Investments

1
Investments
BSC III Winter Semester 2010 Lahore School of
Economics
2
Investments

• Chap 10
• Common Stock Valuation

3
Common Stock Valuation

• Learning Objectives
• Common Stock Valuation
• Dividend Growth model
• Zero Growth
• Constant Growth
• Multiple growth model
• Intrinsic Value Market price
• Relative Valuation Techniques (P/E,P/S,P/S)
• Components of Required Return

4
Capital Market Securities

• Fixed Income (Bonds)
• Treasuries
• Corporates
• Equities
• Preferred Stock
• Common Stock

5
Common Stock

• It is an equity ownership in a corporation,
  initially issued to raise capital
• Points to keep in mind!
• C/Fs are NOT known in advance
• Life of stocks is forever no maturity
• Difficult to observe required rate of return for
  discounting

6
Common stock valuation

• The two approaches to valuing common stock using
  fundamental security analysis are
• Discounted Cash flow techniques
• Relative valuation techniques

7
Common stock valuation

• The two approaches to valuing common stocks
  using fundamental security analysis are
• Discounted Cash flow techniques
• Attempts to estimate the value of a stock today
  using a present value analysis.
• Relative valuation techniques
• A stock is valued relative to other stocks based
  on the basis of ratios.
• Key difference!

8
Discounted Cash Flow Techniques

• The estimated value of a security is equal to
  the discounted value (Present Value) of the
  future stream of cash flows that an investor
  expects to receive from the security
• Estimated Value of any security V0
• V0 Expected Cash Flows/ (1 K)t
• Where
• K is the appropriated Discount Rate

9
Discounted Cash Flow Techniques

• To use Discounted Cash flow Model, an investor
  must
• Estimate the amount timing of future stream of
  Cash flows.
• Estimate an appropriate Discount Rate
• Use these two components in PV Model to estimate
  the value of the security, which is then compared
  to the current Market Price of the security.

10
Discounted Cash Flow Techniques

• Two different approaches to the cash flows
  discount rates can be used in the valuation of
  stocks
• Value the Equity of the Firm, using the required
  rate of Return to shareholders.
• Value the entire firm using the Weighted Average
  Cost of Capital (WACC).

11
Discounted Cash Flow Techniques

• How to come up with the Price of a Stock?
• Assumptions
• 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.

12
Discounted Cash Flow Techniques - Example

• Example
• Stock selling price after 1 year is 70
• Stock dividend will be 10
• Investors require 25 return
• PV 80/(1.25)
• 64

13
Discounted Cash Flow Techniques - Example

• Example
• Stock selling price after 1 year is 70
• Stock dividend will be 10
• Investors require 25 return
• PV 80/(1.25)
• 64
• Or,
• Po (D1P1) / (1k)

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Discounted Cash Flow Techniques
P1 at t1, could also be found the same way by
assuming year 2 price dividend P1
(D2P2) / (1K)
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Discounted Cash Flow Techniques
Substituting P1 in Po equation Po (D1
(D2P2)/(1K)) / (1K) D1/(1K)1
D2/(1K)2 P2/(1K)2
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Dividend Discount Model
Formula Po E Dn/ (1K)n Present
Value of all future dividends as a general
valuation framework!
17
Dividend Discount Model

• Investors must value a stream of dividends that
  may be paid forever, since common stock has no
  maturity value.
• The dividend Stream is uncertain
• There is no specified number of dividends, if in
  fact any are paid at all.
• Dividends are Expected to grow in most cases.

