Stock Valuation

Before moving forward to compute the present value of these cash flows, a terminal value is required to forecast the long term value of the company after 5 years. . Following formula is used to calculate the terminal value.

The dividend policy has grown over the years. This may be so that the company projects itself as a less risky share and thus also gaining investors faith. The investors buy its shares and thus increase its demand. This helps to gives positive signals to the investors signalling that the company is stable and can generate earnings steadily. This hypothesis is gains standing from the dividend hypothesis theory.

We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).

 10. The interest rate used to compute the present value of a future cash flow is called the:

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

13. What is the formula for the Present Value (PV) for a finite stream of cash flows (1 per year) that lasts for 10 years?

George C. Philippatos and William W. Sihler, 'Models of Dividend Policy', Financial Management (Allyn and Bacon), 228-229

The valuation process, in this case, requires us to estimate the short-run non-constant growth rate and predict future dividends. Then, we must estimate a constant long-term growth rate at which the firm is expected to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a rather constant rate. Of course, the difficulty in this framework is estimating the short-term growth rate, how long the short-term growth will hold, and the long-term growth rate.

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

Common Share Value: Total market value of common share = price per share * number of pref. share = $25 * 100000 = $2,500,000

In general the three-stage approach allows us to add complexity to the standard dividend discount models by enabling changing growth scenarios throughout the forecasting period: an initial period of higher than normal growth, a transition/consolidation period of declining growth and final a period of stable growth. The main assumptions are that the company on which we conduct the calculation study currently is in extraordinary strong growth phase. The time period with the extraordinary strong growth must be strictly defined and eventually be replaced with the declining growth assumption. Lastly, Capital Expenditures and Depreciation are expected to grow at the same rate as revenues. .

I. Introduction of company valuation methods and process........................................................3 1. Abstract................................................................................................................................3 2. Valuation methods...............................................................................................................3 2.1 Balance sheets – Based methods

We then get the annuity of the 1,200 semiannual PMTs at year 6, and then at Present Value

In particular, small changes in inputs can result in large changes in the value of a company, given the need to project cash-flow to infinity.  James Montier argues that, "while the algebra of DCF is simple, neat and compelling, the implementation becomes a  minefield of problems". He cites, in particular, problems with  estimating cash flows and estimating discount rates. Despite the issues, DCF analysis is very widely used and is perhaps the primary valuation tool amongst the financial analyst community.

The current EPS of the company is now $14-$15. Historically, the dividend payout ratio mounts to an average 50%. So, the company expects payout the payout in 1959 to be $7/share. In the previous year the dividend rate was cut from $1.3 to $1.2 per share. But after the new deal, the CEO proposed a hike in the quarterly payout to $1.6 per share from the $1.2 given at present. The CEO even suggested the dividend rate to be propped up to $1.80 in 1960.