11/16/2018 Nattawoot Koowattanatianchai 1 Investment Analysis - - PowerPoint PPT Presentation

11/16/2018 Nattawoot Koowattanatianchai 1

11/16/2018 Nattawoot Koowattanatianchai 2

Investment Analysis & Portfolio Management

Assistant Professor Nattawoot Koowattanatianchai, DBA, CFA

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Email: :

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snwk@k wk@ku. u.ac. c.th th

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age: e:

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tp://fin. in.bu bus. s.ku. ku.ac. c.th/nattaw h/nattawoot.h

• ot.htm

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Phone:

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02-942 4287 8777 77 Ext.

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087- 5393525 5393525

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r, KBS Building 4

11/16/2018 Nattawoot Koowattanatianchai 4

Lecture 2

Stock Valuation: Dividend Discount Model

Discussion topics

 The present value of common

stocks

 Estimates of parameters in the

Dividend Discount Model

 The stock markets

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Readings

 Ross, S., Westerfield, R.

and Jaffe, J. (2010), Corporate Finance (9th Edition), McGraw Hill/Irvin. (Chapters 9 and 15)

 CFA Program Curriculum

2015 - Level II – Volume 4: Equity.

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Features of common stocks

 Voting right

 Shareholders elect directors who, in turn, hire

management to carry out their directives.

 Cumulative voting

 The directors are elected all at once.  This permits minority participation.  Total number of votes = number of shares × number of

directors to be elected

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Features of common stocks

 Voting right

 Cumulative voting

 If there are Ɲ directors up for election, then [1/(Ɲ +1)]

percent of the stock plus one share will guarantee you a seat.

 Example: Stock in JRJ Corporation sells for $20 per

share and features cumulative voting. There are 10,000 shares outstanding. If three directors are up for election, how much does it cost to ensure yourself a seat on the board.

 2,501 × $20 = $50,020

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Features of common stocks

 Voting right

 Straight voting

 The directors are elected one at a time.  This guarantees that a majority will win every seat.

 Staggered election

 Only a fraction of the directorships are up for election at

a particular time.

 Staggering makes it more difficult for a minority to elect a director

when there is cumulative voting.

 Staggering makes takeover attempts less likely to be successful

because it makes it more difficult to vote in a majority of new directors.

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Features of common stocks

 Proxy voting

 A proxy is the grant of authority by a shareholder

to someone else to vote her shares.

 Used in large companies with large number of

shareholders.

 Management always tries to get as many proxies as

possible transferred to it. However, if shareholders are not satisfied with management, an “outside” group of shareholders can try to obtain votes via proxy. They can vote by proxy in an attempt to replace management by electing enough directors. The resulting battle is called a proxy fight.

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Features of common stocks

 Classes of stock

 Often, the classes are created with unequal voting

rights.

 A primary reason for creating dual or multiple classes

• f stock has to do with control of the firm. If such stock

exists, management of a firm can raise equity capital by issuing nonvoting or limited-voting stock while maintaining control.

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Features of common stocks

 Other rights

 The right to share proportionally in dividends paid.  The right to share proportionally in assets remaining

after liabilities have been paid in a liquidation.

 The right to vote on stockholder matters of great

importance, such as merger.

 The right to share proportionally in any new stock sold

(preemptive right).

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Features of common stocks

 Dividends

 Unless a dividend is declared by the board of

directors of a corporation, it is not a liability of the corporation.

 Corporations cannot default on an undeclared

• dividend. As a consequence, corporations cannot

become bankrupt because of nonpayment of dividends.

 The payment of dividends by the corporation is

not a business expense, and is, therefore, not deductible for tax purposes.

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Features of common stocks

 Dividends

 Dividends received by individual shareholders are

• taxable. However, corporations that own stock in
• ther corporations are excluded from paying taxes if

 the corporation holds at least 25% of outstanding stocks;  the stock has been held for at least 3 months before and

after the dividend payment; and

 the corporation paying dividends does not hold any stocks

• f the corporation receiving those dividends.

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Stock valuation

 Selecting the appropriate valuation model

 Absolute valuation model

 specifies an asset’s intrinsic value using present value

models.