18
Dividend Discount Models Special cases

• Growth Rate Cases for the DDM
• The Zero Growth rate Case
• The Constant Growth rate Case
• The Multiple Growth rate Case

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The Zero Growth Rate Model
Zero-growth A Dividend Stream resulting from
Fixed dollar Dividend equal to the current
Dividend, Do. So, Value of the stock is a
Present value of a Perpetuity! Po D/K
20
The Zero Growth rate model- Example
A company pays a dividend of 2 per share,
which is not expected to change. Required return
is 20. Whats the price per share today?
21
Discounted Cash Flow Techniques Zero Growth -
Example

• A company pays a dividend of 2 per share, which
  is not expected to change. Required return is
  20. Whats the price per share today?
• Po Do / k
• 2/0.2
• 10

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The Constant Growth Rate Model
The constant Growth rate Case for the DDM
reflects a dividend stream that is expected to
grow at a constant rate g, forever. Which
implies If dividend just paid is Do, then the
next D1 is D1 Do(1g) Dividend for
period 2, D2 D2 D1(1g) Do(1g)
(1g) Do (1g)2
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The Constant Growth Rate Model
Stock Price with constant growth dividends
Po Do (1g) / (K-g) OR P0 D1
/ (K g)
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Dividend Discount Model - Assumptions

• Dividend paying stock
• Required Return by investors is greater than the
  Growth Rate of Dividends.
• Dividends will grow at a constant Rate forever.

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The Constant Growth Rate Model - example
Suppose Do 2.30, K13, g5. Whats the
price per share?
26
The Constant Growth Rate Model - example

• Suppose Do 2.30, K13, g5. Whats the price
  per share?
• P0 D1 / (k g)
• 2.3 (1.05) / (0.13 - 0.05)
• 2.415 / 0.8
• 30.19

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The Constant Growth Rate Model

• Constant Growth Model can be used to find the
  stock price at any point in time!
• Find the Dividend for that year.
• Grow it at (1g)
• Divide by K-g

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The Constant Growth Rate Model - example
Suppose Do 2.30, K13, g5.Whats the price
per share in 5 years? Hint P5 D6 / (K
g)
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The Constant Growth Rate Model - example

• Suppose Do 2.30, K13, g5.Whats the price
  per share in 5 years?
• P5 D6 / (K g)
• 2.3 (1.05)5 / (0.13-0.05)
• 2.935x(1.05) / 0.8
• 3.0822 / .08
• 38.53

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The Constant Growth Rate Model - example
Suppose Company XYZs next dividend will be 4.
Required return is 16. Dividend increases by 6
every year, forever. Whats the price per
share today? in 4 years?
31
The Constant Growth Rate Model - example

• Suppose Company XYZs next dividend will be 4.
  Required return is 16. Dividend increases by 6
  every year, forever.
• Whats the price per share today?
• P0 D1 / (k g)
• 4/(.16-.06)
• 4/.1
• 40

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The Constant Growth Rate Model - example

• Suppose Company XYZs next dividend will be 4.
  Required return is 16. Dividend increases by 6
  every year, forever.
• Price in 4 years?
• P4 D5 / (k g)
• D5 D1 (1g)4
• 4(1.06)4
• 5.05
• P4 5.05/0.1
• 50.50

33
Investments
BSC/BBA III Winter Semester 2010 Lahore School of
Economics
34
Investments

• Chap 10
• Common Stock Valuation

35
Common Stock Valuation

• Learning Objectives
• Common Stock Valuation
• Dividend Growth model
• Zero Growth
• Constant Growth
• Multiple growth model
• Intrinsic Value Market price
• Relative Valuation Techniques (P/E,P/S,P/S)
• Components of Required Return

36
Dividend discount models -Multiple Growth Rate
Case

• For many companies, it is inappropriate to
  assume that dividends will grow at a constant
  rate as Firms typically go through life cycles.
• P0 PV of Expected Future Cash flows

37
Dividend discount models -Multiple Growth Rate
Case

• For many companies, it is inappropriate to
  assume that dividends will grow at a constant
  rate as Firms typically go through life cycles.
• P0 PV of Expected Future Cash flows
• P0 PV of Dividends during the non Constant
  period
• PLUS
• PV of Dividends during the constant Growth
  Period

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Multiple Growth Rate Case

• To find Value of Stock with Non Constant Growth,
  we go through the following three steps
• Find the PV of Dividends during the period of Non
  Constant Growth.
• Find the PV of Stock at the end of Non Constant
  Growth period at which point it has become a
  constant growth Stock, and discount the price
  back to the present.
• Add these two components to find the intrinsic
  Value of the Stock.

