Video Transcript: Stock Valuation

hello, welcome. We're going to discuss stock valuation. Facts about common  stock, it represents ownership stake into a company, right? So I buy shares of a  stock now I have a piece of the ownership of that company. It's an equity piece  into that company. Ownership implies control. Now I have voting rights. I can  vote on issues of a firm. Stockholders elect board of directors to represent them, to guide the company and to have their interest brought forward to upper  management. Directors elect management, CEO, CFO CIO, they put them in  place at the stockholders. Shareholders, at their vote right. They'll put them in  place. They'll vote them in right. And then the direct bill. So the shareholders are vote in the board of directors, and then the board of directors will speak for the  shareholders and elect the upper management. Management's goal, optimize  stock price by optimizing their output, efficiency and effectiveness, and whatever market or industry that they are competing in, intrinsic value and stock price.  Outside investors, corporate insiders and analysts use a variety of approaches  to estimate a stock's intrinsic value, or real value. In equilibrium, we assume that a stock's price equals its intrinsic value. So equilibrium in the market is when  supply meets demand, it will create an equilibrium price. Outsiders estimate  intrinsic value to help determine which stocks are attractive to buy or sell. Stocks with a price below intrinsic value are usually viewed as undervalued and which  could be an attractive buying opportunity. So determinants of intrinsic value and  stock prices at the top managerial actions, the actions of the CEO CFO and the  decisions they make and the outcomes the economic environment. Are we in  recession? Are we growing taxes? We have high taxes, low taxes? What is the  climate like there and the political climate? Are we having conservative political  climate, or are we having more liberal political climate? Those will all, in fact,  affect the market. True investor cash flows stem from these true risk, perceived  investor cash flows and perceived risk. So the intrinsic value is the true value,  whereas the perceived value is the market value of an equity so the market  equilibrium is when the intrinsic value of a stock price equals the market value of a stock price. So we can discuss the dividend discount model. The dividend  discount model is a value of a stock and its present value of the future dividends expected to be generated by the stock. So we can take the dividend, we can run it through the growth phase, and then we can come back and we can calculate  out the price of the stock. Now, constant growth stock, a stock whose dividends  are expected to grow forever at a constant rate. So we'll look out into perpetuity  and figure out, okay, it was our investment time horizon 10 years. So we can  look over a 10 year span, and we can expect to see the dividend grow. So the  dividend is our return from the company. They pay us out as a risk premium. So  if we have a $10 stock and they have a $3 dividend or a 3% dividend, we'll  receive $3 for every share of stock that we own when they issue the dividends,  typically Quarterly. We can know by performing the calculation in this model,  what the growth rate of that dividend will be, and we'll be able to see what we're 

