Application: 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.)

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.

General Guidance on Application Length:

Your Assignment, due by Day 7, will typically be 2?3 pages in length as a general expectation/estimate. Refer to the rubric for the Week 4 Application for grading elements and criteria. Your Instructor will use the rubric to assess your work.

I have attached the Stock Model Excel Sheet and the Rubric. Thank you in Advance :)

Stock pricesensitivity 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 ( 1 + rs ) + D2 ( 1 + rs ) 2 + . . . . Dn ( 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: P0 = D1 (rsg) 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 g rs $2.15 8.3% 13.7% P0 = D1 ( rs g ) P0 = $43.12 = D0 (1+g) ( rs g ) $2.33 0.054 = 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 r s. % Change in D0 -30% -15% 0% 15% 30% Resulting Price Dividend, D0 $43.12 $0.81 $0.98 $1.15 $1.32 $1.50 Last rs % Change -30% -15% 0% 15% 30% 9.38% 11.39% 13.40% 15.41% 17.42% % Change -30% -15% 0% 15% 30% g 5.60% 6.80% 8.00% 9.20% 10.40% $43.12 Stock Price Stock Price Sensitivity $90 D i v $80 $70 $60 $50 $40 $30 $20 $10 $43.12 $0 -30% -20% -10% 0% 10% 20% 30% % Change in Input 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 r s and g have especially strong effects on the stock price. This occurs because as r s 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 r s. In doing so, we are now solving for an expected return. Here is the resulting equation: D1 P0 rs = + g 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 D1 g $23.06 $1.245 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 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 rs gs gL $1.15 13.4% 30% 8% Year Dividend 0 $1.15 PV of dividends $ 1.3183 1.5113 1.7326 $ 4.5622 34.6512 $ 39.2135 Short-run g; for Years 1-3 only. Long-run g; for Year 4 and all following years. 8% 1 2 3 4 1.495 1.9435 2.5266 2.7287 2.7287 50.5310 = Terminal value = 0.054 = 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 = Vp = Vp = Dp $10.00 $97.09 / / rp 10.30% = rs gL 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 I/YR PMT FV = Par value Price 50 10% $10 $100 $100.00 What would its value be if the required return declined to 8%? N I PMT Face value Price 50 8% $10 $100 $124.47 Had this been a perpetual preferred with a required return of 8%, what would be the stock price?: Price $125.00 Week 4 Application Rubric Stock Valuation Percent Score: 100% Calculations - Available Points Available Points: Total Points Available: Minimum Requirements - Both Categories Must Be Met or Peer Review Post(s) will not be graded Timeliness Follows Specific Weekly Instructions (Focused) Acceptable Submitted by the deadline Calculations x Analysis x Followed All Peer Review Instructions in Classroom and Syllabus Calculations x Analysis x Assessment of Qualified Assignments Criteria - Calculations Calculation for: Stock Price Valuation Element (1): (12 pts max) Model Choice The author uses MS Excel or calculator. Formulas and calculations are correct. Criteria - Analysis, Decisions, Conclusions 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. Element (2) Valuation vs. Current Price (5 pts max) 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. Element (3): Reasons and Rationales (15 pts max) 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. Writing exhibits evidence of thoughtful critical analysis and thinking; careful examination is made of assumptions and possible biases, with detailed Element (4): Critical Thinking, supporting rationale. Writing synthesizes the Analysis, and Synthesis (10 classroom experiences and content; analyze patterns pts max) or connections between theory and practice; and draws logical conclusions based on well-reasoned arguments. New questions may be presented based on synthesis of ideas and input. Writing is clear, logical, well-organized and appropriate for graduate level work. Writing spellElement (5) Standards of checked and proofread. Sentences are complete and Scholarship (8 pts max) Note: grammatically correct. Words are chosen for their Sub-standard writing, format, precise meaning. Tone is professional and free from or APA will result in lower bias (i.e., sexism, racism). Consistent form and style scores in other categories as are used. Each citation is referenced, and only cited without these elements, the sources are referenced, aligned with APA format. content areas above are When students reference/reuse their own work, they inherently weaker. provide self-reference per APA rules and Walden policy. 