39
Dividend discount models -Multiple Growth Rate
Case
Multiple Growth model Company grows at a
certain high rate first, then slows down to grow
at a constant sustainable rate.
40
Dividend discount models -Multiple Growth Rate
Case
Multiple Growth model Company grows at a
certain high rate first, then slows down to grow
at a constant sustainable rate. Value PV
of dividends PV of terminal price E Dt
/(1k)t Dn1 /(k-g)(1/1k)n
41
Multiple Growth Rate Case - Example

• The last dividend paid by Klein Company was
  1.00. Kleins growth rate is expected to be a
  constant 5 percent for 2 years, after which
  dividends are expected to grow at a rate of 10
  percent forever. Kleins required rate of return
  on equity (ks) is 12 percent. What is the
  current price of Kleins common stock?

42
Multiple Growth Rate Case - Example

• The last dividend paid by Klein Company was
  1.00. Kleins growth rate is expected to be a
  constant 5 percent for 2 years, after which
  dividends are expected to grow at a rate of 10
  percent forever. Kleins required rate of return
  on equity (ks) is 12 percent. What is the
  current price of Kleins common stock?

43
Multiple Growth Rate Case - Example

• The last dividend paid by Klein Company was
  1.00. Kleins growth rate is expected to be a
  constant 5 percent for 2 years, after which
  dividends are expected to grow at a rate of 10
  percent forever. Kleins required rate of return
  on equity (ks) is 12 percent. What is the
  current price of Kleins common stock?
• Financial calculator solution
• Enter in Cash register CF0 0, CF1 1.05, and
• CF2 61.74.
• Then,
• Enter I 12, and press NPV to get NPVP0
  50.16.

44
Multiple Growth Rate Case - Example

• Your company paid a dividend of 2.00 last year.
  The growth rate is expected to be 4 percent for
  1 year, 5 percent the next year, then 6 percent
  for the following year, and then the growth rate
  is expected to be a constant 7 percent
  thereafter. The required rate of return on
  equity (ks) is 10 percent. What is the current
  stock price?

45
Multiple Growth Rate Case - Example

• Your company paid a dividend of 2.00 last year.
  The growth rate is expected to be 4 percent for
  1 year, 5 percent the next year, then 6 percent
  for the following year, and then the growth rate
  is expected to be a constant 7 percent
  thereafter. The required rate of return on
  equity (ks) is 10 percent. What is the current
  stock price?

46
Multiple Growth Rate Case - Example

• Your company paid a dividend of 2.00 last year.
  The growth rate is expected to be 4 percent for
  1 year, 5 percent the next year, then 6 percent
  for the following year, and then the growth rate
  is expected to be a constant 7 percent
  thereafter. The required rate of return on
  equity (ks) is 10 percent. What is the current
  stock price?
• Financial calculator Solution
• CF0 0 CF1 2.08 CF2 2.1840 and CF3
  84.8848
• I 10 and press NPV to get NPV P0 67.47.

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Intrinsic Value Market Price
If Intrinsic Value gt Market Price
under-valued Intrinsic Value lt Market Price
over-valued
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Assignment (7 Questions)

• Q1A stock is expected to pay 0.45 dividend at
  the end of the year. The dividend is expected to
  grow at a constant rate of 4 percent a year, and
  the stocks required rate of return is 11
  percent. What is the expected price of the stock
  10 years from today?

49
Q2

• A stock that currently trades for 40 per share
  is expected to pay a year-end dividend of 2 per
  share. The dividend is expected to grow at a
  constant rate over time. The stock has a
  required rate of return of 11. What is the
  stocks expected price seven years from today?

