FIN311- INTRODUCTION TO BUSINESS
FINANCE
FIN431- FINANCE FOR MANAGERS
Dr. Muhammad Usman Zafar
Office Hours: TBC
Email: musman.zafar@iqraisb.edu.pk
TODAYS LECTURE
DEBT AND TAXES,
VALUATION OF STOCKS
Learning Goals
• Discuss the role of taxes and debt for companies and how
they can be managed
• Determine the intrinsic value of a stock using the dividend
valuation model and common stock ratios
What are stocks?
– Corporate ownership is divided into shares known
as stock
– The sum of all the outstanding shares of a corporation is known as
the equity of the corporation
– Owner of a share of stock is called
• Shareholder
• Or stockholder
• Or equity holder
3
What are stocks?
• Stock is an equity investment that represents ownership in a
corporation
• A unique feature of this ownership is that there is no limitation on
who can own the stock.
• This feature allows free trade in the stock of a corporation.
Corporations can raise substantial amounts of capital because they can
sell ownership shares to anonymous outside investors.
4
Stock returns?
The return on investment in stock comes from two sources: dividends
and capital gains
• Dividends are payments the corporation makes to its shareholders
• Capital gains occur when the stock price rises above an investor’s
initial purchase price
– Capital gains may be realized or unrealized
5
Stock returns (S&P 500)
6
Stock returns
Several interesting historical patterns:
• Big returns (or losses) come from capital gains,
rather than from dividends.
• Stocks generally earn positive returns over long
periods of time:
From 1930 to 2014, the average total return on the
S&P 500 was 11.4% per year.
7
Stock returns
Investing in stocks is clearly not without risk:
• In 2008, the S&P 500 lost roughly 36% of its value.
• From 2000 through 2009, the U.S. stock market’s
average annual return was only 1.1% per year.
The stock index, which shows the average market performance
of stocks, gives a benchmark against which to assess current
stock returns and our own expectations.
8
Stock returns (KSE 100)
Source:
Dividends:
https://www.khistocks.com/compan
y-information/dividend-data.html
Capital Gains/Losses:
https://tradingeconomics.com
/pakistan/stock-market
9
Basic Characteristics of Common Stock
– Market capitalization: the share price (market value per share)
times the number of shares outstanding.
– The ask and bid price.
– Bid-ask spread: difference between the bid and ask prices for a
stock.
• Cost you incur when you make a roundtrip trade (i.e. purchase and
then later sell).
– How do investors determine the price they are willing to pay for the
stock?
– EPS, PE ratio, Forward dividend & yield, what are they?
10
Stock Valuation Models
• According to the Law of One Price, the intrinsic value of a security
should equal the present value of the expected cash flows an investor
will receive from owning it.
– Intrinsic value: The underlying or inherent value of a security
• To value a stock is to find its intrinsic value.
• To find the intrinsic value of a stock, we need to know the expected
cash flows a stock investor will receive.
– For stocks, the expected cash flows are dividends received
each year plus the future sale price of the stock.
11
Stock Valuation Models
12
Stock Valuation Models
13
Stock Valuation Models
14
Applying the Dividend Valuation Model
15
Applying the Dividend Valuation Model
• Zero Growth
– Assumes dividends will not grow over time, i.e., g = 0.
– Value of a zero-growth stock is simply the present value of
its annual dividends.
16
Applying the Dividend Valuation Model
• Changing Growth Rates
– We cannot use the constant dividend growth model to
value a stock if the dividend growth rate is not constant.
• For example, young firms often have very high initial earnings
growth rates. During this period of high growth, these firms often
retain 100% of their earnings to exploit profitable investment
opportunities. As they mature, their growth slows. At some point,
their earnings exceed their investment needs, and they begin to
pay dividends.
17
Changing Growth Rates
18
Example
Assume you’ve generated the following information about the stock
of Bufford’s Burger Barns:
• The company’s latest dividends of $4 a share are expected to
grow to $4.32 next year, to $4.67 the year after that, and to $5.04
in three years.
• After that, you think dividends will grow at a constant 6% rate.
Use the variable growth version of the dividend valuation model
and a required return of 15% to find the value of the stock.
19
Example
20
Example
• The third year cash flow is the dividend of $5.04 plus
the $59.36, the stock value at the end of year 3.
• The value of the stock today is simply the present
value of all the future cash flows, $49.63.
21
Limitations of the Dividend Valuation
Model (DVM)
• There is a tremendous amount of uncertainty associated
with forecasting a firm’s dividend growth rate and future
dividends.
• Small changes in the assumed dividend growth rate can
lead to large changes in the estimated stock price.