2014 Laureate Education, Inc. Rubric n 20 50 70 or Peer Review Post(s) will not be graded Score Score: Total Score: 20 50 70 Unacceptable Not submitted by the deadline Met Met Did not follow Instructions in Classroom and Syllabus Met Met Assignments Instructor Assessment Calculations are Accurate and Results are Correct (100%) Instructor Feedback x Calculations are on the Right Track, But Some Errors (50%) Calculations are Not Provided Or Not Appropriate (0) Criteria Met Instructor Assessment Exemplary (100%) x Proficient (85%) Student demonstrates exemplary work on all criteria listed for category. Opportunity for Improvement (75%) Unacceptable (0) Score Exemplary (100%) 12.0 x Student demonstrates exemplary work on all criteria listed for category. Proficient (85%) Opportunity for Improvement (75%) Unacceptable (0) Exemplary (100%) x Proficient (85%) Student demonstrates exemplary work on all criteria listed for category. Opportunity for Improvement (75%) Unacceptable (0) Weighting 15 Exemplary (100%) x Proficient (85%) Student demonstrates exemplary work on all criteria listed for category. Opportunity for Improvement (75%) Unacceptable (0) Exemplary (100%) Proficient (85%) Opportunity for Improvement (75%) Unacceptable (0) x Student demonstrates exemplary work on all criteria listed for category. Instructor Feedback Instructor Feedback Exemplary Criteria 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 values used in the model, including why the assumptions were Element (1): Model Choice the required. Model chosen is compared with other potential models that (12 pts max) 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. Element (2) Valuation vs. Current Price (5 pts max) 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. Element (3): Reasons and Rationales (15 pts max) 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. Writing exhibits evidence of thoughtful critical analysis and thinking; careful examination is made of assumptions and possible biases, with Element (4): Critical Thinking, detailed supporting rationale. Writing synthesizes the classroom Analysis, and Synthesis (10 experiences and content; analyze patterns or connections between theory and practice; and draws logical conclusions based on well-reasoned pts max) arguments. New questions may be presented based on synthesis of ideas and input. Writing is clear, logical, well-organized and appropriate for graduate level Element (5) Standards of work. Writing spell-checked and proofread. Sentences are complete and Scholarship (8 pts max) Note: grammatically correct. Words are chosen for their precise meaning. Tone is Sub-standard writing, format, or APA will result in lower scores in other categories as without these elements, the content areas above are inherently weaker. professional and free from bias (i.e., sexism, racism). Consistent form and style are used. Each citation is referenced, and only cited sources are referenced, aligned with APA format. When students reference/reuse their own work, they provide self-reference per APA rules and Walden policy. Proficient Criteria Author defends choice of model as to why it is appropriate to use for the chosen stock and explains any assumptions he or she made regarding the values used in the model, including how those assumptions were identified or why they were needed. The author determines whether the chosen company appears to be correctly valued, overvalued or undervalued based on the company's stock current price and model result. The author provides reasons as to why the company's stock appears to be over-, under-, or correctly valued. Writing exhibits some evidence of thoughtful critical analysis and thinking. Examination is made of assumptions and possible biases, with some supporting rationale. Writing synthesizes the classroom experiences and content; analyzes patterns or connections between theory and practice; and draws logical conclusions based on wellreasoned arguments adequately, but not superbly. New questions are not presented based on synthesis of ideas and input. Writing is somewhat clear, logical, well-organized and appropriate for graduate level work. Writing was not spell-checked and proofread. Most sentences were complete and grammatically correct. Most words were chosen for their precise meaning. Tone is professional and free from bias (i.e., sexism, racism). Consistent form and style are used. The author provides appropriate citations using APA format.When students reference/reuse their own work, they provide self-reference per APA rules and Walden policy. Opportunity for Improvement Author does not defend choice of model as to appropriateness and/or does not adequately explain how any assumptions on the values used in the model were arrived at. The author does not determine whether the chosen company appears to be correctly valued, overvalued or undervalued based on the company's stock current price and model result. Current price and/or model result is missing. The author provides a few reasons as to why the company's stock appears to be over-, under-, or correctly valued, but rationales given are cursory and are not evidence-based. Writing exhibits little or no evidence of thoughtful critical analysis and thinking. Examination is not made of assumptions and possible biases. Writing does not synthesize the classroom experiences and content; nor analyzes patterns or connections between theory and practice. Logical conclusions based on well-reasoned arguments are not exhibited. New questions are not presented based on synthesis of ideas and input. Writing is not very clear, logical, well-organized or appropriate for graduate level work. Writing was not spell-checked and proofread. Too many sentences were not complete and grammatically correct for graduate level work. Word choice could be better. Tone is professional and free from bias (i.e., sexism, racism). Consistent form and style were not used. Some citations were referenced, and many cited sources were not referenced, or aligned with APA format. When students reference/reuse their own work, they provide self-reference per APA rules and Walden policy.