Stock Valuation/Managerial Finance- Human Resource Management

Stock Valuation

As a manager, it is important to understand how decisions can be analyzed in terms of alternative courses of action and their likely impact on a firm’s value. Thus, it is necessary to know how stock prices can be estimated before attempting to measure how a particular decision might affect a firm’s market value.

To prepare for this Assignment, choose a publicly-traded company, and then estimate your company’s common stock price, using one of the valuation models presented in the assigned readings or outside readings. (If you want to analyze a dividend paying company, you can find a robust list at http://www.dividenddetective.com/big_dividend_list.htm.)

http://dividenddetective.com/big_dividend_list.htm

In addition, here is a template you will find to be useful for the assignment. It matches the examples given in the textbook on stock valuation models in Chapter 9: Stock Models (Excel workbook)

Defend your choice of model, and explain why it is appropriate to use for your company’s stock. Be sure to explain how you arrived at any assumptions regarding values used in the model. Determine whether your company appears to be correctly valued, overvalued, or undervalued based on your company’s stock current price and model result. Check Yahoo Finance for current stock prices. Finally, explain why your company’s stock appears to be over-, under-, or correctly valued.

Please reference information from the following chapter

Brigham, E. F. , & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage Learning. Chapter 9, “Stocks and Their Valuation” (pp. 303-326)

IMPORTANT – Assignment will be graded based on fulfilling the below rubric –

1. The author uses MS Excel or calculator. Formulas and calculations are correct.

2. Author defends choice of model as to why it is appropriate to use for the chosen stock and explains how he or she determined any assumptions on the values used in the model, including why the assumptions were required. Model chosen is compared with other potential models that could have been used in the analysis. Assumptions used for model inputs are evidenced-based through cited research and/or use of estimation techniques based on historical data.

3. The author assesses whether the chosen company appears to be correctly valued, overvalued or undervalued based on the company’s stock current price and model result and discusses the implications of his or her conclusion. The author correctly determines the current price of the stock and cites the source of the price data.

4. The author provides reasons as to why the company’s stock appears to be over-, under-, or correctly valued. Reasons cited provide rationales that are evidenced-based and beyond personal opinion. Both the model’s estimation inaccuracies/weaknesses and the stock’s current price are assessed in the reasons given.

I am aiming for an A+, therefore, original work is mandatory.