22
Other Approaches to Stock Valuation
– The market has developed other approaches to valuing stock in
addition to the DVM.
• Free cash flow to equity method (or flow to equity method):
estimates cash flow that a firm generates for common
stockholders, whether it pays those out as dividends or not.
• P/E approach: builds the stock valuation process around the
stock’s price-to-earnings ratio.
– Major advantage is that these approaches do not rely on
dividends as the primary input.
23
Other Approaches to Stock Valuation
Free cash flow to equity model
It computes equity value at time t by replacing expected dividends
with expected free cash flows to equity
Free cash flows to equity =cash flows from operations – capital expenditures +
increases (minus decreases) in debt
Example
Example ( Dividend Discount Model)
Example (Free cash flow to equity model)
FCFE value?
Common Stock Ratios
Earnings Per Share: the amount of annual earnings
available to common stockholders, stated on a per-share
basis.
28
Common Stock Ratios
29
Common Stock Ratios
30
Common Stock Ratios
31
Other Approaches to Stock Valuation
32
Practice Question 1
a. Coastal Rail is currently trading at $35 per share. The
company pays a quarterly dividend of $0.92 per share.
What is the dividend yield?
b. Mountain Rail has a net profit of $750 million. It has
600 million shares outstanding and pays annual
dividends of $1.1 per share. What is the dividend payout
ratio?
33
Practice Question 1
a. Annual dividend payments = $0.92 × 4 = $3.68 per
annum.
Dividend yield = $3.68/$35 = 10.51%
b. Payout ratio = Dividends per share/EPS
Dividends per share = $1.10.
Earnings per share = $750million/$600million = $1.25
Payout ratio = ($1.1/$1.25) × 100 = 88%
34
Practice Question 2
Danny is considering a stock purchase. The stock pays a
constant annual dividend of $2.00 per share and is
currently trading at $20. Danny’s required rate of return
for this stock is 12%. Should he buy this stock?
35
Practice Question 2
Intrinsic value = Annual dividend/ Required rate
of return = $2/.12 = $16.67
Danny should not buy the stock, as it is
overpriced based on his valuation.
36
Practice Question 3
This year, Shoreline Light and Gas (SL&G) paid its stockholders an annual
dividend of $3 a share. A major brokerage firm recently put out a report on SL&G
predicting that the company’s annual dividends would grow at the rate of 10% per
year for each of the next five years and then level off and grow at 6% thereafter.
a. Use the variable-growth DVM and a required rate of return of 12% to find the
maximum price you should be willing to pay for this stock.
b. Redo the SL&G problem in part a, this time assuming that after year 5,
dividends stop growing altogether (for year 6 and beyond, g = 0). Use all the
other information given to find the stock’s intrinsic value.
c. Contrast your two answers and comment on your findings. How important is
growth to this valuation model?
37
Practice Question 3
Estimated annual growth rate for year 6 and
Projected Annual Dividends beyond: 6%
Year Dividends Step 1: Present value of dividends using
0 $3.00 a required rate of return of 12%:
1 3.30 (g = 10%)
Present
2 3.63 (g = 10%) Year Dividends Value
3 3.99 (g = 10%) 1 3.30 $2.95
4 4.39 (g = 10%) 2 3.63 2.89
5 4.83 (g = 10%) 3 3.99 2.84
6 5.12 (g = 6%) 4 4.39 2.79
5 4.83 2.74
Total: $14.22
38
Practice Question 3
Step 2: Price of stock at the end of year 5:
P5 = D6 $5.12 $5.12
= = = $85.33
r - g 0.12 - 0.06 0.06
Step 3: Take the price of the stock price at the end of year 5 and calculate its
present value as of today:
$85.33 / (1.12)5 = $48.42
Step 4:
Value of SLL&G stock = $14.22 (Step 1) + $48.42 (Step 3)
= $62.65
Therefore, $62.65 is the maximum price you should be willing to pay for
this stock.
39
Practice Question 3
b. Since g = 0 for year 6 and beyond, dividends for year 6 will
be the same as the dividend for year 5, i.e., $4.83. We just
need to redo steps 2 and 3 to find the intrinsic value of the
stock:
Step 2: Price of stock at the end of year 5:
D6 $4.83 $4.83
P5 = = = = $40.25
r - g 0.12 - 0 0.12
Step 3: Present value of the stock price = $40.25 / (1.12)5 = $22.84
Since the present value of the first 5 years of dividends is the same as in a.
above, the intrinsic value of the stock is:
Intrinsic value = $14.22 + $22.84 = $37.06
40
