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Chapter 8 Stock Valuation
Overview Preferred Stock Characteristics and
Valuation Common Stock Characteristics Common Stock as a Financing Tool Common Stock Valuation
Dividend Discount Model
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.
Preferred Stock Valuation Promises to pay the same dividend year
after year forever, never matures. A perpetuity. Vps = D/kps Example: GM preferred stock has a $25
par value with a 8% dividend yield. What price would you pay if your required return is 9%?
D = $25(0.08) = $2 Vps = $2/0.09 = $22.22
Expected Rate of Return on Preferred
Just adjust the valuation model:
D
Po
kps =
Example
If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:
Example
If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:
D
Po
kps = = = 4.125
40
Example
If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:
D
Po
kps = = = .10314.125
40
The Financial Pages:Preferred Stocks
52 weeks Yld VolHi Lo Sym Div % PE 100s Close2788 2506 GM pfG 2.28 8.9 … 86 25 53
Dividend: $2.28 on $25 par value = 9.12% dividend rate.
Expected return: 2.28 / 25.53 = 8.9%.
Facts about Common Stock: Claim on Income after interest and dividend
payments to creditors and preferred stockholders.
Represents ownership. Ownership implies control. Limited liability. Stockholders elect directors. = Voting
Rights Directors elect management. Management’s goal: Maximize stock price.
Advantages of Financing with Stock: No required fixed payments. No maturity. Improves debt ratio, coverage.
Disadvantages of Financing with Stock: Controlling shareholders may lose some
ownership control. Preemptive Right
Future earnings shared with new stockholders. Possible EPS Dilution.
Higher flotation costs vs. debt. Higher component cost of capital. Too little debt may encourage a takeover
bid.
Common Stock Valuation(Single Holding Period)
You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time.
If you require a 15% rate of return, what would you pay for the stock now?
Common Stock Valuation(Single Holding Period)
You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time.
If you require a 15% rate of return, what would you pay for the stock now?
0 1
? 5.50 + 120
Common Stock Valuation(Single Holding Period)
Solution:
Vcs = (5.50/1.15) + (120/1.15) = 4.783 + 104.348 = $109.13
Common Stock Valuation(Single Holding Period)
Financial Calculator solution:P/Y =1, I = 15, n=1, FV= 125.50CPT PV = -109.13or:P/Y =1, I = 15, n=1, FV= 120, PMT = 5.50CPT PV = -109.13
The Financial Pages:Common Stocks
52 weeks Yld Vol NetHi Lo Sym Div % PE 100s Close Chg126 87 IBM .56 0.6 23 77995 98.12 +0.29
63 42 WalMart .28 0.5 47 119515 62.01 -0.24
IBMs Dividend Yield = $0.56/$98.12 = 0.6% PE Ratio = Close Price/Earnings Per
Share(EPS) IBMs Latest EPS = Close/PE = $98.12/23 =
$4.27
Stock Valuation
Multiple Holding PeriodsStock Value = PV of Future
Expected Dividends
cscscscs
csk
D
k
D
k
D
k
DV
1. . .
111 33
22
11
Stock Valuation: Dividend PatternsFor 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 “Supernormal” (non-constant) growth
rate in dividends(see Chapter 8 notes in Syllabus book)
Doh! Doughnuts Stock Valuation Example: Basic Information We have found the following
information for Doh! Doughnuts: current dividend = $2, beta of 0.9 T-bill (risk-free) rate = 1.75% the market risk premium is 9.5%
Using the SML equation to find Doh!’s required return = krf +(krp)b =
1.75% +(9.5%)0.9 = 10.3% = kcs
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%).
Moe Homer Simpson & Bernard expect 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.
Our Task: Valuation Estimates What should be each analyst’s
estimated value of Doh! Doughnuts?
First Analyst: Zero Growth Stock Valuation No growth in dividends, so Doh!
Doughnuts will remain at the current dividend of $2 forever.
