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 athttp://www.dividenddetective.com/big_dividend_list.htm.)

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 will typically be 2?3 pages in length as a general expectation/estimate.Written in APA style Word document.

http://www.dividenddetective.com/big_dividend_list.htm

The Dividend Detective site provides a listing of 800 high-dividend stocks. Each company on the list contains an estimate of its stock's annual dividend in addition to its dividend's annual yield.

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 rs. % 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 St ock Price Sensit ivit y $90 D i v $80 $70 $60 $50 $40 $30 $20 $10 $43.12 $0 -30% -2 0% -10% 0% 10% 20% 30% % Ch an ge in In put 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