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Copyright 1996 by The McGraw-Hill Companies, Inc
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.
2
Copyright 1996 by The McGraw-Hill Companies, Inc
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.
H - Time horizon for your investment.
PDiv
r
Div
r
Div P
rH H
H01
12
21 1 1
( ) ( )
...( )
3
Copyright 1996 by The McGraw-Hill Companies, Inc
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?
4
Copyright 1996 by The McGraw-Hill Companies, Inc
Valuing Common Stocks
ExampleCurrent 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?
PV
PV
300
1 12
324
1 12
350 94 48
1 12
00
1 2 3
.
( . )
.
( . )
. .
( . )
$75.
5
Copyright 1996 by The McGraw-Hill Companies, Inc
Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.
6
Copyright 1996 by The McGraw-Hill Companies, Inc
Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.
Perpetuity PDiv
ror
EPS
r 0
1 1
Assumes all earnings are paid to shareholders.
7
Copyright 1996 by The McGraw-Hill Companies, Inc
Valuing Common Stocks
Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).
8
Copyright 1996 by The McGraw-Hill Companies, Inc
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?
$100$3.
.
.
00
12
09
g
g
Answer
The market is assuming the dividend will grow at 9% per year, indefinitely.
9
Copyright 1996 by The McGraw-Hill Companies, Inc
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.
10
Copyright 1996 by The McGraw-Hill Companies, Inc
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
11
Copyright 1996 by The McGraw-Hill Companies, Inc
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?
12
Copyright 1996 by The McGraw-Hill Companies, Inc
Valuing Common Stocks
ExampleOur 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?
P0
5
1267
.$41.
No Growth With Growth
13
Copyright 1996 by The McGraw-Hill Companies, Inc
Valuing Common Stocks
ExampleOur 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?
P0
5
1267
.$41.
No Growth With Growth
g
P
. . .
. .$75.
20 40 08
3
12 08000
14
Copyright 1996 by The McGraw-Hill Companies, Inc
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).
15
Copyright 1996 by The McGraw-Hill Companies, Inc
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.
16
Copyright 1996 by The McGraw-Hill Companies, Inc
FCF and PVFCF 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.
17
Copyright 1996 by The McGraw-Hill Companies, Inc
FCF and PVFCF and PVValuing 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.
HH
HH
r
PV
r
FCF
r
FCF
r
FCFPV
)1()1(...
)1()1( 22
11
18
Copyright 1996 by The McGraw-Hill Companies, Inc
FCF and PVFCF and PVValuing a Business
HH
HH
r
PV
r
FCF
r
FCF
r
FCFPV
)1()1(...
)1()1( 22
11
PV (free cash flows) PV (horizon value)
19
Copyright 1996 by The McGraw-Hill Companies, Inc
FCF and PV
ExampleGiven 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%
66613132020202020(%) growth .EPS
1.891.791.681.59.23-.20-1.39-1.15-.96-.80- FlowCash Free
1.891.781.681.593.042.693.462.882.402.00Investment
3.783.573.363.182.812.492.071.731.441.20Earnings
51.3173.2905.2847.2643.2374.2028.1740.1400.1200.10ValueAsset
10987654321
Year
20
Copyright 1996 by The McGraw-Hill Companies, Inc
FCF and PV
Example - continuedGiven 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%
.
4.2206.10.
59.1
1.1
1 value)PV(horizon 6
6.3
1.1
23.
1.1
20.
1.1
39.1
1.1
15.1
1.1
96.
1.1
.80-PV(FCF) 65432
21
Copyright 1996 by The McGraw-Hill Companies, Inc
FCF and PV
Example - continuedGiven 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%
.
$18.8
22.4-3.6
value)PV(horizonPV(FCF)s)PV(busines
22
Copyright 1996 by The McGraw-Hill Companies, Inc
WHAT DETERMINES THE REQUIRED RATE
OF RETURN ON AN INVESTMENT?
WHAT DETERMINES THE REQUIRED RATE
OF RETURN ON AN INVESTMENT?
REQUIRED RETURN DEPENDS ON THE RISK OF THE INVESTMENT
– GREATER THE RISK, GREATER THE RETURN
WHAT KIND OF RISK RESULTS IN A HIGHER RETURN?
LOOK AT THE HISTORY OF CAPITAL MARKETS.