Estimated Value (Vcs)= PV(perpetuity) = D0/kcs
Doh! Kcs = 10.3% NEDFlanders Estimate P0 = $2/.103
= $19.42
Constant Growth Stock Valuation Model Dividends are expected to grow at
an annual constant rate, g, forever. D1 = D0(1+g) Dt = D0(1+g)t
Vcs = D0(1+g) = D1
kcs – g kcs – ggg
g
kD
kDV
cscscs -
=-
)+1(= 10
Constant Growth Stock Valuation Model Terms D0 = today’s (or current) dividend D1 = expected dividend at the end
of this year(year 1) kcs = stock’s required rate of return g = the constant growth rate in
dividends
2nd Analyst: Constant Growth in Dividends Current Dividend = $2 Projected Constant Growth Rate = 8%
or 0.08 Kcs = 10.3%
What happens if g > kcs?
.kcs requires 1 ggkcs
DVcs
If kcs< g, get negative stock price, which is nonsense.
We can’t use model unless (1) kcs> g and (2) g is expected to be constant forever.
Doh! A good buy? Assume Doh! Doughnuts current stock
price is $100. Required return = 1.75% + 9.5%(0.9) =
10.3% Let’s assume the 2nd analyst is correct
and Doh! Has a constant growth rate of 8% and its current dividend is $2.
What is the stock’s expected return? Is Doh! Doughnuts’ current stock price
in equilibrium?
Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield +
Expected Capital Gains Yield D1/P0 = D0(1+g)/P0 = Expected Dividend Yield g = Expected Capital Gains Yield From our example, D1=$2(1.08) = 2.16, P0=$100, g =
8% or 0.08
%16.10%8%16.2%8100$
16.2$
0
1^
gP
Dcsk
DOH! Doh! Doughnuts
Stock Market Equilibrium
The stock price when the stock’s expected return = stock’s required return (CAPM)
D1/P0 + g = krf +(km - krf)b
Expected Return = Required Return
The Effect On the Stock Price
Expected Return needs to rise to the required return of 10.3%. This means the stock price must fall to the the equilibrium price which yields the required return of 10.3%
New Price = D1/(kcs- g)=$2.16/(.103 - .08)= $93.91 At the current price of $100, Doh! has NPV of
$93.91 - $100 = -$6.09
Return
Beta
SML
0.9
1.75
“Supernormal” 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(gc).
0 g1 1 g2 2 g3 3 gc 4 gc 5 gc…
D1 D2 D3
“Supernormal” Growth Period Constant Growth
Supernormal Growth Valuation Process
3 Step Process Estimate Dividends during “supernormal”
growth period. Estimate Price, which is the PV of the
constant growth dividends, at the end of “supernormal” growth period which is also the beginning of the constant growth period.
Find the PV of “supernormal” dividends and constant growth price. The total of these PVs = Today’s estimated stock value.
3rd Analyst:“Supernormal” Growth Stock Valuation for Doh!
“supernormal” growth rate g for years 1-3 = 20% or 0.2
After year 3, Doh! Has constant growth rate gc = 8% or 0.08
D0 = $2.00 kcs = 10.3% or .103
Finally, the Answer!0 g = 20%g = 20% 1 g = 20%g = 20% 2 g = 20% g = 20% 3 ggcc = 8% = 8%
$2.40 $2.88 $3.46PV= P0 $162.28 = P3
10.3%,1 $165.74 2.17 10.3%,2 2.37 10.3%,3123.51128.05 = $128.05 $128.05 = P0
PP00 = $2.40(PVIF = $2.40(PVIF10.3%,110.3%,1)+$2.88(PVIF)+$2.88(PVIF10.3%,210.3%,2)+$3.46(PVIF)+$3.46(PVIF10.3%,310.3%,3))
+ $162.28(PVIF+ $162.28(PVIF10.3%,310.3%,3) = $128.05) = $128.05
Fin’l CalculatorSolution:CF0=0,C01= 2.40C02 = 2.88C03 = 165.74I = 10.3NPV=128.05 NPV=128.05 = P= P00
Summary of Doh! Doughnuts Stock Price Estimates NEDFlanders: 0% constant growth:
P0 = $19.42 Barton Kruston Simpson: 8%
constant growth: P0 = $93.91 Moe Homer Simpson & Bernard:
20%, 3-year supernormal growth followed by 8% constant growth: P0 = $128.05
Other Valuation Approaches Our dividend discount models are best for
established dividend paying companies, which makes it difficult to apply to non-dividend paying start-up companies.
PE Multiple Approach: Forecast a company’s earnings per share and multiply this forecast times the company’s PE ratio.
Value entire firm by finding PV of future expected Free Cash Flows available to stockholders, then divide by number of shares. (Chapter 13)