 Dividen

idend d Disc scou

• unt

nt Mode del

 Free Cash Flow Model  Residual Income model

 Relative valuation model

 estimates an asset’s value relative to that of another asset.  Price multiples  Enterprise value multiples

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The PV of common stocks

 The value of any asset is the present value of its

expected future cash flows.

 Stock ownership produces cash flows from:

 Dividends  Capital Gains

 Valuation with a short-term holding period  Valuation with indefinite holding period

 Zero Growth  Constant Growth  Differential Growth

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Dividend Discount Model

 Assume that R = appropriate discount rate, P

= selling price, Div = dividend

 P0 = Div1/(1+R) + P1/(1+R)  P1 = Div2/(1+R) + P2/(1+R)  etc.

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       

3 3 2 2 1 1

) R 1 ( Div ) R 1 ( Div ) R 1 ( Div P

Case 1: a single holding period

 Suppose that you expect Carrefour SA

(NYSE Euronext Paris: CA) to pay a €0.58 dividend next year. You expect the price of CA stock to be €27.00 in one year. The required rate of return for CA stock is 9%. What is your estimate of the value of CA stock?

 P0 = Div1/(1+R) + P1/(1+R) = 0.58/1.09 + 27/1.09

= 25.30

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Case 2: multiple holding periods

 For the next five years, the annual dividends

• f a stock are expected to be $2.00, $2.10,

$2.20, $3.50, and $3.75. In addition, the stock price is expected to be $40.00 in five

• years. If the required return on equity is 10%,

what is the value of this stock?

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76 . 4 3 P ) 1 . 1 ( 40 ) 1 . 1 ( 3.75 ) 1 . 1 ( 3.50 ) 1 . 1 ( 2.20 ) 1 . 1 ( 2.10 ) 1 . 1 ( 2 P

5 5 4 3 2 1

      

Case 3: zero growth

 Assume that dividends will remain at the

same level forever.

 Since future cash flows are constant, the value of

a zero growth stock is the present value of a perpetuity:

11/16/2018 Nattawoot Koowattanatianchai 20

   

3 2 1

Div Div Div

R Div P ) R 1 ( Div ) R 1 ( Div ) R 1 ( Div P

3 2 1

        

Case 3: zero growth

 Assume that a stock will pay $1 of annual

dividends forever. If the required return on equity is 15%, determine whether investors should purchase this stock at the current market price of $5?

 Investors should buy this stock because it is

currently undervalued (market value < intrinsic value).

11/16/2018 Nattawoot Koowattanatianchai 21

67 . 6 15 . 1 R Div P0   

Case 4: constant growth

 Assume that dividends will grow at a constant

rate, g, forever, i.e.,

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g) 1 ( Div Div

1

 

2 1 2

g) 1 ( Div g) 1 ( Div Div    

3 2 3

g) 1 ( Div g) 1 ( Div Div    

. . .

Case 4: constant growth

 Since future cash flows grow at a constant

rate forever, the value of a constant growth stock is the present value of a growing perpetuity:

11/16/2018 Nattawoot Koowattanatianchai 23

g g    R ; R Div P

1

Case 4: constant growth

 Suppose Big D, Inc., just paid a dividend of

$1. It is expected to increase its dividend by 8% per year. If the market requires a return of 15% on assets of this risk level, how much should the stock be selling for?

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43 . 15 08 . 15 . .08) 1(1 g R Div P

1

     

Case 5: differential growth

 Assume that dividends will grow at different

rates in the foreseeable future and then will grow at a constant rate thereafter.

 To value a Differential Growth Stock, we need

to:

 Estimate future dividends in the foreseeable future.  Estimate the future stock price when the stock

becomes a Constant Growth Stock (case 4).

 Compute the total present value of the estimated

future dividends and future stock price at the appropriate discount rate.

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Case 5: differential growth

 Assume that dividends will grow at rate g1 for

N years and grow at rate g2 thereafter.

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) g (1 Div Div

1 1

 

2 1 1 1 2

) g (1 Div ) g (1 Div Div    

. . .

N 1 1 1 N N

) g (1 Div ) g (1 Div Div    



) g (1 ) g (1 Div ) g (1 Div Div

2 N 1 2 N 1 N

    



. . .

