STOCKS AND THEIR VALUATION

• Common stock dividends


  Not contractual, depend on the firm's earnings, which in turn depend on many random factors
• Two models used to estimate stock's intrinsic or "true" values

  • Discounted dividend model
  • Corporate valuation model
• A stock should be bought


  If its price is less than its estimated intrinsic value
• A stock should be sold


  If its price exceeds its intrinsic value
• Marginal Investor


  A representative investor whose actions reflect the beliefs of those people who are currently trading a stock; it is the marginal investor who determines a stock's price
• Market Price


  The price at which a stock sells in the market
• Growth rate


  The expected rate of growth in dividends per share
• Required rate of return

  The minimum rate of return on a common stock that a stockholder considers acceptable
• Expected rate of return

  The rate of return on a common stock that a stockholder expects to receive in the future
• Actual (Realized) Rate of Return


  The rate of return on a common stock actually received by stockholders in some past period; this may be greater than or less than expected rate of return and/or required rate of return
• Dividend yield


  The expected dividend divided by the current price of a share of stock
• Capital Gains Yield


  The capital gain during a given year divided by the beginning price
• Expected Total Return


  The sum of the expected dividend yield and the expected capital gains yield
• The value of a share of stock must be established as the present value of the stock's EXPECTED dividend stream
• Constant Growth (Gordon) Model


  Used to find the value of a constant growth stock
• A higher value for Dividend Yield


  Increases a stock's price
• A higher growth rate


  Also increases the stock's price
• Dividends are paid out of earnings

  Growth in dividends requires growth in earnings
• Earnings growth in the long run


  Occurs primarily because firms retain earnings and reinvest them in the business
• The higher the percentage of earnings retained


  The higher the growth rate
• Corporate valuation model


  A valuation model used as an alternative to the discounted dividend model to determine a firm's value, especially one with no history of dividends, or the value of a division of a larger firm; it first calculates the firm's free cash flows, then finds their present values to determine the firm's value
• The discounted dividend model


  Is useful for mature, stable companies; it is easier to use
• The corporate valuation model

  Is more flexible and better for use with companies that do not pay dividends or whose dividends would be especially hard to predict
• Free cash flows


  The amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows
• The traditional financial statements are designed primarily for use by creditors and tax collectors, not for managers and stock analysts
• Corporate decision makers and security analysts often modify accounting data to meet their needs
• Management is not completely free to use the available cash flow however it pleases
• The value of a company's operations depends on all the future expected free cash flows
• Free cash flow calculation

  1. EBIT (1-T) + Depreciation and amortization

  2. Less Capital Expenditures

  3. Change in Net Operating Working Capital
• Free cash flow


  The after-tax operating income minus the investments in working capital and fixed assets necessary to sustain the business
• Positive FCF


  The firm is generating more than enough cash to finance its current investments in fixed assets and working capital
• Negative FCF


  The company does not have sufficient internal funds to finance its investments in fixed assets and working capital, and that it will have to raise new money in the capital markets in order to pay for these investments
• Negative FCF is not always bad
• Exceptions to negative FCF being bad


  • Startup companies
  • Companies incurring significant current expenses to launch a new product line
  • High-growth companies with large investments in capital that cause low current free cash flow, but will increase future free cash flow
• Eventually, new investments must be profitable and contribute to free cash flow
• Many analysts regard FCF as being the single and most important number that can be developed from accounting statements, even more important than net income
• FCF


  Shows how much cash the firm can distribute to its investors