Mr. Hillbrandt is impressed with your ability to explain financial concepts so he asks for help with learning about stock valuation. Mr. Hillbrandt really liked the examples you provided last time (module 1), so it seems as if you need to sit down and create some relevant examples for this topic too. Below is some information that helps you brush up on the topic.
Read this article related to the intrinsic value of stock, paying special attention to the section entitled “Constant Growth Model”:
Alvarez, S. (2015). What is the intrinsic value of stock? Investopedia. Retrieved from http://www.investopedia.com/articles/basics/12/intrinsic-value.asp
Now, let’s work the following problem:
A company just paid an annual dividend of $2.00 per share. Dividends are anticipated to grow at a rate of 8% per year forever. The stock’s beta is 1.5, the risk-free rate is 2.5%, and the expected return on the overall stock market is 7.5%. What’s the intrinsic value of the company’s common stock?
Using the formula:
Stock Price = D1 ÷ (k – g)
D1 = dividend for the coming year
k = required rate of return (NOTE: k must be greater than g)
g = growth rate of dividends
(Note: Decimals and not percentages must be used for the model to work)
1) To calculate the dividend for the coming year, we need to multiply the last dividend by the expected dividend growth rate. And so:
D1 = $2.00 x 1.08 = $2.16
2) Find the Market risk premium using the following formula:
Market risk premium = Expected return on stock – Risk free rate
= 7.5% – 2.5%
3) Then, to find k, or the required rate of return, use the following formula:
k = risk free rate + [market risk premium x beta]
= 2.5% + (5% * 1.5)
4) g = 8% (or 0.08) growth rate of dividends
5) Stock Price = D1 ÷ (k – g)
= $2.16 ÷ (.10 – .08)
= $2.16 ÷ .02
5) Check your answer with this online calculator: http://www.zenwealth.com/businessfinanceonline/SV/CGStockCalculator.html
Now, work the following problems:
1 A company just paid an annual dividend of $3.25 per share. Dividends are anticipated to grow at a rate of 5% per year forever. The stock’s beta is 1.2, the risk-free rate is 3.5%, and the expected return on the overall stock market is 5.5%. What’s the intrinsic value of the company’s common stock? ANSWER = $379.17
2 A company just paid an annual dividend of $2.35 per share. Dividends are anticipated to grow at a rate of 6.25% per year forever. The stock’s beta is 1.6, the risk-free rate is 4.25%, and the expected return on the overall stock market is 8.5%. What’s the intrinsic value of the company’s common stock? ANSWER = $51.48
Part I consists of three questions.
Do the computations for the example below. Show the computations step by step, so Mr. Hillbrandt can easily follow your examples.
1. The company’s common stock dividends are anticipated to grow at a constant 5.5% growth rate per year going forward. The company just paid an annual dividend (that is, D-zero) of $3 per share. What’s the intrinsic value of the stock based on the following required rates of return?
2. If the stock is currently selling for $40 per share, is the stock a good buy? Interpret the results and justify your decision.
3. The company just paid an annual dividend of $1.50 per share. Dividends are anticipated to grow at a stable rate of 10% per year forever. The stock’s beta is 1.2, the risk-free rate is 4%, and the expected return on the overall stock market is 11%. What is the intrinsic value of the company’s common stock?
Select one company that is a member of the Dow Jones Industrial Average. The listing is here:
Apply the Dividend Discount Model and justify why you think that the stock is currently undervalued, overvalued, or fully valued. Please be sure to state your assumptions and justify your results. What is the relationship, if any, between stockholders’ wealth and financial decisions?
Computations (use Excel).
Use Excel to make the part I and II computations. Make sure you separate the two parts and organize the information, so Mr. Hillbrandt easily understands.
Memo (use Word).
Explain the concept and computations in part I to the CEO. Start with an introduction and end with a conclusion. Each of the four or five paragraphs should have a heading.
Short Essay – Part II (use Word).
Let’s look at this issue from an investor’s perspective and respond to the question above. Do research as needed and respond to the questions posed in part II.
Start with an introduction and end with a summary or conclusion. Use headings. Don’t forget to reference your sources. Maximum length of two pages.
Each submission should include two files: (1) An Excel file; and (2) A Word document. The Word document shows the memo first and short essay last. Assume a knowledgeable business audience and use required format and length. Individuals in business are busy and want information presented in an organized and concise manner.
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Module 2 – Background
Stocks and Bonds
Stocks and Bonds Podcast. (n.d). Pearson Learning Solutions, New York, NY.
