Dear mrsifter,
The analyst will develop a financial model extending out multiple
years into the future to determine the firm's present value. In
particular, the analyst seeks to identify the firm's long-term growth
rate, market capitalization rate, and future free cash flows. The
company's price per share is equal to the firm's discounted stream of
free cash flow per share, where free cash flow equals revenue minus
costs minus investment. This free cash flow matches the amount
available for future dividends. Each annual free cash flow amount is
discounted by the market capitalization rate, which is the annual rate
of return that is expected by investors. The rate of return is
strongly influenced by investors' perception of the riskiness of the
stock. Higher rates of return decrease the present value of distant
expected future dividends, which adjusts the stock's valuation for the
perceived risk. The firm's long-term growth rate is used to identify
the rate at which free cash flow per year will grow on annual basis.
In the case of two firms with all factors being identical except for
when free cash flow turns positive, the firm achieving profitability
first will be more valuable.
In formula terms, Po (present value of a share) = Sigma (t = 1 to
infinity) (Free cash flow per share)t/(1 +r)^t
"Some companies have such extensive growth opportunities that they
prefer to pay no dividends for long periods of time. Up to the time
when this chapter was written, Digital Equipment Corp. (DEC) had never
paid dividends, because any cash paid out to investors would have
meant either slower growth or raising capital by some other means.
Investors were evidently happy with management's decision to reinvest
earnings. How else can explain DEC's $15 billion market value in
1989?
Investors are willing to forego cash dividends in exchange for higher
earnings in the expectation of high dividends sometime in the future.
Thus DEC's common stock is not really a counterexample to the
statement that stock price equals the present value of expected future
dividends. DEC's dividends may continue to be zero for many years,
but they are likely to be positive sooner or later. Eventually growth
must slow down, releasing funds that can be paid to the stockholders.
It is that prospect which makes DEC shares valuable today."
Source: "Principles of Corporate Finance" Fourth Edition by Brealey &
Myers, McGraw-Hill Inc., 1991, page 60
For more information on valuing stocks and bonds, I encourage you to
consult Chapter 4, pages 47-67 of the above reference.
I hope the above information is helpful to you.
Sincerely,
Wonko |
