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STREETSMART GUIDE TO VALUING A STOCK
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present value of Mary s 360 mortgage payments of $734 (discounted now @ 9 percent) decreases to only $91,223. Mary s 8 percent mortgage is now worth only $91,223. A new mortgage by the bank would have monthly payments increased to $805 (a monthly payment difference of $71) so that its present value, discounted at 9 percent, would equal $100,000. 2. If interest rates fall, the bank must decrease its lending rates in order to compete for new loans. Due to the declining interest rates, the bank s cost of deposits also drops. For example, if interest rates fall 1 percent, the present value of Mary s 360 mortgage payments of $734 (discounted now @ 7 percent) increases to $110,326. A new mortgage by the bank would have monthly payments decreased to $665 (a payment difference of $69) so that their present value, discounted at 7 percent, equals $100,000.
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A Simple Stock: A DCF Example Valuation
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The basic valuation calculation for a stock is the same as that used by the bank in making a fixed-rate mortgage loan, with an important exception. A mortgage has cash flows (the monthly payments) that are known with certainty. The range of future cash flows for a stock can be enormous. Let s use the DCF approach to value a stock. We ll use a simple example. Assume that ABC Utility Company produces and distributes electric power to an urban rustbelt area that has no growth potential, and little competition. ABC has had revenue of $1 billion per year and profits and cash flows after taxes of $200 million per year for the last 20 years. ABC expects revenue and profits to remain exactly the same for the next 20 years. Further, the company pays out the entire $200 million per year in profits to its shareholders in the form of dividends. Also assume that ABC is financed solely with common stock, and that the yield required by common stockholders is 10 percent. What dollar amount of stock market equity can ABC s underlying business and operations support in today s market environment Our assumptions make this is an easy exercise. To calculate ABC s market equity, we capitalize (which means to divide an amount by a number between zero and one) ABC s expected annual profits at the
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yield required by the market. If ABC s profits are $200 million, its cost of capital is 10 percent, and there are no expectations of growth, the market capitalization that the operations can support is: [$200 million/(.10)] $2 billion. That $2 billion equity can be divided in many ways: 2 billion shares @ $1 per share; or 200 million shares @ $10 per share; or 20 million shares @ $100 per share; or 2 million shares @ $1000 per share you get the idea. This price/share trade-off is similar to what happens when a stock splits (for example, the company issues two shares for every share that a shareholder owns a two-for-one split). It s easy to change the number of shares and per-share intrinsic value, but the aggregate enterprise value should always equal $2 billion the amount of market equity that ABC s profits of $200 million per year capitalized at 10 percent can support. What if the unexpected happens on the upside, and as a result of growth in revenue or lower costs, ABC s profits and dividends increase by 50 percent to $300 million per year and are expected to stay at that amount for the next 20 years The $300 million per year in profits and dividends, capitalized at a 10-percent yield, supports: [$300 million/(.10)] $3 billion in market equity an increase of 50 percent. Likewise, shareholders should experience an increase in their stock price of 50 percent from $1 to $1.50 per share, or $10 to $15 per share, or $100 to $150 per share depending on how many shares the company has outstanding. What about the downside What if a competitor enters the market or a new technology makes the pricing of ABC s power too expensive and reduces ABC s profits and dividends by 90 percent to $20 million per year, where it s expected to stay for the next 20 years. The $20 million in profits and dividends, capitalized at a 10 percent yield, supports: [$20 million/(.10)] $200 million in market equity a decrease of 90 percent from its $2 billion level. Shareholders also should experience a decrease in their stock price of 90 percent from $1 to 10 cents per share, or $10 to $1 per share, or $100 to $10 per share. Sound like what s recently happened to high-tech stocks If profits and dividends go to zero and are expected to stay there for the next hundred years, the stock price should be zero (0), no matter how many shares are outstanding. Table 3-1 shows the direct relationship of a company s growth in earnings and market equity.
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