50
Q3

• Motor Homes Inc. (MHI) is presently in a stage
  of abnormally high growth because of a surge in
  the demand for motor homes. The company expects
  earnings and dividends to grow at a rate of 20
  percent for the next 4 years, after which time
  there will be no growth (g 0) in earnings and
  dividends. The companys last dividend was
  1.50. MHIs required return on stock is 18.
  What should be the current common stock price?

51
Q4

• A stock is not expected to pay a dividend over
  the next four years. Five years from now, the
  company anticipates that it will establish a
  dividend of 1.00 per share. Once the dividend
  is established, the market expects that the
  dividend will grow at a constant rate of 5
  percent per year forever.. The required rate of
  return on the companys stock is expected to
  remain constant at 12. What is the current
  stock price?

52
Q5

• R. E. Lee recently took his company public
  through an initial public offering. He is
  expanding the business quickly to take advantage
  of an otherwise unexploited market. Growth for
  his company is expected to be 40 percent for the
  first three years and then he expects it to slow
  down to a constant 15 percent. The most recent
  dividend (D0) was 0.75. Based on the most recent
  returns, his companys required return is 20.
  What is the current price of Lees stock?

53
Q6

• DAAs stock is selling for 15 per share. The
  firms income, assets, and stock price have been
  growing at an annual 15 percent rate and are
  expected to continue to grow at this rate for 3
  more years. Dividend of 0.50 has been declared
  recently. After super normal growth, dividends
  are expected to grow at the firms normal growth
  rate of 6 percent. The firms required rate of
  return is 18 percent. Determine whether the
  stock is under or overvalued. State reasons for
  your answer!

54
Q7

• Philadelphia Corporations stock recently paid a
  dividend of 2.00 per share (D0 2), and the
  stock is in equilibrium. The company has a
  constant growth rate of 5 percent. The required
  rate of return on its stock is 29.5.
  Philadelphia is considering a change in policy
  that will increase its required return to 33.25.
  If market conditions remain unchanged, what new
  constant growth rate will cause Philadelphias
  common stock price to remain unchanged?

55
Investments
BBA III Winter Semester 2010 Lahore School of
Economics
56
Investments

• Chap 10
• Common Stock Valuation

57
Common Stock Valuation

• Learning Objectives
• Common Stock Valuation
• Dividend Growth model
• Zero Growth
• Constant Growth
• Multiple growth model
• Intrinsic Value Market price
• Relative Valuation Techniques (P/E,P/S,P/S)
• Components of Required Return

58
Discounted Cash flow approaches

1. Dividend Discount Model
2. Free Cash Flow to Equity (FCFE) Model
3. Free Cash Flow to Firm (FCFF) Model

59
Free Cash Flow to equity Model

• Free Cash Flow to Equity (FCFE) is defined as
  the cash flow remaining after principle
  interest payments have been made Capital
  Expenditures have been provided for.
• FCFE Model differs from the DDM in the sense
  that FCFE measures what firm could pay out as
  dividends rather than what they actually paid
  out.
• FCFE NI NCC Debt repayments Capital
  Expenditures Investment in Working capital
  New Debt Issues

60
Free Cash Flow to equity Model Special Cases

• 1. Zero Growth Case
• P0 FCFE / K
• 2. Constant Growth Case
• P0 FCFE1 / (K G)
• 3. Multiple Growth Case
• P0 PV of FCFE during the non Constant period
• PLUS
• PV of FCFE during the constant Growth Period

61
Free Cash Flow to equity Model Zero Growth
example

• An analyst has collected the following
  information about Franklin Electric
• Projected NI for the next year 300 million.
• Projected depreciation expense for the next year
  50 million.
• Projected capital expenditures for the next year
  100 million.
• Projected increase in operating working capital
  next year 60 million.
• Interest Expense for the year was 5 million
  Company paid back 50 Million of its debt
  outstanding but also issued 4 million of new
  debt.
• Cost of equity 13.
• Number of shares outstanding today 20 million.
• The companys free cash flow is NOT expected to
  grow. What is the stocks intrinsic value today?

