
Stock Valuation 24
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Accounting Definitions
Most variables are “per share” in Year t.
:: Pt ex-dividend price per share.
:: EPSt = DIVt + REt
:: BVEt = book-value of equity, at the beginning of Year t.
:: Return on Equity: ROE = EPStBVEt
.
:: Plowback ratio: PLOW = REtEPSt
:: Payout ratio: PAY = DIVtEPSt
= 1− PLOW
Stock Valuation 24
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Engine of Growth
Assume ROE is constant over time
:: EPSt = ROE × BVEt
:: Just the definition of ROE, rewritten. “To figure out earnings, justmultiply ROE times BVEt”
:: BVEt = BVEt−1 + EPSt−1 × PLOW
:: BVE grows by plowing back earnings. Same as saying “BVE thisyear equals BVE last year plus retained earnings.”
:: Combine these two equations and arrive at growth rate, g :
BVEt = BVEt−1 + ROE × BVEt−1 × PLOW
= BVEt−1
(1 + ROE × PLOW
)︸ ︷︷ ︸growth=g
=⇒ g = ROE × PLOW
:: Makes sense: if each dollar of BVE earns an ROE of 12 cents (or 12%),and then 40% of these cents are PLOWED back in, you will have grownby 0.12× 0.40 = 4.8 cents, per dollar of BVE (or 4.8%).
Stock Valuation 25
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Engine of Growth
Assume ROE is constant over time
:: EPSt = ROE × BVEt
:: Just the definition of ROE, rewritten. “To figure out earnings, justmultiply ROE times BVEt”
:: BVEt = BVEt−1 + EPSt−1 × PLOW
:: BVE grows by plowing back earnings. Same as saying “BVE thisyear equals BVE last year plus retained earnings.”
:: Combine these two equations and arrive at growth rate, g :
BVEt = BVEt−1 + ROE × BVEt−1 × PLOW
= BVEt−1
(1 + ROE × PLOW
)︸ ︷︷ ︸growth=g
=⇒ g = ROE × PLOW
:: Makes sense: if each dollar of BVE earns an ROE of 12 cents (or 12%),and then 40% of these cents are PLOWED back in, you will have grownby 0.12× 0.40 = 4.8 cents, per dollar of BVE (or 4.8%).
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Engine of Growth
Assume ROE is constant over time
:: EPSt = ROE × BVEt
:: Just the definition of ROE, rewritten. “To figure out earnings, justmultiply ROE times BVEt”
:: BVEt = BVEt−1 + EPSt−1 × PLOW
:: BVE grows by plowing back earnings. Same as saying “BVE thisyear equals BVE last year plus retained earnings.”
:: Combine these two equations and arrive at growth rate, g :
BVEt = BVEt−1 + ROE × BVEt−1 × PLOW
= BVEt−1
(1 + ROE × PLOW
)︸ ︷︷ ︸growth=g
=⇒ g = ROE × PLOW
:: Makes sense: if each dollar of BVE earns an ROE of 12 cents (or 12%),and then 40% of these cents are PLOWED back in, you will have grownby 0.12× 0.40 = 4.8 cents, per dollar of BVE (or 4.8%).
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Engine of Growth
Assume ROE is constant over time
:: EPSt = ROE × BVEt
:: Just the definition of ROE, rewritten. “To figure out earnings, justmultiply ROE times BVEt”
:: BVEt = BVEt−1 + EPSt−1 × PLOW
:: BVE grows by plowing back earnings. Same as saying “BVE thisyear equals BVE last year plus retained earnings.”
:: Combine these two equations and arrive at growth rate, g :
BVEt = BVEt−1 + ROE × BVEt−1 × PLOW
= BVEt−1
(1 + ROE × PLOW
)︸ ︷︷ ︸growth=g
=⇒ g = ROE × PLOW
:: Makes sense: if each dollar of BVE earns an ROE of 12 cents (or 12%),and then 40% of these cents are PLOWED back in, you will have grownby 0.12× 0.40 = 4.8 cents, per dollar of BVE (or 4.8%).
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Growth
:: Since EPSt is proportional to BVEt ,
EPSt = ROE × BVEt
EPSt must grow at rate g .
:: Same, then, applies for DIVt and REt :
DIVt = PAY × EPSt
REt = PLOW × EPSt
:: Growth:
BVEt+1 = BVE1
(1 + g
)tEPSt+1 = EPS1
(1 + g
)t= BVE1 × ROE
(1 + g
)tDIVt+1 = DIV1
(1 + g
)t= EPS1 × PAY
(1 + g
)t= BVE1 × ROE × PAY
(1 + g
)tStock Valuation 26
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Valuation
Recall, “growing perpetuity:”
P0 =DIV1
r − g
=PAY × EPS1
r − g
=PAY × ROE × BVE1
r − ROE × PLOW
where r is the cost of capital.