– RETURNS FROM NONFINANCIAL INVESTMENTS HAVE TO BE COMPARABLE WITH RETURNS FROM FINANCIAL INVESTMENTS OF SIMILAR RISK
23
Copyright 1996 by The McGraw-Hill Companies, Inc
IBBOTSON ASSOCIATESIBBOTSON ASSOCIATES
COMMON STOCKS S&P500
SMALL STOCKS SMALLEST 20% NYSE STOCKS
LONG-TERM CORPORATE BONDS HIGH QUALITY
20-YEAR CURRENT MATURITY
LONG-TERM TREASURY BONDS 20-YEAR CURRENT MATURITY
US TREASURY BILLS CURRENT MATURITY < 1 YEAR
24
Copyright 1996 by The McGraw-Hill Companies, Inc
VALUE AT END OF 1994 OF $1 INVESTMENT AT THE
BEGINNING OF 1926
VALUE AT END OF 1994 OF $1 INVESTMENT AT THE
BEGINNING OF 1926
NOMINAL REAL SMALL CAP $2,843 $340
S&P500 $811 $97
CORPORATE BONDS $38 $4.5
TREASURY BONDS $26 $3.1
T-BILLS $12 $1.5
INFLATION $7– $7 AT THE END OF 1994 HAD THE SAME
PURCHASING POWER AS $1 AT THE BEGINNING OF 1926
25
Copyright 1996 by The McGraw-Hill Companies, Inc
RISKS OF DIFFERENT ASSET CLASSES
RISKS OF DIFFERENT ASSET CLASSES
SECURITY RISK
TREASURY BILLS NO RISK IN NOMINAL RETURN
BUT UNCERTAIN REAL RETURN
TREASURY BONDS AND INTEREST RATE RISK
CORPORATE BONDS AND DEFAULT RISK
AND EVENT RISK
COMMON STOCKS AND MARKET RISK
AND UNSYSTEMATIC RISK
26
Copyright 1996 by The McGraw-Hill Companies, Inc
AVERAGE RETURNS AND STANDARD DEVIATIONS1926 - 1994
AVERAGE RETURNS AND STANDARD DEVIATIONS1926 - 1994
Average Average Average nominal real risk
Portfolio return return premium
Treasury bills 3.7% 0.6% 0
% Government bonds 5.2 2.1 1.4
Corporate bonds 5.7 2.7 2.0
Common stocks 12.2 8.9 8.4
Small-firm stocks 17.4 13.9
13.7
Source: Stocks, Bonds, Bills, and Inflation:
1995 Yearbook, Ibbotson Associates, Chicago, 1995
27
Copyright 1996 by The McGraw-Hill Companies, Inc
-50
-40
-30
-20
-10
0
10
20
30
40
50
60
1926
1929
1932
1935
1938
1941
1944
1947
1950
1953
1956
1959
1962
1965
1968
1971
1974
1977
1980
1983
1986
Year
Return
%
THE U.S. STOCK MARKET HAS BEEN APROFITABLE BUT VARIABLE
INVESTMENT
THE U.S. STOCK MARKET HAS BEEN APROFITABLE BUT VARIABLE
INVESTMENTSource: Ibbotson Associates (1989)
28
Copyright 1996 by The McGraw-Hill Companies, Inc
0
2
4
6
8
10
12
14
Number of
years
ANNUAL MARKET RETURNS IN THE US
1926 - 1994
ANNUAL MARKET RETURNS IN THE US
1926 - 1994
1
2
4
11
8
13
9 9
3
2
SOURCE: IBBOTSON ASSOCIATES (1989)
-50 -40 -30 -20 -10 010 20 30 40 50 60
Return, percent
1
29
Copyright 1996 by The McGraw-Hill Companies, Inc
STATISTICAL MEASURES OF SPREADSTATISTICAL MEASURES OF SPREAD
VARIANCE, 2 = (r - r)2
-UNITS ARE (RETURN)2
STANDARD DEVIATION, = VARIANCE(r)
-UNITS ARE RETURN
30
Copyright 1996 by The McGraw-Hill Companies, Inc
CALCULATING VARIANCE AND STANDARD DEVIATION OF MERCK
RETURNS FROM PAST MONTHLY DATA
CALCULATING VARIANCE AND STANDARD DEVIATION OF MERCK
RETURNS FROM PAST MONTHLY DATA
Deviation from mean Squared Month Return return deviation
1 5.4% 2.6% 6.8 2 1.7 - 1.1 1.2 3 - 3.6 - 6.4 41.0 4 13.6 10.8 116.6 5 - 3.5 - 6.3 39.7 6 3.2 0.4 0.2
Total 16.8 205.4
Mean: 16.8/6 = 2.8% Variance: 205.4/6 = 34.2 Standard deviation: 34.2 = 5.9% per month Annualized standard deviation 5.9 x (12) = 20.3%
31
Copyright 1996 by The McGraw-Hill Companies, Inc