62
Free Cash Flow to equity Model Zero Growth
example

• Step 1 Calculate Free Cash Flow To Equity
• FCFE NI NCC Debt repayments Capital
  Expenditures Investment in Working capital
  New Debt Issues
• 300 50 50 100 60 4
• 144 Million
• FCFE Per Share 144 / 20
• 7.2 Per Share
• Step 2 Calculate Intrinsic Value
• P0 7.2 / 0.13 55.38

63
Free Cash Flow to equity Model Constant Growth
example

• An analyst has collected the following
  information about Franklin Electric
• Projected NI for the next year 300 million.
• Projected depreciation expense for the next year
  50 million.
• Projected capital expenditures for the next year
  100 million.
• Projected increase in operating working capital
  next year 60 million.
• Interest Expense for the year was 5 million
  Company paid back 50 Million of its debt
  outstanding but also issued 4 million of new
  debt.
• Cost of equity 13.
• Number of shares outstanding today 20 million.
• The companys free cash flow is expected to grow
  at a constant rate of 6 forever. What is the
  stocks intrinsic value today?

64
Free Cash Flow to equity Model Constant Growth
example

• Step 1 Calculate Free Cash Flow To Equity
• FCFE NI NCC Debt repayments Capital
  Expenditures Investment in Working capital
  New Debt Issues
• 300 50 50 100 60 4
• 144 Million
• FCFE Per Share 144 / 20
• 7.2 Per Share

65
Free Cash Flow to equity Model Constant Growth
example

• Step 2 Calculate Intrinsic Value
• P0 Expected FCFE / (K G)
• 7.2 / (0.13 0.06)
• 102.8571

66
Free Cash Flow to equity Model Multiple Growth
example

• Projected NI for the next year 300 million.
• Projected depreciation expense for the next year
  50 million.
• Projected capital expenditures for the next year
  100 million.
• Projected increase in operating working capital
  next year 60 million.
• Interest Expense for the year was 5 million
  Company paid back 50 Million of its debt
  outstanding but also issued 4 million of new
  debt.
• Cost of equity 13.
• Number of shares outstanding today 20 million.
• The companys free cash flow is expected to grow
  at a constant rate of 12 for two years then
  will grow at 6forever. What is the stocks
  intrinsic value today?

67
Free Cash Flow to equity Model Multiple Growth
example

• Step 1 Calculate Free Cash Flow To Equity for
  year 1
• FCFE NI NCC Debt repayments Capital
  Expenditures Investment in Working capital
  New Debt Issues
• 300 50 50 100 60 4
• 144 Million
• FCFE Per Share 144 / 20
• 7.2 Per Share

68
Free Cash Flow to equity Model Multiple Growth
example

• Step 2 Calculate FCFE for Non Constant Growth
  Period
• FCFE in Year 2 7.2 (1 0.12)
• 8.0640
• FCFE in Year 3 8.0640 (1 0.12)
• 9.03
• Step 3 Calculate FCFE for Constant Growth period
• FCFE in Year 4 9.03 ( 1 0.06)
• 9.57

69
Free Cash Flow to equity Model Multiple Growth
example

• Step 4 Calculate PV of CF during Non Constant
  Growth Period
• PV CF1 / (1K) CF2/(1K)2 CF3/(1K)3
• 7.2 / (1.13) 8.06/(1.13)2
  9.03/(1.13)3
• 18.94
• Step 5 Calculate PV of CF during Constant
  Growth Period
• PV P3 / (1K)3 P3 9.57/0.07
• 136.71/ (1.13)3 136.71
• 94.75

