MGT3030 Fall 1999, Mar

el Rindisba her: Le ture 5 1

University of Toronto
Rotman S hool of Management
MGT337: Business Finan e
Mar el Rindisba her
LECTURE 5

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 2

Obje tives of Le ture 5

In the previous le ture have introdu ed the basi valuation
on epts for bonds. In this le ture we will extend these te hniques
to the valuation of sto ks.
 Chara terization of sto ks (equity).
 Valuation of preferred sto ks.
 Valuation of ommon sto ks:
{ Dividends and sto k valuation
{ Dividend growth model
{ Earning per share and ommon sto k valuation
{ Pri e earnings ratio
{ NPV of growth opportunities (NPVGO).
MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 3

Chara teristi of Preferred Sto ks

From legal standpoint, preferred sto ks are equity but from
pra ti al standpoint, preferred sto ks are \ ombination of sto k
and debt"
Chara teristi s:
 dividend payments:
{ xed in advan e (like \ oupons" of bonds.
{ take preferen e over payment of ommon sto ks
{ omission of dividend payment does not onstitute event of
default (not as interest payments of bonds)
 fa e value or par value: dividend stated in per entage of par.
 umulative provision: unpaid dividends arried forward.
Until obligation leared no dividends on ommon sto ks.

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 4

 Claim on in ome and assets: priority over ommon sto k

and after reditors' laims.
 rights of preferred sto kholders: ovenants to preserve
priority of laims and ontrol over sale of new se urities.
{ voting rights: ele t one third of the members of the board of
dire tors only after rm has skipped several preferred dividend
payments.
{ onvertibility: onvertible into ommon sto ks. (unexpe ted
appre iation of ommon sto k).
 retirement of preferred sto k: all provision (buy ba k) or
sinking fund (set aside money to retire ertain number of
preferred sto ks) like bonds.
 Tax status: dierent treatment than bonds (see long term
nan ing le ture).
MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 5

Valuation of Preferred Sto ks

Equivalent to bond pri ing formula:

Vn =
X
n+m
P Dk
+
Vn+m
k=n
(1 + rp )k n (1 + rp )m
 Vk : value of preferred sto k in period k .
 P Dk : expe ted preferred dividend in period k.
 r p : requireed rate of return on preferred sto k.
 m maturity of preferred sto k.

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 6

Chara teristi s of Common Sto ks

Common shareholders are owner of orporation: proportional share
of residual after laims of debtholders and preferred sto kholders
have been fully met.
sto kholders rights:
 laim on in ome: residual in ome after reditors and
preferred sto k holders have been paid..
 laim on assets: ommon equity ushion against possible
losses in liquidation for the other laimants of the rm.
(\riskiness" of sto ks).
 voting rights:appointmens to the board of dire tors who then
sele ts management.
 preemptive right: right to pur hase new ommon sto ks in
same proportion as urrent ownership.
MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 7

Valuation of Common Sto ks

The urrent pri e per share will depend on the future ash ows
expe ted to a rue to share holders. This ash ows are obtained in
form of dividends and the pri e you obtain when you liquidate the
sto k.
Diu ulty: Future dividend payments and future pri es are
unknown ) risk involved in investment. General prini ple: sin e
investors are risk averse they must be ompensated with a risk
premium to be willing to bear the risk.
Value of ommon sto k

DIVn+1 P
Pn = + n+1e
1 + rn
e 1 + rn

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 8

Equivalently required rate of return on equity or ost of

equity apital is
DIVn + Pn+1 Pn
rne =
Pn

Remark: Either spe ify ost of equity apital or future pri e of

sto k.
MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 9

Multiple Periods
Uf we want to answer what is next years pri e we have to do same
thing and so on

Pn =
X
n+m
DIVk
+
Pn+m
k=n
(1 + re )(k n) (1 + re )m

Remark: Formula as for preferred sto k.

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 10

Constant Dividend Growth

We already know that if we assume onstant dividend growth at
rate g and onstant apital osts re we an write theat
DIVn+k = DIVn (1 + g )k

using this we get for innite horizon that

DIVn
Pn =
re g

it follows in this ase that ost of apital

DIVn
re = +g
Pn
MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 11

Warning:
Formula is based on strong assumptions. There is a lot of
un ertainty about growth rate g . The un ertainty is about the
return on retained earnings
Have that

Retained earnings per period

g=
earning per period
 Return on retained earnings

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 12

Earning per Share (EPS)

Future dividends paid must depend on the future ash ows of the
rm. Se urity analysts spend a lot of time looking at earnings for
sto k valuation not ash ows ) Why ?
 earnins bulk part of ash ows.
 dividend growth an not ex eed the rate at whi h earning per
share grow.
 ash ows diÆ ult to measure for publi .
Warning: reported earnings depend mu h on degree of
onservatism used in a ounting. Changes in a ounting rules
should not ae t value of sto k.
MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 13

Value of Growth Opportunities

If a ompany pays all its earning per share EP S as dividends we
must have that
E
Pn =
re
But if the ompany has growth opportunities we have to add
the NPV of these growth opportunities
EP S
Pn = + N P V GO
re
where NPVGO is given as the PV of net ash ows generated by
the growth opportunity N P V GO = CFGO
re .

MGT3030 Fall 1999, Mar el Rindisba her: Le ture 5 14

Pri e - Earnings Ratio

We have found that
EP S
Pn = + N P V GO
re

su h that if we divide by the earnings per period we obtain

Pn 1 NPVGO
P=En  EP S
= e+
r E

Information ontained in pri e - earnings ratio

 high NPVGO/EPS ) P/E high.
 high apital osts (high risk premium) ) P/E low
 onservative a ounting rules ) P/E high