AVERAGE RETURNS AND STANDARD DEVIATIONS1926 - 1994
AVERAGE RETURNS AND STANDARD DEVIATIONS1926 - 1994
Average Average Average Standard nominal real risk deviation Portfolio return return premium of returnsTreasury bills 3.7% 0.6% 0 % 3.3% Government bonds 5.2 2.1
1.4 8.7Corporate bonds 5.7 2.7 2.0 8.3Common stocks 12.2 8.9 8.4 20.2Small-firm stocks 17.4 13.9 13.7 34.3
Source: Stocks, Bonds, Bills, and Inflation:
1995 Yearbook, Ibbotson Associates, Chicago, 1995
32
Copyright 1996 by The McGraw-Hill Companies, Inc
VARIABILITY IN STOCK MARKET RETURNS VARIABILITY IN STOCK MARKET RETURNS
BRIEF PERIODS OF EXTREMELY HIGH VOLATILITY
OCTOBER 19, 1987, MARKET FELL 23% IN ONE DAY
33
Copyright 1996 by The McGraw-Hill Companies, Inc
VARIABILITY IN RETURNS OF INDIVIDUAL STOCKS
VARIABILITY IN RETURNS OF INDIVIDUAL STOCKS
CALCULATED OVER RECENT FIVE-YEAR PERIOD– FIRM FACES CHANGING BUSINESS RISKS OVER 70-YEAR
PERIOD– CALCULATE MONTHLY VARIANCE AND MULTIPLY BY TWELVE,
ASSUMING SUCCESSIVE MONTHLY RETURNS ARE INDEPENDENT
– STANDARD DEVIATION INCREASES WITH THE SQUARE ROOT OF THE LENGTH OF TIME OVER WHICH IT IS BEING MEASURED
MOST STOCKS MORE VARIABLE THAN MARKETDIVERSIFICATION REDUCES VARIABILITY
– CHANGES IN THE PRICE OF DIFFERENT STOCKS ARE NOT PERFECTLY CORRELATED
– TEND TO OFFSET EACH OTHER
34
Copyright 1996 by The McGraw-Hill Companies, Inc
DIVERSIFICATION ELIMINATES UNIQUE RISK
DIVERSIFICATION ELIMINATES UNIQUE RISK
deviationstandardPortfolio
UNIQUE RISK
MARKET RISK
Number ofsecurities
5 10
35
Copyright 1996 by The McGraw-Hill Companies, Inc
INDIVIDUAL STOCKS HAVE TWO KINDS OF RISK:
INDIVIDUAL STOCKS HAVE TWO KINDS OF RISK:
MARKET RISK
– OR SYSTEMATIC RISK OR UNDIVERSIFIABLE RISK
– AFFECTS ALL STOCKS
UNIQUE RISK
– OR UNSYSTEMATIC RISK OR DIVERSIFIABLE RISK OR SPECIFIC RISK OR RESIDUAL RISK
– AFFECTS INDIVIDUAL STOCKS OR SMALL GROUPS OF STOCKS
– UNIQUE RISK OF DIFFERENT FIRMS UNRELATED
– ELIMINATED BY DIVERSIFICATION
36
Copyright 1996 by The McGraw-Hill Companies, Inc
UNIQUE OR UNSYSTEMATIC RISK
UNIQUE OR UNSYSTEMATIC RISK
A DRUG TRIAL SHOWING THAT BETA BLOCKERS INCREASE RISK OF CANCER IN OLDER PEOPLE WILL AFFECT PFIZER’S STOCK – BUT HAS NO AFFECT ON SHARES OF GM OR IBM
A STRIKE AT A SINGLE GM PLANT WILL AFFECT ONLY GM AND PERHAPS ITS SUPPLIERS AND COMPETITORS
A HOT SUMMER WILL INCREASE DEMAND FOR AIR CONDITIONERS – BUT WON’T AFFECT THE DEMAND FOR
COMPUTERS
37
Copyright 1996 by The McGraw-Hill Companies, Inc
MARKET OR SYSTEMATIC RISK
MARKET OR SYSTEMATIC RISK
ALL FIRMS AFFECTED BY ECONOMY AND EXPOSED TO MARKET RISK– EXAMPLE: SURPRISE IN RATE OF GROWTH IN GNP
MARKET RISK CANNOT BE DIVERSIFIED AWAY
38
Copyright 1996 by The McGraw-Hill Companies, Inc
PORTFOLIO RISKPORTFOLIO RISK
RISK OF A WELL-DIVERSIFIED PORTFOLIO
DEPENDS ONLY ON THE MARKET OR SYSTEMATIC
RISK OF THE SECURITIES IN THE PORTFOLIO
RISK OF A NON- DIVERSIFIED PORTFOLIO
DEPENDS ON THE MARKET RISK AND THE UNIQUE
RISK OF THE SECURITIES IN THE PORTFOLIO
39
Copyright 1996 by The McGraw-Hill Companies, Inc
SYSTEMATIC RISK OF A STOCK MEASURED
BY ITS BETA COEFFICIENT