70
Free Cash Flow to equity Model Multiple Growth
example

• Step 6 Calculate Intrinsic Value
• P0 PV of FCFE during the non Constant period
• PLUS
• PV of FCFE during the constant Growth Period
• 18.94 94.75
• 113.69

71
Free Cash Flow to Firm Model

• FCFF is defined as cash amounts available to be
  paid to both bondholders stockholders.
• FCFF FCFE Interest (1 T) Principle
  Repayments New Debt issues Preferred
  Dividends
• OR
• FCFF EBIT(1-T) NCC Capital Expenditure
  Change in working Capital
• OR
• FCFF NI NCC INT (1-T) Capital
  Expenditures Changes in Working Capital

72
Free Cash Flow to Firm Model Implementing the
model

• Forecast Expected FCFF
• Estimate the Discount Rate (WACC)
• Calculate the Value of the Corporation
• Calculate Intrinsic Stock Value
• Value of Corporation MINUS Value of Debt
  MINUS Value of Preferred Stock.

73
Free Cash Flow to Firm Model Special Cases

• 1. Zero Growth Case
• V0 FCFF / WACC
• 2. Constant Growth Case
• V0 FCFF1 / (WACC G)
• 3. Multiple Growth Case
• V0 PV of FCFF during the non Constant period
• PLUS
• PV of FCFF during the constant Growth Period

74
Free Cash Flow to Firm Model Example

• Today is December 31, 2003. The following
  information applies to Addison Airlines
• After-tax, operating income EBIT(1 - T) for the
  year 2004 is expected to be 400 million.
• The companys depreciation expense for the year
  2004 is expected to be 80 million.
• The companys capital expenditures for the year
  2004 are expected to be 160 million.
• No change is expected in the companys net
  operating working capital.
• The companys free cash flow is expected to grow
  at a constant rate of 5 percent per year.
• The companys WACC is 10 percent.
• The current market value of the companys debt is
  1.4 billion. The company currently has 125
  million shares of stock outstanding.

75
Free Cash Flow to Firm Model Example

• Step 1 Calculate the free cash flow amount
• FCFF EBIT(1-T) NCC Capital Expenditure
  Change in working Capital
• 400 million80 million-160 million-0
• 320 million.
• Step 2Calculate the firm value today using the
  constant growth corporate value model
• V0 FCFF1 / (WACC G)
• 320 / (0.10 0.05)
• 6,400 Million
• This is the total firm value today!

76
Free Cash Flow to Firm Model Example

• Step 3 Determine the market value of the equity
  and price per share
• MVTotal MVEquity MVDebt
• 6,400 million MVEquity 1,400 million
• MVEquity 5,000 million.
• This is todays market value of the firms
  equity.
• Divide by the number of shares to find the
  current price per share
• 5,000 million/125 million 40.00.

77
Relative Valuation Techniques

• The relative value concept is based on making
  comparisons in order to determine value. Relative
  Valuation measures include
• Price / Earnings Ratio
• Price / Book Ratio
• Price / Sales Ratio

78
Earnings Multiplier Approach - The P/E Ratio

• The P/E ratio is simply the number of times
  investors value earnings as expressed in stocks
  price.
• Companies with higher P/E ratio as compared to a
  benchmark are considered over valued Vice
  Versa.
• However, sometimes investors realize that the
  P/E ratio should be higher for companies whose
  earnings are expected to grow rapidly, which
  then, does not necessarily indicate
  overvaluation!

79
The P/E Ratio FOR A Constant Growth Company-
Determinants

• P0 D1 / (K G)
• Dividing both sides of Equation by Expected
  Earnings
• P0/E1 (D1/E1) / (K G)

80
P/E Ratio Interest rates

• The P/E ratio reflects investors optimism
  pessimism. As the required rate of Return
  increases, other things being equal, the P/E
  ratio increases.
• As interest rates increase, bonds become More
  attractive compared to Stocks on a current return
  basis.
• Hence, As interest rates rise, P/E ratio should
  decline Vice Versa.