Stocks and Bonds Interactive Tutorial. (n.d.). Pearson Learning Solutions, New York, NY.
Part of what you learned in Module 1 was the time value of money. It’s good to have a strong understanding of the time value of money since time value of money techniques are used for stock valuation and bond valuation.
The Dividend Discount Model can be used to value common stock. There are several varieties of the Dividend Discount Model, including the zero growth model, the constant growth model, and the differential growth model. An analyst needs to use his or her best judgment to determine which model variety should be used to value a company’s common stock. For example, if the analyst forecasts that the company’s dividends will grow at a fixed rate of 3% per year forever, then the constant growth model should be used. If, on the other hand, the analyst forecasts that the company’s dividends will grow at a 25% growth rate for the next three years and then grow at a constant rate of 5% per year, then the differential growth model should be used. The zero growth model is a special version of the constant growth model, whereby the constant growth rate is 0%. The Dividend Discount Model will result in an estimate for the intrinsic value of the common stock. An analyst would then compare the intrinsic value of the common stock to the market price of the common stock. If the intrinsic value of the common stock is greater than the market price, the stock should be bought. If the intrinsic value of the common stock is less than the market price, the stock should be sold if it’s currently owned. If the intrinsic value of the common stock is equal to or just about equal to the market price, the stock should be held if it’s currently owned or avoided if it’s not currently owned. The required rate of return can be calculated from the Capital Asset Pricing Model (CAPM).
Review the following website links:
Investopedia.com (n.d.).The Gordon growth model. Retrieved from http://www.investopedia.com/terms/g/gordongrowthmodel.asp
Pages.stern.nyu.edu (n.d.).Dividend discount models. Retrieved from http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf
Valuebasedmanagement.net (n.d.).Capital asset pricing model (CAPM). Retrieved from http://www.valuebasedmanagement.net/methods_capm.html
Preferred stock is a hybrid security; that is, a combination of common stock and preferred stock. Preferred stock is another financing option for companies. Preferred stock is valued as a perpetuity.
Corporations issue bonds and stocks to raise funds. Governments also issue bonds to raise funds. Bonds typically pay interest every six months and then when the bond matures, the investor gets the par value of a bond. The interest every six months is calculated by multiplying the coupon rate by the par value and dividing the result by two. Since the interest paid is constant for a number of years, that’s an annuity. Since the par value is only obtained once at the bond’s maturity date, that’s not an annuity but instead is a lump sum. Therefore, to find the value of a bond you add the present value of an annuity to the present value of a lump sum. A financial calculator and/or Excel can help speed up the process to determine a bond’s value. Here’s how to value a typical corporate bond:
Bond Valuation = C * [1 – (1+i)-n / i] + F / (1+i)n
C = coupon interest payment
i = yield to maturity
n = time to maturity
F = par value
There are three main interest rates when working with bonds: the coupon rate, the yield to maturity, and the current yield. The coupon rate is typically fixed and is the interest rate that’s paid on the bond. You multiply the coupon rate by the par value to determine the annual interest paid on the bond. The par value is also known as the maturity value or the face value. The yield to maturity changes and indicates what rate of return an investor can expect to earn if the bond was held to maturity. There’s an inverse relationship between interest rates and bond prices. As interest rates increase, bond prices decline. As interest rates decrease, bond prices increase. When a bond’s yield to maturity equals the bond’s coupon rate, the bond will sell at par value. When a bond’s yield to maturity exceeds the bond’s coupon rate, the bond will sell at a “discount” or less than par value. When a bond’s yield to maturity is less than the bond’s coupon rate, the bond will sell at a “premium” or more than par value. Investors can lose money in bonds. For example, if an investor buys a bond when interest rates are low and then sells the bond before maturity when interest rates are much higher, the investor is likely going to have a large capital loss. The current yield is equal to the bond’s annual interest payment divided by the bond’s current price. It measures the interest component of a bond’s return. The coupon rate has the same numerator as the current yield, but it has the bond’s par value in the denominator instead of the bond’s current price.
Review these website links:
Investopedia.com (n.d.). Bond basics. Retrieved from http://www.investopedia.com/university/bonds/
Wps.aw.com (n.d.). Investing in bonds (Chapter 16). Retrieved from http://wps.aw.com/wps/media/objects/525/537983/ch16/chapter16.pdf
Bookboon.com. (2008). Corporate Finance. Retrieved from http://bookboon.com/en/economics-and-finance-ebooks
Welch, Ivo. (2014). Corporate Finance (3rd Ed.).Chpts 3, 5 and 9. Retrieved from http://book.ivo-welch.info/ed3/toc.html
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