Chapter 5

Valuing Stocks

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Topics Covered

Preferred Stock and Common Stock Properties Valuing Preferred Stocks Valuing Common Stocks - the Dividend Discount

Model No growth Constant growth Variable growth

Valuing the Enterprise (the Firm) – Free Cash Flow Approach

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Debt vs. Equity: Debt

Debt securities represent a legally enforceable claim.

Debt securities offer fixed or floating cash flows.

Bondholders don’t have any control over how the company is run.

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Debt vs. Equity: Equity

Debt and equity have substantially different marginal benefits and marginal costs.

Common stockholders are residual claimants.

• No claim to earnings or assets until all senior claims are paid in full

• High risk, but historically also high return

Stockholders have voting rights on important company decisions.

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Rights of Common Stockholders

Common stockholders’ voting rights can be exercised in person or by proxy.

Most US corporations have majority voting, with one vote attached to each common

share. Cumulative voting gives minority

shareholders greater chance of electing one or more directors.

Shareholders have no legal rights to receive dividends.

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Preferred Stock Characteristics

Unlike common stock, no ownership interest Second to debt holders on claim on company’s

assets in the event of bankruptcy. Annual dividend yield as a percentage of par

value Preferred dividends must be paid before

common dividends If cumulative preferred, all missed past dividends

must be paid before common dividends can be paid.

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Preferred Stock Valuation

Promises to pay the same dividend year after year forever, never matures.

A perpetuity. PS0 = DP/rP

Expected Return: r = DP/PS0 Example: GM preferred stock has a $25 par

value with a 8% dividend yield. What price would you pay if your required return is 7%?

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The Financial Pages: Common & Preferred Stocks

Yld VolSym Div % PE 100s CloseGM 1.00 4.6 n/a 111187 21.41GM pfG 2.28 9.5 … 86 24.00 For GM pfG (preferred stock) Dividend: $2.28 on $25 par value = 9.12%

dividend rate. Yld% = Expected return: 2.28 / 24.00 = 9.5%.

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What do investors in common stock want?Periodic cash flows: dividends, and…To sell the stock in the future at a higher

priceManagement to maximize their wealth

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Valuing Common Stocks: Expected Return

Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR).

Expected Return r Div P PP

1 1 0

0

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Expected Return

The formula can be broken into two parts.

Dividend Yield + Capital Gains Yield

Expected Return r Div

PP PP

1

0

1 0

0

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Example

Lisa Simpson buys Grease Gougers stock for $25 per share. In a year she expects the receive $1 in dividends and the price of the stock to be $28.

What is Lisa’s expected return?

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Stock Valuation

Stock Value = PV of Future Expected Dividends

rD

rD

rD

rDP

1. . .

111 33

22

11

0

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Stock Valuation: Dividend Patterns

For Valuation: we will assume stocks fall into one of the following dividend growth patterns. Constant growth rate in dividends Zero growth rate in dividends, like preferred

stock Variable (non-constant) growth rate in dividends

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Stock Valuation Case Study: Doh! Doughnuts We have found the following information for Doh!

Doughnuts: current dividend = $2.00 = Div0

Required return = 14% = r

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Analysts Estimates for Doh! Doughnuts

NEDFlanders predicts a constant annual growth rate in dividends and earnings of zero percent (0%)

Barton Kruston Simpson predicts a constant annual growth rate in dividends and earnings of 8 percent (8%).

Homer Co. expects a dramatic growth phase of 20% annually for each of the next 3 years followed by a constant 8% growth rate in year 4 and beyond.

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Our Task: Valuation Estimates

What should be each analyst’s estimated value of Doh! Doughnuts?

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Valuing Common Stocks: No Growth

If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

Perpetuity P Divror EPS

r 0

1 1

Assumes all earnings are paid to shareholders.

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Ned Flanders’ Valuation

Div0 = $2.00, r = 14% or 0.14, g = 0%

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Constant Growth Valuation Model Assumes dividends will grow at a constant rate

(g) that is less than the required return (r) If dividends grow at a constant rate forever, you

can value stock as a growing perpetuity, denoting next year’s dividend as D1:

Commonly called the Gordon growth model

grgrg DDP -

=-

)+1(= 10

0

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Barton Kruston Simpson’s Valuation

Div0 = $2.00, g = 8%, r = 14%

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Expected Return of Constant Growth StocksExpected Rate of Return = Expected

Dividend Yield + Expected Capital Gains Yield

Div1/P0 = Expected Dividend Yieldg = Expected Capital Gains Yieldr = Div1/P0 + g = Div0(1+g)/P0 + g

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Example

Burns International’s stock sells for $80 and their expected dividend is $4. The market expects a return of 14%.

What constant growth rate is the market expecting for Burns International?

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Homer Co. Valuation

Variable (non-constant) growthYears 1-3 expect 20% growthAfter year 3: constant growth of 8%

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Variable Growth Stock Valuation

Framework: Assume Stock has period of non-constant growth in dividends and earnings and then eventually settles into a normal constant growth pattern (gn).

0 g1 1 g2 2 g3 3 gn 4 gn 5 gn ...

D1 D2 D3

Non-constant Growth Period Constant Growth

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Variable Growth Valuation Process

3 Step Process Estimate Dividends during non-constant growth

period. Estimate Price, which is the PV of the constant

growth dividends, at the end of non-constant growth period which is also the beginning of the constant growth period.

Find the PV of non-constant dividends and constant growth price. The total of these PVs = Today’s estimated stock value.

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Back to Homer Co’s Valuation: Step 1

D0 = $2.00, g = 20% or 0.2 for next 3 years

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Homer Co’s Valuation: Step 2

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Homer Co’s Valuation: Step 3