81
P/E Ratio- Example
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? 45
82
P/E Ratio- Example

• The Charleston Company is a relatively small,
  privately owned firm. Last year the company had
  net income of 15,000 and 10,000 shares were
  outstanding. The owners were trying to determine
  the equilibrium market value for the stock prior
  to taking the company public. A similar firm
  that is publicly traded had a price/earnings
  ratio of 5.0. Using only the information given,
  estimate the market value of one share of
  Charlestons stock.

83
P/E Ratio- Example

• The Charleston Company is a relatively small,
  privately owned firm. Last year the company had
  net income of 15,000 and 10,000 shares were
  outstanding. The owners were trying to determine
  the equilibrium market value for the stock prior
  to taking the company public. A similar firm
  that is publicly traded had a price/earnings
  ratio of 5.0. Using only the information given,
  estimate the market value of one share of
  Charlestons stock.
• Sol
• EPS 15,000/10,000 1.50.
• P/E 5.0 P/1.50.
• P 7.50.

84
Price/Book Value

• Price to Book Value is calculated as the ratio
  of price to stockholders Equity as measured on
  the Balance Sheet.
• If the Value of the Ratio is 1, the Market price
  is equal to the accounting Value Vice Versa.
• Companies with higher P/BV ratio as compared to
  a benchmark are considered over valued Vice
  Versa.

85
Price/Book Value - Example

• You are given the following information
  Stockholders equity 1,250 price/earnings
  ratio 5 shares outstanding 25 and
  market/book ratio 1.5. Calculate the market
  price of a share of the companys stock.

86
Price/Book Value - Example

• You are given the following information
  Stockholders equity 1,250 price/earnings
  ratio 5 shares outstanding 25 and
  market/book ratio 1.5. Calculate the market
  price of a share of the companys stock.
• Total market value 1,250(1.5) 1,875.
• Market value per share 1,875/25 75.

87
Price/Book Value - Example
Making Valuations through comparisons P/BV
Price to Book Value (S.Equity) ratio So, if
comparable stocks are trading at x10. BV for
a stock is equal to 5 What should be the stock
price? 50
88
PRICE/Sales Ratio

• The PSR is calculated by dividing a companys
  current stock Price by its revenue per share.
• One rule of thumb for PSR is to say that PSR os
  1 is average for all companies, therefore those
  with a PSR considerably less than 1 are
  undervalued.
• Companies with higher P/S ratio as compared to
  a benchmark are considered over valued Vice
  Versa.

89
PRICE/Sales Ratio
Making Valuations through comparisons P/S
Price to Sales ratio So, if comparable stocks
are trading at x1. Sales per share for a stock
is equal to 5 What should be the stock
price? 5
90
Components of Required Return
Lets break down the K, discount rate which we
used in the Dividend Discount Model or DDM Po
D1 / (K-g) if we rearrange to solve for
K. then K-g D1/Po K (D1/ Po) g
91
Components of Required Return
K (D1/ Po) g This means TR has two
components D1/Po Dividend Yield g
same rate as the increase in stock price
Capital gains yield
92
Components of Required Return - Example
If a stock is selling for 20 per share. Next
dividend will be 1 per share. Dividend will
grow by 10 per year forever. What is the return
on this stock?
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Components of Required Return - Example

• If a stock is selling for 20 per share. Next
  dividend will be 1 per share. Dividend will
  grow by 10 per year forever.
• What is the return on this stock?
• K Div yield Cap gains yield
• 1/20 10
• 5 10
• 15

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• Thank you for your time Patience ?