:: This is a model of how earnings maps into dividends.
:: We can use it to get some important insights
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NPV
Suppose that ROE = r
P0 =PAY × r × BVE1
r − r × PLOW= BVE1
NPV = 0
:: Makes sense
:: If ROE > r , NPV > 0
:: If ROE < r , NPV < 0
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NPV
Suppose that ROE = r
P0 =PAY × r × BVE1
r − r × PLOW= BVE1
NPV = 0
:: Makes sense
:: If ROE > r , NPV > 0
:: If ROE < r , NPV < 0
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NPV
Suppose that ROE = r
P0 =PAY × r × BVE1
r − r × PLOW= BVE1
NPV = 0
:: Makes sense
:: If ROE > r , NPV > 0
:: If ROE < r , NPV < 0
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I No growth (PLOW=0): PVGO = 0. But, if ROE > r , NPV is stillpositive. Just none from growing!
I Growth and investing in loser projects. PLOW > 0 and ROE < r . Here,you can verify that PVGO < 0. The firm is growing, but in doing so it iswasting the money of its owners. Recall that if ROE < r then the firmrepresents a negative NPV project. By growing the firm through plowingback earnings, the managers are taking a dumb idea and exacerbating it.
I PLOW > 0 and ROE > r . Well done!
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I No growth (PLOW=0): PVGO = 0. But, if ROE > r , NPV is stillpositive. Just none from growing!
I Growth and investing in loser projects. PLOW > 0 and ROE < r . Here,you can verify that PVGO < 0. The firm is growing, but in doing so it iswasting the money of its owners. Recall that if ROE < r then the firmrepresents a negative NPV project. By growing the firm through plowingback earnings, the managers are taking a dumb idea and exacerbating it.
I PLOW > 0 and ROE > r . Well done!
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I No growth (PLOW=0): PVGO = 0. But, if ROE > r , NPV is stillpositive. Just none from growing!
I Growth and investing in loser projects. PLOW > 0 and ROE < r . Here,you can verify that PVGO < 0. The firm is growing, but in doing so it iswasting the money of its owners. Recall that if ROE < r then the firmrepresents a negative NPV project. By growing the firm through plowingback earnings, the managers are taking a dumb idea and exacerbating it.
I PLOW > 0 and ROE > r . Well done!
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I No growth (PLOW=0): PVGO = 0. But, if ROE > r , NPV is stillpositive. Just none from growing!
I Growth and investing in loser projects. PLOW > 0 and ROE < r . Here,you can verify that PVGO < 0. The firm is growing, but in doing so it iswasting the money of its owners. Recall that if ROE < r then the firmrepresents a negative NPV project. By growing the firm through plowingback earnings, the managers are taking a dumb idea and exacerbating it.
I PLOW > 0 and ROE > r . Well done!
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I No growth (PLOW=0): PVGO = 0. But, if ROE > r , NPV is stillpositive. Just none from growing!
I Growth and investing in loser projects. PLOW > 0 and ROE < r . Here,you can verify that PVGO < 0. The firm is growing, but in doing so it iswasting the money of its owners. Recall that if ROE < r then the firmrepresents a negative NPV project. By growing the firm through plowingback earnings, the managers are taking a dumb idea and exacerbating it.
I PLOW > 0 and ROE > r . Well done!
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I Growth but no growing value. If PLOW > 0 but ROE = r thenPVGO = 0. Competitive markets make us consider this situationseriously. The firm’s growth represents a series of investments inNPV = 0 projects. Growth, per-se, does not give a high P/E.
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Growth
PVGO = “Present Value of Growth Options”
PVGO = P0 −EPS1r
=PAY × ROE × BVE1
r − ROE × PLOW− ROE × BVE1
r
Special cases:
I Why do P/E ratios vary in the cross-section? One last way to express themain point is to write the definition of the PVGO as
P0
EPS1=
PVGO
EPS1+
1
r
A high P/E ratio is indicative of either a high PVGO, a lowcost-of-capital, or a bit of both. The “link between the stock price andearnings per share” is that the price will be high, relative to earnings, ifeither (or both) of these things hold.
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Hidden Assumptions
:: ROE, PAY and PLOW are time invariant
:: Constant growth in all variables (earnings, dividends, BVE,etc.)
:: No capital structure (yet)
:: Constant discount rate
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Summary
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Summary: Where do Stock Prices Come From?