Case 5: differential growth

) g (1 Div

1



2 1

) g (1 Div 

N 1

) g (1 Div 

) g (1 ) g (1 Div ) g (1 Div

2 N 1 2 N

   

…

1 2

…

N N+1

…

11/16/2018 27 Nattawoot Koowattanatianchai

Case 5: differential growth

11/16/2018 Nattawoot Koowattanatianchai 28

N 2 1 N N N 1 1 1

) R 1 ( g R Div ) R 1 ( ) g 1 ( 1 g R Div P                      



We c can value ue this as the sum of:

• a

a N-year ar annuity ity growin ing at rate te g1

• plus

s the disco coun unted ted value ue of a perpetu etuity ity growin ing g at rate e g2 that t star arts ts in year r N+1 +1

Case 5: differential growth

 A common stock just paid

a dividend of $2. The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in

• perpetuity. What is the

stock worth? The discount rate is 12%.

11/16/2018 Nattawoot Koowattanatianchai 29

Case 5: differential growth

08) . 2(1 $

2

08) . 2(1 $

…

1 2 3 4

3

08) . 2(1 $ ) 04 . 1 ( 08) . 2(1 $

3

16 . 2 $ 33 . 2 $

1 2 3

04 . 12 . 62 . 2 $ 52 . 2 $   89 . 28 $ ) 12 . 1 ( 75 . 32 $ 52 . 2 $ ) 12 . 1 ( 33 . 2 $ 12 . 1 16 . 2 $ P

3 2

    

11/16/2018 30 Nattawoot Koowattanatianchai

Case 5: differential growth

11/16/2018 Nattawoot Koowattanatianchai 31

3 3 3 3

) 12 . 1 ( 04 . 12 . ) 04 . 1 ( ) 08 . 1 ( 2 $ ) 12 . 1 ( ) 08 . 1 ( 1 08 . 12 . ) 08 . 1 ( 2 $ P                    

  



3

) 12 . 1 ( 75 . 32 $ 8966 . 1 54 $ P    

31 . 23 $ 58 . 5 $ P   89 . 28 $ P 

Case 6: non-dividend-paying stock

 A stock has not paid any dividends, but is

expected to pay a dividend of $1 in five

• years. The dividend is then expected to grow

at 5% in perpetuity. What is the stock worth? The discount rate is 11%.

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67 . 16 05 . 11 . 1.00 g R Div P

5 4

    

98 . 10 11 . 1 16.67 ) R 1 ( P P

4 4 4

   

Case 7: the H-Model

 Suppose that growth begins at a high rate

(g1) at year 1 and declines linearly throughout the supernormal growth period until it reaches a normal rate (mature phase growth rate, g2) over the next N years.

 Fuller and Hsia’s (1984) H-Model

11/16/2018 Nattawoot Koowattanatianchai 33

   

2 2 1 2

g R g g 2 N Div g 1 Div P      

Case 7: the H-Model

 The current dividend of a stock is €1.77. The

initial dividend growth rate is 7%, declining linearly during a 10-year period to a final and perpetual growth rate of 4%. Analysts estimate the stock’s required rate of return on equity as 9.5%.

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   

30 . 38 04 . 095 . 04 . 07 . 2 10 77 . 1 04 . 1 77 . 1 P0      

Case 8: three-stage DDM

 A stock has just paid dividends of $0.56 per share.

Its current market price is $56.18. Analysts considers any security trading within a band of ±20% of her estimate of intrinsic value to be within a “fair value range”.

 Analysts forecast an initial 5-year period of 11% per

year earnings and dividend growth. It is also anticipated that this stock can grow 6.5% per year as a mature company, and allows a 10 years for the transition to the mature growth period.

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Case 8: three-stage DDM

 The required return on equity is assumed to

be 8%.

 Div5 = Div0(1+g1)5 = 0.56(1.11)5 = 0.9436  g2 = 11%  g3 = 6.5%  R = 8%  P5 = 81.1524

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   

3 3 2 5 3 5 5

g R g g 2 N Div g 1 Div P      

Case 8: three-stage DDM

Time Divt or Pt Calculatio ulation Value PV @ 8% 1 Div1 0.56(1.11)1 0.6216 0.5756 2 Div2 0.56(1.11)2 0.6900 0.5915 3 Div3 0.56(1.11)3 0.7659 0.6080 4 Div4 0.56(1.11)4 0.8501 0.6249 5 Div5 0.56(1.11)5 0.9436 0.6422 5 P5 H-Model 81.1524 55.2310 Total 58.2731

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Where does g come from?