going to receive some time out in the future, as far as dividend growth. Now, if g  if the growth rate is constant. Dividend discount formula converges to this  equation at the bottom. So you'll see at the top, dividend one equals the  dividend from the previous period times one plus the growth rate raised to the  period. So now we can see, if the growth is constant, you'll have d1 which is  dividend, or you'll say D zero times one plus the growth rate divided by the rate  of the market minus growth. This will give you dividend one, and then you can  take dividend one and divide it by the rate of return minus growth, and this will  give you the stock price that we're looking for. What happens if growth is greater than return? If growth is greater than return, the constant growth formula leads  to a negative stock price, which does not make sense. So if we are going to be  looking at stocks that we want to invest in, and if the rate of return is less than  growth, we will not buy that stock. The constant growth model can only be used  if the return is greater than growth, and growth is expected to be constant in  perpetuity or forever. Remember CAPM formula, the risk free rate of return plus  the market premium times beta. So we can run through this calculation again,  really simply. So let's say the risk free rate 7% right, plus market return, the  expected market return 12% minus the 7% risk free rate. And this security has a  1.2 beta, simple math order of operations, parentheses. First, multiply 1.2 add  the 7% 13% return on this particular security. So now we can predict out the  present value of the dividend stream simply by using your financial calculator, as we demonstrated in an earlier video, find the future value. Let's say for period  one, 2.12 the rate of return for your iy is 13 and your number of periods is three,  your future. So now you are solving for present value. Can see our present  value is here, 1.87 so forth for our dividend present values. So now we can see  that the return on the security, the expected return, 13% constant growth at 6%  what is the stock's intrinsic value? What's its real value? So we're going to use  the constant growth model approach. So now we can go back and see the stock price at period zero. We want to know what is the stock price going to be in year  one. Notice. We'll take the 212 dividend right? We're in period one. The 212  dividend first at zero, we can see that it was two. The dividend D zero was two.  So zero is two. The growth of the dividend is expected to be 6% this gives us  2.12 we want to find what the stock price is at period one with a dividend at 2.12 so now we're going to plug this in to the constant growth model. Our dividend,  remember, is 2.12 our expected return in the market is 13% and we're going to  subtract out the growth forecast. This will give us 2.12 minus point 07 which will  give us a $30.29 cent stock price based on the calculation of the dividend  growth. Now, why is this significant? The 30.29 price is our intrinsic value. This  is the real value based on real metrics, not just assumed market value based  on. A potential speculation from trading, right? This is the real intrinsic value on  the books, right? So now we want to look at the market value price. If the market value price is lower than this, if it's lower than 30.29 maybe it's 28 or 25 that may

present a buying opportunity, because the market will do its best to push prices  into equilibrium. Remember that market equilibrium is equal when stock price,  intrinsic stock price equals market stock price. So when this, when our price  gets up to 30.29 when the market value for the stock gets at the 30.29 then they will be in equilibrium. But until then, if it's under 30.29 it's a buying opportunity.  Now, if the price is above $30.29 it's a sell opportunity, right? Maybe it's  overvalued. So we want to always markets will always bring prices into  equilibrium. Now we want to find out a stock's dividend yield. What is this going  to return us? What is this going to yield us? For me being invested into the stock and risking my capital. What is the firm going to return to me? So we'll notice  that dividend one again was 212 right? Dividend one 212, 2.12 now we're going  to divide that by the price. 30 point. Two nine, which is going to give us a 7%  dividend yield. This company might be a little risky. 7% is kind of a high dividend  yield, so you'll see you'll get rewarded for taking on additional risk with a higher  rate of return. Now let's look at Capital Gains yield. Now for price one, notice we  have price zero already at 30.29 now we need to calculate price one, so we will  use period two, dividend yield or dividend price. So we'll use instead of the 2.12  like we did in period one, in period two, we'll use the 2.2472 seven, same  required return. Remember, growth is constant. This will calculate. So we will  take the 2.247 and divide that by point 07, and this will give us $32.10 so now  this is price zero. So now we have price 130, $2.10 minus $30.29 then we'll  divide that by $30.29 this will give us a capital gains yield of 6% remember,  capital gains is the appreciation on our stock price year over year. So we buy a  stock at $5 and we sell it at 10 we just made a $5 capital gain. So if the capital  gain is the appreciation on an asset price or the value of that asset going up, so  let's look at our total returns, so our dividend yield plus our capital gain yield. So  what was our dividend yield, 7% what was our capital gain yield, 6% so our total  return for investing in this stock will be 13% looks like we are doing just as good  as the market with our investment choice. Now our dividend yield is really high  7% but our total return is going to be 13 and the market is a 13% return. So why  are we going to accept or are we going to accept a return that is equal to the  market when our dividend yield is typically twice as high as it would be in the  market, usually three and a half percent is good for a. Low risk, solid company,  three and a half percent. So 7% is pretty high. So why would would we accept  the same return as the market for a higher risk stock is 13% my total return a  wise investment for the risk that I'm going to take as a financial manager. You  have to figure that out for yourself and make the right decision for your  shareholders.