:: Where do stock prices come from? DCF
:: PV of all future dividends
:: PV of tomorrow’s dividend and tomorrows stock price:dividend and capital gain
:: Hardest part is getting the discount rate right
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Summary: Where do Stock Prices Come From?
Valuing a stock is similar to valuing a bond:
:: DCF the cash flows: “dividend discount model”
:: If dividends are risky, DCF the expected dividends, discount byappropriate expected return
But the cash flow to the stockholder depends on the financial policy of the firm... it’s payout policy. So,
:1: If you have a good handle on dividends, directly, then P = d/(r − g) orP = E
∑t dt/(1 + r)t or something similar
:2: If you’d like to go slightly deeper, and model where growth comes from,then P = (PAY × ROE × BVE)/(r − ROE × PLOW ).
:3: Or model the FCF, PV it, subtract the debt and divide by number ofshares. This is next. It makes less stringent assumptions about “constantgrowth,” but requires many alternative assumptions.
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Summary: Where do Stock Prices Come From?
Valuing a stock is similar to valuing a bond:
:: DCF the cash flows: “dividend discount model”
:: If dividends are risky, DCF the expected dividends, discount byappropriate expected return
But the cash flow to the stockholder depends on the financial policy of the firm... it’s payout policy. So,
:1: If you have a good handle on dividends, directly, then P = d/(r − g) orP = E
∑t dt/(1 + r)t or something similar
:2: If you’d like to go slightly deeper, and model where growth comes from,then P = (PAY × ROE × BVE)/(r − ROE × PLOW ).
:3: Or model the FCF, PV it, subtract the debt and divide by number ofshares. This is next. It makes less stringent assumptions about “constantgrowth,” but requires many alternative assumptions.
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Summary: Where do Stock Prices Come From?
Valuing a stock is similar to valuing a bond:
:: DCF the cash flows: “dividend discount model”
:: If dividends are risky, DCF the expected dividends, discount byappropriate expected return
But the cash flow to the stockholder depends on the financial policy of the firm... it’s payout policy. So,
:1: If you have a good handle on dividends, directly, then P = d/(r − g) orP = E
∑t dt/(1 + r)t or something similar
:2: If you’d like to go slightly deeper, and model where growth comes from,then P = (PAY × ROE × BVE)/(r − ROE × PLOW ).
:3: Or model the FCF, PV it, subtract the debt and divide by number ofshares. This is next. It makes less stringent assumptions about “constantgrowth,” but requires many alternative assumptions.
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Summary: Where do Stock Prices Come From?
Valuing a stock is similar to valuing a bond:
:: DCF the cash flows: “dividend discount model”
:: If dividends are risky, DCF the expected dividends, discount byappropriate expected return
But the cash flow to the stockholder depends on the financial policy of the firm... it’s payout policy. So,
:1: If you have a good handle on dividends, directly, then P = d/(r − g) orP = E
∑t dt/(1 + r)t or something similar
:2: If you’d like to go slightly deeper, and model where growth comes from,then P = (PAY × ROE × BVE)/(r − ROE × PLOW ).
:3: Or model the FCF, PV it, subtract the debt and divide by number ofshares. This is next. It makes less stringent assumptions about “constantgrowth,” but requires many alternative assumptions.
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Summary: Where do Stock Prices Come From?
Valuing a stock is similar to valuing a bond:
:: DCF the cash flows: “dividend discount model”
:: If dividends are risky, DCF the expected dividends, discount byappropriate expected return
But the cash flow to the stockholder depends on the financial policy of the firm... it’s payout policy. So,
:1: If you have a good handle on dividends, directly, then P = d/(r − g) orP = E
∑t dt/(1 + r)t or something similar
:2: If you’d like to go slightly deeper, and model where growth comes from,then P = (PAY × ROE × BVE)/(r − ROE × PLOW ).
:3: Or model the FCF, PV it, subtract the debt and divide by number ofshares. This is next. It makes less stringent assumptions about “constantgrowth,” but requires many alternative assumptions.
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Summary: Link Between Dividends and Earnings
:: Strictly speaking, stock holders get dividends, so stock pricesderive from dividends
:: But dividend policies vary a lot across firms, time. Dividendstake many forms. Earnings, in contrast, are not a financialpolicy. They are the outcome of business operations. Sowhat’s the link?
:: If plowback = 0, then EPS=DPS and the link is trivial
:: If plowback > 0, then DPS<EPS. But we can use ROE andplowback to estimate D-growth
:: If plowback > 0, and if its being plowed into NPV>0 projects,then part of firm value is PVGO: growth firm. E/P ratio issmaller than cost-of-capital: “growth firms” have bigger P/Eratios than non-growth firms with same cost-of-capital.
Stock Valuation 36