Posted by Prem on Monday, May 09, 2011 | Tags : Equity Valuation
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Suppose that a company is investing $500 million dollars in a new project and the present value of the after tax future cash flow is $1000 million. The company has 200 million of outstanding shares with a market price of $50 per share. The stock price will react to this new information of the investment in capital project. However, the question is how much the stock price will increase or decrease, irrespective of other expectations about the company, and how to calculate the impact?
The impact of new investment on stock price can be calculated by adding the net present value (NPV) to the market value of the company before the investment. The NPV of the capital project is $1000 million - $500 million = $500 million
The market value of the company before investment is $50 * 200 million outstanding shares which is equal to $10,000 million. The value of the company should increase by $500 million to 10500 million after the investment. So the price per share should increase by the NPV per share or $500 / 200 million outstanding shares = $2.5 per share. The share price should increase from $50 per share to $52.5 per share.
Sometimes, the share price can increase far more than the calculated price, keeping rest of the expectations about the company constant. This might happen due to the linkage of other profitable projects with it. Market might expect other new projects underway and the share price might go up well in advance.
If the investment done by the company on capital project results in positive NPV, these should impact the share price also positively and create wealth for the shareholders on longer period of time. In board sense, the value of a company is the value of its existing investments and the NPV of its future investments.
Many times, even if the capital investment turns to be a positive NPV for the company, the market may not react positively to the stock price. The profitability of the project might not be as expected by the market, which leads to down fall in the stock price. So the investor should also check the profitability of the project alone with the positive NPV.