Stock Valuation Models: Variable-Growth Model

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Stock Valuation Models:

Variable-Growth Model
The non-constant dividend growth or variablegrowth model assumes that the stock will pay dividends
that grow at one rate during one period, and at another
rate in another year or thereafter.
We will use a four-step procedure to estimate the value
of a share of stock assuming that a single shift in growth
rates occurs at the end of year N.
We will use g1 to represent the initial growth rate and g2
to represent the growth rate after the shift.

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Stock Valuation Models:


Variable-Growth Model (cont.)
Step 1. Find the value of the cash dividends at the end of
each year, Dt, during the initial growth period, years 1
though N.

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Stock Valuation Models:


Variable-Growth Model (cont.)
Step 2. Find the present value of the dividends expected
during the initial growth period.

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Stock Valuation Models:


Variable-Growth Model (cont.)
Step 3. Find the value of the stock at the end of the initial
growth period, PN = (DN+1)/(ks-g2), which is the present
value of all dividends expected from year N+1 to infinity,
assuming a constant dividend growth rate, g2.

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Stock Valuation Models:


Variable-Growth Model (cont.)
Step 4. Add the present value components found in
Steps 2 and 3 to find the value of the stock, P 0, given
in Equation 7.6.

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Stock Valuation Models:


Variable-Growth Model (cont.)
The most recent annual (2006) dividend payment of Warren
Industries, a rapidly growing boat manufacturer, was $1.50
per share. The firms financial manager expects that these
dividends will increase at a 10% annual rate, g1, over the
next three years. At the end of three years (the end of
2009), the firms mature is expected to result in a slowing of
the dividend growth rate to 5% per year, g2, for the
foreseeable future. The firms required return, ks, is 15%.
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Stock Valuation Models:


Variable-Growth Model (cont.)
Steps 1 and 2. See Table 7.3 below.

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Stock Valuation Models:


Variable-Growth Model (cont.)
Step 3. The value of the stock at the end of the initial
growth period (N = 2009) can be found by first calculating
DN+1 = D2010.
D2010 = D2009 X (1 + 0.05) = $2.00 X (1.05) = $2.10
By using D2010 = $2.10, a 15% required return, and a 5%
dividend growth rate, we can calculate the value of the
stock, P2009, at the end of 2009 as follows:
P2009 = D2010 / (ks-g2) = $2.10 / (.15 - .05) = $21.00
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Stock Valuation Models:


Variable-Growth Model (cont.)
Step 3 (continued). Finally, in Step 3, the share value of
$21 at the end of 2009 must be converted into a present
(end of 2006) value.
PVIFks,N X PN = PVIF15%,3 X P2009 = 0.658 X $21.00 = $13.82
Step 4. Adding the PV of the initial dividend stream
(found in Step 2) to the PV of the stock at the end of the
initial growth period (found in Step 3), we get:
P2006 = $4.14 + $13.82 = $17.96 per share
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Stock Valuation Models:


Variable-Growth Model (cont.)
This example can be summarized using the time line below:

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Stock Valuation Models:


Free Cash Flow Model
The free cash flow model is based on the
same premise as the dividend valuation models
except that we value the firms free cash flows
rather than dividends.

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Stock Valuation Models:


Free Cash Flow Model (cont.)
The free cash flow valuation model estimates
the value of the entire company and uses the
cost of capital as the discount rate.
As a result, the value of the firms debt and
preferred stock must be subtracted from the
value of the company to estimate the value
of equity.

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Stock Valuation Models:


Free Cash Flow Model (cont.)
Dewhurst Inc. wishes to value its stock using the free
cash flow model. To apply the model, the firms CFO
developed the data given in Table 7.4.

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Stock Valuation Models:


Free Cash Flow Model (cont.)
Step 1. Calculate the present value of the free cash flow
occurring from the end of 2012 to infinity, measured at
the beginning of 2012.

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Stock Valuation Models:


Free Cash Flow Model (cont.)
Step 2. Add the PV (in 2011) of the FCF for 2012 found in
Step 1 to the FCF for 2011 to get total FCF for 2011.
Total FCF2011 = $600,000 + $10,300,000 = $10,900,000
Step 3. Find the sum of the present values of the FCFs for
2007 through 2011 to determine, VC, and the market values
of debt, VD, and preferred stock, VP, given in Table 7.5 on the
following slide.
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Stock Valuation Models:


Free Cash Flow Model (cont.)

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Stock Valuation Models:


Free Cash Flow Model (cont.)
Step 4. Calculate the value of the common stock using
equation 7.8. Substituting the value of the entire
company, VC, calculated in Step 3, and the market value
of the debt, VD, and preferred stock, VP, yields the value
of the common stock, VS.
VS = $8,628,620 - $3,100,000 = $4,728,620
P0 = $4,728,628 / 300,000 shares = $15.16 per share
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Other Approaches to Stock Valuation:


Book Value
Book value per share is the amount per share
that would be received if all the firms assets
were sold for their exact book value and if the
proceeds remaining after paying all liabilities
were divided among common stockholders.
This method lacks sophistication and its
reliance on historical balance sheet data
ignores the firms earnings potential and lacks
any true relationship to the firms value in
the marketplace.
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Other Approaches to Stock Valuation:


Liquidation Value
Liquidation value per share is the actual amount
per share of common stock to be received if al of
the firms assets were sold for their market
values, liabilities were paid, and any remaining
funds were divided among common stockholders.
This measure is more realistic than book value
because it is based on current market values of
the firms assets.
However, it still fails to consider the earning power
of those assets.
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Other Approaches to Stock Valuation:


Price/Earnings (P/E) Multiples
Some stocks pay no dividendsusing P/E
ratios are one way to evaluate a stock under
these circumstances.
The model may be written as:
P0 = (EPSt+1) X (Industry Average P/E)
For example, Lamars expected EPS is
$2.60/share and the industry average P/E
multiple is 7, then P0 = $2.60 X 7 = $18.20/share.
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