 Earnings next year = Earnings this year +

Retained earnings this year × Return on retained earnings

 Dividing both sides of the equation by Earnings

this year:

 1+g = 1 + retention ratio × ROE  g = retention ratio × ROE  retention ratio = (NI - Div)/NI  ROE = NI/Sales × Sales/Total Asset × Total Asset/Equity

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Where does R come from?

 The capit

ital al asset t pri ricing cing model l (C (CAPM) APM):

 Multifactor models

 E.g., the Fama-French model

 Other methods

 bond yield plus risk premium method

11/16/2018 Nattawoot Koowattanatianchai 39

(1/3)(1.0) beta) (2/3)(raw beta adjusted premium risk equity beta adjusted rate free risk R     

Where does R come from?

 Use information in the following table to

estimate the required return on equity for XOM (a US stock) BP (a UK stock) and TOT (a European stock)

11/16/2018 Nattawoot Koowattanatianchai 40

Stock ck Adjusted sted beta Equity y risk premium emium Risk-fre ree e rate XOM 0.77 4.5% 3.20% BP 1.99 4.1% 3.56% TOT 1.53 4.0% 2.46%

Where does R come from?

 XOM

 R = 3.20% + 0.77(4.50%) = 6.67%

 BP

 R = 3.56% + 1.99(4.10%) = 11.72%

 TOT

 R = 2.46% + 1.53(4.0%) = 8.58%

11/16/2018 Nattawoot Koowattanatianchai 41

Is DDM an appropriate choice?

 DDM is most suitable when:

 the company is dividend-paying;  the board of directors has established a dividend

policy that bears an understandable and consistent relationship to the company’s profitability; and

 the investor takes a noncontrol perspective.

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Is DDM an appropriate choice?

Year ar COKE HRL HRL EPS EPS DPS Payou

• ut

Ratio io EPS EPS DPS Payou

• ut

Ratio io 2012 3.08 1.00 32 1.86 0.60 32 2011 3.08 1.00 32 1.74 0.51 29 2010 3.94 1.00 25 1.51 0.42 28 2009 3.56 1.00 28 1.27 0.38 30 2008 1.77 1.00 56 1.04 0.37 36 2007 2.17 1.00 46 1.07 0.30 28 2006 2.55 1.00 39 1.03 0.28 27 2005 2.53 1.00 40 0.91 0.26 29 2004 2.41 1.00 41 0.78 0.23 31 2003 3.40 1.00 29 0.67 0.21 29 2002 2.56 1.00 39 0.68 0.20 29

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Is DDM an appropriate choice?

 DDM does not appear to be an appropriate

choice for valuing COKE.

 COKE’s dividends do not appear to adjust to

reflect changes in profitability.

 Using a DDM to value HRL is appropriate.

 HRL’s dividends have generally followed its

growth in earnings.

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The Stock Markets

 Dealers vs. Brokers  New York Stock Exchange (NYSE)

 Largest stock market in the world  License Holders (formerly “Members”)

 Entitled to buy or sell on the exchange floor  Commission brokers  Specialists  Floor brokers  Floor traders

 Operations  Floor activity

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NASDAQ

 Not a physical exchange – computer-based

quotation system

 Multiple market makers  Electronic Communications Networks  Three levels of information

 Level 1 – median quotes, registered

representatives

 Level 2 – view quotes, brokers & dealers  Level 3 – view and update quotes, dealers only

 Large portion of technology stocks

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Stock Market Reporting

52 WEEKS YLD VOL NET HI LO STOCKSYM DIV % PE 100s CLOSE CHG 21.89 9.41 Gap Inc GPS 0.34 3.1 8 88298 11.06 0.45

Gap has been as high as $21.89 89 in the last t year. r. Gap has been as low as $9.41 1 in the last t year. r. Gap pays a dividend of 34 cents/ ts/share. share. Given en the curre rent t price, , the dividend dend yield d is 3.1%. %. Given en the curren ent t price, , the PE ratio io is 8 times es earnings. ings. 8,829,8 9,800 00 shares es traded ded hands s in the last day’s trading. Gap ended trading at $11.06, which is up 45 cents from yesterday.

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4/6/2011 Natt Koowattanatianchai 48