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MBA Corporate Finance Class Of 2014

V. Stock and Company Valuation

Ian Garrett

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Some Terminology

• Dividend – periodic cash distribution of (part of) proﬁts from the company to its shareholdersa • Earnings Per Share (EP S) – proﬁt divided by the number of shares outstanding • Payout Ratio – the fraction of earnings paid out • P/E Ratio – current share price divided by annual earnings per share: the multiple of earnings at which the stock currently sells can take other forms besides cash (e.g. stock dividends), and many ﬁrms make cash distributions to shareholders via share repurchases. a Dividends

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A Quick Look At Dividends In Practice

BT Financial Summary

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3-1 From the BT Annual Report and Form 20-F, 2008 and 2005:

Years ended 31 March In £m unless otherwise stated Basic earnings per share Dividends per share 2008 21.7p 15.8p 2007 34.4p 15.1p 2006 18.4p 11.9p 2005 21.4p 10.4p 2004 16.4p 8.5p 2003 31.4p 6.5p

' What Useful Information Could We Get From This?

1. The Payout Ratio Payout Ratio = As a percentage: ( Payout Ratio (%) = 2. Dividend Growth from t − 1 to t Dividend Growth = As a percentage: ( Dividend Growth (%) = Dividendt − Dividendt−1 Dividendt−1 ) × 100 Dividendt − Dividendt−1 Dividendt−1 Dividend Per Share Earnings Per Share ) × 100 Dividend Per Share Earnings Per Share

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Years ended 31 March In £m unless otherwise stated Basic earnings per share Dividends per share Payout Ratio Dividend Growth 2008 21.7p 15.8p 72.8% 4.6% 2007 34.4p 15.1p 43.9% 26.9% 2006 18.4p 11.9p 64.7% 14.4% 2005 21.4p 10.4p 48.6% 22.3% 2004 16.4p 8.5p 51.8% 30.8% 2003 31.4p 6.5p 20.7%

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Valuing Stocks

• Apply the discounted cash ﬂow principle to the cash ﬂows shareholders receive • If an investor buys and holds shares, the cash ﬂow they receive is from two sources – any dividend the company pays – any capital gain should the investor decide to sell the shares • These are, of course, uncertain

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The Price Of A Stock Over One Period

• The “correct” (fair) current price stock price, P0 , is the present value of the cash ﬂows the investor receives • Suppose an investor buys a share now and sells it after one period. P0 is given by Div1 + P1 Div1 P1 P0 = or P0 = + (1) 1 + rE 1 + rE 1 + rE Div1 dividends per share paid during the period P0 current market price per share market price per share at the end of the period P1 discount rate (required return on equity given it’s risk) rE

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' The Total Return On This Stock

• The return on this share over time period 0 to time period 1 can be found by solving (1) for rE : Total Return

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rE =

Div1 + P1 − P0 = P0

Div1 P0

Dividend Yield

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P1 − P0 P0

Capital Gain Rate

(2)

– If another stock with the same risk oﬀered a higher return investors would sell this stock and buy the other ∗ this would drive the current price of this stock down, driving up the dividend yield and the capital gain rate ∗ it would be vice versa for the other stock ∗ the buying and selling activity would stop when the two oﬀered the same total return

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The Price When We Have A Multi-Period Horizon

• Suppose an investor holds the stock over two periods • Use the same logic as above: P0 = Div1 Div2 + P2 + 1 + rE (1 + rE )2

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P0 =

Div1 Div2 P2 + + (3) 1 + rE (1 + rE )2 (1 + rE )2

• Will this lead to diﬀerent values for the stock if we have diﬀerent investment horizons? – No. Why? • Suppose we are now in time period 1 and we are interested in holding the stock for one period. What would the price be? P1 = Div2 + P2 1 + rE (4)

• Substitute (4) for P1 in (1) gives (3) • The price when we are interested in a two-period horizon is the same as two one-period horizons

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Keep going . . . • What determines P2 ? P2 = ⇒ P0 = Div1 1 + rE Div3 P3 + 1 + rE 1 + rE Div2 Div3 P3 + + + (1...