USW1_WMBA_6070_

Stock_Models.xlsx

09 Chapter model

Chapter 9. Stocks and Their Valuation (Models)
This model is similar to the bond valuation models developed in Chapter 7 in that we employ discounted cash flow analysis to find the value of a firm’s stock.
THE DISCOUNTED DIVIDEND MODEL (Section 9-4)
The value of any financial asset is equal to the present value of future cash flows provided by the asset. Stocks can be evaluated in two ways: (1) by finding the present value of the expected future dividends, or (2) by finding the present value of the firm’s expected future free cash flows, subtracting the market value of the debt and preferred stock to find the total value of the common equity, and then dividing that total value by the number of shares outstanding to find the value per share. Both approaches are examined in this spreadsheet.
When an investor buys a share of stock, he/she typically expects to receive cash in the form of dividends and then, eventually, to sell the stock and to receive cash from the sale. Moreover, the price any investor receives is dependent upon the dividends the next investor expects to earn, and so on for different generations of investors.
The basic dividend valuation equation is:
P0 =	D1	+	D2	+	. . . .	Dn
( 1 + rs )	( 1 + rs ) 2	( 1 + rs ) n
The dividend stream theoretically extends on out forever, i.e., n = infinity. It would not be feasible to deal with an infinite stream of dividends, but if dividends are expected to grow at a constant rate, we can use the constant growth equation as developed in the text to find the value.
CONSTANT GROWTH STOCKS (Section 9-5)
In the constant growth model, we assume that the dividend will grow forever at a constant growth rate. This is a very strong assumption, but for stable, mature firms, it can be reasonable to assume that the firm will experience some ups and downs throughout its life but those ups and downs balance each other out and result in a long-term constant rate. In addition, we assume that the required return for the stock is a constant. With these assumptions, the price equation for a common stock simplifies to the following expression:
P 0 =	D 1
( r s − g )
The long-run growth rate (g) is especially difficult to measure, but one approximates this rate by multiplying the firm’s return on equity by the fraction of earnings retained, ROE x (1 – Payout ratio). Generally speaking, the long-run growth rate is likely to fall between 5% and 8%.
EXAMPLE
Allied Food Products just paid a dividend of $1.15, and the dividend is expected to grow at a constant rate of 8.3%. What stock price is consistent with these numbers, assuming a 13.7% required return?
D0	$2.15
g	8.3%
rs	13.7%
P0 =	D1	=	D0 (1+g)	=	$2.33
( rs − g )	( rs − g )	0.054
P0 =	$43.12
STOCK PRICE SENSITIVITY
One of the keys to understanding stock valuation is knowing how various factors affect the stock price. We construct below a series of data tables and a graph to show how the stock price is affected by changes in the dividend, the growth rate, and rs.
Resulting
% Change	Last	Price
in D0	Dividend, D0	$43.12
-30%	$0.81	$16.14
-15%	$0.98	$19.60
0%	$1.15	$23.06
15%	$1.32	$26.52
30%	$1.50	$29.98
% Change	rs	$43.12
-30%	9.38%	$215.60
-15%	11.39%	$75.35
0%	13.40%	$45.66
15%	15.41%	$32.75
30%	17.42%	$25.53
% Change	g	$43.12
-30%	5.60%	$28.03
-15%	6.80%	$33.28
0%	8.00%	$40.74
15%	9.20%	$52.17
30%	10.40%	$71.93
From the chart we see that the stock price increases with increases in the dividend and the growth rate but decreases with increases in the required return. The dividend relationship is linear, while price is a nonlinear function of the growth rate and the required return. Changes in rs and g have especially strong effects on the stock price. This occurs because as rs declines or g increases, the denominator approaches zero, and this leads to exponential increases in the stock price.
The constant growth assumption is reasonable only if we are valuing mature firms with a stable history of growth and a likelihood that this stability will continue. There are some special scenarios when the Gordon DCF constant growth model will not make sense, and this will be discussed later.
EXPECTED RATE OF RETURN ON A CONSTANT GROWTH STOCK
Using the constant growth equation, we transpose the equation to solve for rs. In doing so, we are now solving for an expected return. Here is the resulting equation:
rs =	D1	+	g
P0
This expression tells us that the expected return on a stock comprises two components, the expected dividend yield, which is simply the next expected dividend divided by the current price, and the expected capital gains yield, which is the expected annual rate of price appreciation, g. This shows us the dual role of g in the constant growth rate model: It is both the expected dividend growth rate and also the expected stock price growth rate.
EXAMPLE
You buy a stock for $23.06, and you expect the next annual dividend to be $1.245. Furthermore, you expect the dividend to grow at a constant rate of 8.3%. What is the expected rate of return and dividend yield on the stock?
P0	$23.06
D1	$1.245
g	8.3%
rs =	13.70%
Div Yield =	5.40%
Capital Gains Yield =	8.30%
EXTENSION
What is the expected price of this stock in 5 years?
N =	5
Using the growth rate we find that:
P5 =	$34.36 Christopher Buzzard: If growth is constant, we can use the following formula to find the value after any number of years (n): Value (in year n) = Beginning value x (1+g)n
VALUING NONCONSTANT GROWTH STOCKS (Section 9-6)
For many companies, it is unreasonable to assume constant growth. Here valuation procedures become a little more complicated, because we must estimate a short-run nonconstant growth rate, then assume that after a certain point of time the firms will grow at a constant rate, and estimate that constant long-run growth rate.
The point in time when the dividend begins to grow at a constant rate is called the “horizon date,” and the value of the stock at that time is called the “horizon, or continuing, value,” and it is calculated as follows:
HV =	PN =	DN+1
( rs − g )
EXAMPLE
A company just paid a $1.15 dividend, and it is expected to grow at 30% for the next 3 years. After 3 years the dividend is expected to grow at the rate of 8% indefinitely. If the required return is 13.4%, what is the stock’s value today?
D0	$1.15
rs	13.4%
gs	30%	Short-run g; for Years 1-3 only.
gL	8%	Long-run g; for Year 4 and all following years.
<———- 30% ———->	8%
Year	0	1	2	3	4
Dividend	$1.15	1.495	1.9435	2.5266	2.7287
PV of dividends
$ 1.3183
1.5113
1.7326	2.7287
$ 4.5622	50.5310	= Terminal value =
34.6512	0.054	= rs − gL
$ 39.2135	= P0
PREFERRED STOCK (Section 9-8)
A special case of the constant growth model is a stock with a zero growth rate. Such a stock is a preferred stock, which pays a constant dividend in perpetuity. Perpetuity valuation was discussed in Chapter 5, and the formula is simply V = Cash flow / Required return.
EXAMPLE
A perpetual preferred stock pays a $10 annual dividend and has a required return of 10.3%. What is its value?
Vp =	Dp	/	rp
Vp =	$10.00	/	10.30%
Vp =	$97.09
EXAMPLE
Consider another preferred stock that has a finite life of 50 years (a sinking fund preferred issue), a $100 par value, and a $10 annual dividend. The required return is 10%. If the par value is repaid at maturity in 50 years, what is the price of the stock?
N	50
I/YR	10%
PMT	$10
FV = Par value	$100
Price	$100.00
What would its value be if the required return declined to 8%?
N	50
I	8%
PMT	$10
Face value	$100
Price	$124.47
Had this been a perpetual preferred with a required return of 8%, what would be the stock price?:
Price	$125.00

Stock price sensitivity