95
Assignment 9 (6 Questions)

• Q1 ABC Co. recently had FCFE of 120 Million.
  Company had 50,000 Bonds outstanding trading _at_
  par with a Coupon Rate of 8. Capital Expenditure
  Change in Working Capital during the year were
  15 Million 5Million, respectively. Company had
  Depreciation Amortization charges of 2 Million
  0.5 Million, Respectively. XYZ Co. has a tax
  rate of 35 with Cost of equity of 12 WACC
  equivalent to 10. No debt outstanding was paid
  during the year. Although, company issued new
  bonds worth of 1 million. Company has 500,000
  shares of preferred stock outstanding with a par
  of 120 dividend rate of 5. Company is
  expected to grow at a constant rate of 5
  forever. With the given information, calculate
  Value of the firm intrinsic value per share
  using FCFF Model assuming 1 million Common Stock
  shares outstanding.

96
Assignment 9 (6 Questions)

• Q2 ABC Co. recently had EBIT of 100 Million.
  Company had 20,000 Bonds outstanding trading _at_
  par with a Coupon Rate of 7. Capital Expenditure
  Change in Working Capital during the year were
  5 Million 1Million, respectively. Company had
  Depreciation Amortization charges of 2.5
  Million 1.5 Million, Respectively. XYZ Co. has
  a tax rate of 35 with Cost of equity of 12
  WACC equivalent to 9. Company is expected to
  grow at a constant rate of 7 forever. With the
  given information, calculate Value of the firm
  intrinsic value per share using FCFF Model
  assuming 1.5 million shares of common stock
  outstanding.

97
Assignment 9 (6 Questions)

• Q3An analyst has collected the following
  information about XYZ Co.
• Projected NI for the next year 200 million.
• Projected depreciation expense for the next year
  10 million.
• Projected capital expenditures for the next year
  65 million.
• Projected increase in operating working capital
  next year 30 million.
• Interest Expense for the year was 2.5 million
  Company paid back 20 Million of its debt
  outstanding but also issued 4 million of new
  debt.
• Cost of equity 12.
• Number of shares outstanding today 20 million.

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Assignment 9 (6 Questions)

• Q3
• The companys free cash flow to firm is expected
  to grow at 15 for first two years, then _at_ 10
  for year 3 year 4 then it will grow _at_ 5
  forever. What is the stocks intrinsic value
  today using FCFF Model?
• The companys free cash flow to Equity is
  expected to grow at 10 for first two years, then
  _at_ 8 for year 3 then it will grow _at_ 5 forever.
  What is the stocks intrinsic value today using
  FCFE Model?

99
Assignment 9 (6 Questions)

• Q4 The analyst has estimated the companys free
  cash flows for the following years 
• Year Free Cash Flow
• 1 3,000
• 2 4,000
• 3 5,000 
• The analyst estimates that after three years (t
  3) the companys free cash flow will grow at a
  constant rate of 6 percent per year. The analyst
  estimates that the companys weighted average
  cost of capital is 10 percent. The companys
  debt and preferred stock has a total market value
  of 25,000 and there are 1,000 outstanding shares
  of common stock. What is the (per-share)
  intrinsic value of the companys common stock?

100
Assignment 9 (6 Questions)

• Q5 Lamonica Motors just reported earnings per
  share of 2.00. The stock has a price earnings
  ratio of 40, so the stocks current price is 80
  per share. Analysts expect that one year from now
  the company will have an EPS of 2.40, and it
  will pay its first dividend of 1.00 per share.
  The stock has a required return of 10 percent.
  What price earnings ratio must the stock have one
  year from now so that investors realize their
  expected return?

101
Assignment 9 (6 Questions)

• Q6 Dean Brothers Inc. recently reported net
  income of 1,500,000. The company has 300,000
  shares of common stock, and it currently trades
  at 60 a share. The company continues to expand
  and anticipates that one year from now its net
  income will be 2,500,000. Over the next year
  the company also anticipates issuing an
  additional 100,000 shares of stock, so that one
  year from now the company will have 400,000
  shares of common stock. Assuming the companys
  price/earnings ratio remains at its current
  level, what will be the companys stock price one
  year from now?