SYSTEMATIC RISK OF A STOCK MEASURED
BY ITS BETA COEFFICIENT
THE MARKET OR AN AVERAGE STOCK HAS
=1
A STOCK WITH =2 HAS TWICE AS MUCH SYSTEMATIC RISK AS THE MARKET
AN INVESTOR IN A HIGH BETA STOCK WILL EXPECT TO EARN A HIGHER RETURN THAN AN INVESTOR IN A LOW BETA STOCK
40
Copyright 1996 by The McGraw-Hill Companies, Inc
MAJOR INVESTORS HOLD DIVERSIFIED PORTFOLIOS,
WITH LITTLE OR NO DIVERSIFIABLE OR UNIQUE RISK
MAJOR INVESTORS HOLD DIVERSIFIED PORTFOLIOS,
WITH LITTLE OR NO DIVERSIFIABLE OR UNIQUE RISK
THE RETURN ON A PORTFOLIO, DIVERSIFIED OR NOT, DEPENDS ONLY ON THE
MARKET RISK OF THE PORTFOLIO
The market doesn’t reward us for taking unique risks we can avoid at very little cost by
diversification– otherwise mutual funds would always sell at a
premium to the value of their underlying shares
41
Copyright 1996 by The McGraw-Hill Companies, Inc
MARKET RISK (BETA) FOR COMMON STOCKS
1989 - 1994
MARKET RISK (BETA) FOR COMMON STOCKS
1989 - 1994
Stock Beta Stock Beta
AT&T .92. Exxon .51Biogen 2.20 Ford Motor Co. 1.12Bristol Myers Squib .97 General Electric 1.22Coca Cola 1.12 McDonald’s 1.32Compaq 1.18 Microsoft 1.23
42
Copyright 1996 by The McGraw-Hill Companies, Inc
BIOGENBIOGEN
= 2.2
BIOGEN HAS 2.2 TIMES AS MUCH MARKET RISK AS THE MARKET
RELATION BETWEEN AND ACTUAL RETURNS NOT PRECISE BECAUSE OF BIOGEN’S UNIQUE RISK– ACTUAL RETURNS SCATTERED ABOUT FITTED
LINE
43
Copyright 1996 by The McGraw-Hill Companies, Inc
RISK OF INDIVIDUAL STOCKS
RISK OF INDIVIDUAL STOCKS
1. TOTAL RISK = DIVERSIFIABLE RISK + MARKET RISK2. MARKET RISK IS MEASURED BY BETA, THE SENSITIVITY TO MARKET CHANGES
beta
EXPECTED
RETURN
EXPECTEDMARKETRETURN
STOCK
44
Copyright 1996 by The McGraw-Hill Companies, Inc
DIVERSIFICATION AND VALUE ADDITIVITY
DIVERSIFICATION AND VALUE ADDITIVITY
DIVERSIFICATION MAKES SENSE FOR INVESTORSDOES IT ALSO MAKE SENSE FOR A FIRM?
– IF DIVERSIFICATION MAKES SENSE FOR THE FIRM, EACH NEW PROJECT HAS TO BE ANALYZED IN THE CONTEXT OF THE FIRM’S PORTFOLIO OF EXISTING PROJECTS
– VALUE OF THE DIVERSIFIED PORTFOLIO OF PROJECTS WOULD BE GREATER THAN THE SUM OF THE PROJECTS CONSIDERED SEPARATELY
NO. INVESTORS CAN EASILY DIVERSIFY BY HOLDING DIFFERENT SECURITIES; THEY WILL NOT PAY MORE FOR FIRMS THAT DIVERSIFY– IN COUNTRIES WITH EFFICIENT CAPITAL MARKETS,
DIVERSIFICATION DOES NOT INCREASE OR DECREASE A FIRM’S VALUE
– TOTAL VALUE OF A FIRM IS THE SUM OF ITS PARTS
45
Copyright 1996 by The McGraw-Hill Companies, Inc
SECURITY MARKET LINE
SECURITY MARKET LINE
EXPECTEDRETURN
Expectedmark
etreturn
Riskfreerate
0 .5 1.0 BETA
r = rf + (rm - rf)
MARKET PORTFOLIO
46
Copyright 1996 by The McGraw-Hill Companies, Inc
MARKET RISK PREMIUMMARKET RISK PREMIUM
rm - rf – RATE OF RETURN ON MARKET - T-BILL RATE
HAS AVERAGED 8.4% OVER 69 YEARS
47
Copyright 1996 by The McGraw-Hill Companies, Inc
INVESTMENTS LYING BELOW THE SECURITY MARKET
LINE ARE DOMINATED BY A MIXTURE OF THE MARKET PORTFOLIO AND THE RISKLESS
ASSET
INVESTMENTS LYING BELOW THE SECURITY MARKET
LINE ARE DOMINATED BY A MIXTURE OF THE MARKET PORTFOLIO AND THE RISKLESS
ASSET
f
m r
r
EXPECTED RETURN
BETA1.0