STOCK VALUATION

Principles Used in This Chapter

y Money Has a Time Value y There is a Risk-Return Tradeoff y Cash Not Profits-is King y The Agency Problem
y Managers wont work for the owners unless it is in their

best interest.
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Security Valuation
y In general, the intrinsic value of an

asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

Differences Between Debt and Equity

y Debt
y Not an ownership interest y Creditors do not have voting

y Equity
y Ownership interest y Common stockholders vote for

rights y Interest is considered a cost of doing business and is tax deductible y Creditors have legal recourse if interest or principal payments are missed y Excess debt can lead to financial distress and bankruptcy

the board of directors and other issues y Dividends are not considered a cost of doing business and are not tax deductible y Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid y An all equity firm can not go bankrupt

Cash Flows for Stockholders

y If you buy a share of stock, you can receive cash in two

ways
y The company pays dividends y You sell your shares, either to another investor in the

market or back to the company y (you receive capital gain/loss)

y As with bonds, the price of the stock is the present value

of these expected cash flows

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Preferred Stock
A hybrid security
y Its like common stock - no fixed maturity.
y Technically, its part of equity capital.

y Its like debt - preferred dividends are fixed.

y Missing a preferred dividend does not

constitute default.

Preferred Stock Features

y Firms may have multiple classes of preferred, each

with different features.

y Priority of claim: lower than debt, higher than common

stock.
y Cumulative feature: all past unpaid preferred stock

dividends must be paid before any common stock dividends are declared.
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Preferred Stock Features-cont

y Protective provisions are common. y Convertibility: many preferred stocks are convertible

into common shares.

y Adjustable rate preferred stocks have dividends tied

to interest rates.
y Participation: some (very few) preferred stocks have

dividends tied to the firms earnings.

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Preferred Stock Features-cont

y PIK Preferred: Pay-in-kind preferred stocks pay

additional preferred shares to investors rather than cash dividends.

y Retirement: Most preferred stocks are callable, and

many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.

Preferred Stock Valuation

y A preferred stock can usually be

valued like a perpetuity:

Vps =

D kps
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Example
y If we know XYZs preferred stock is selling at

RM40, and the preferred dividend is RM4.125, the expected return is:

kps

D = Po

4.125 = = .1031 40
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y Suppose our required rate of return on

XYZs preferred is 9.5%. 4.125 .095

Vps =

RM43.42

Should we purchase XYZs preferred stocks?

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Common Stock
y Is a variable-income security.
y Dividends may be increased or decreased,

depending on earnings. y Represents equity or ownership. y Includes voting rights. y Limited liability: liability is limited to amount of owners investment. y Priority of claim: lower than debt and preferred.
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Common Stock Characteristics

y Claim on Income - a stockholder has a claim on the

firms residual income.

y Claim on Assets - a stockholder has a residual claim

on the firms assets in case of liquidation.

y Preemptive Rights - stockholders may share

proportionally in any new stock issues.

y Voting Rights - right to vote for the firms board of

directors.
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Common Stock Valuation

(Single Holding Period)
y You plan to purchase XYZ stock and hold it for only

ONE year. XYZ is expected to pay a RM2.50 dividend at the end of the year. The stock price is expected to be RM15 at that time. y If you require a 15% rate of return, how much would you pay for the stock now?

? 0

RM2.50 + RM15 1 year

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Common Stock Valuation

(Single Holding Period) Solution:

Vcs = (RM2.50/1.15) + (RM15/1.15) = RM2.17 = RM15.21 + RM13.04

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Common Stock Valuation

(Two Holding Period)
y Now what if you decide to hold the stock for two years? In

addition to the dividend in one year, you expect a dividend of RM3 in two years and a stock price of RM16 at the end of year 2. Now how much would you be willing to pay?

Vcs = RM2.50/(1.15) + RM3/(1.15)2 + RM16/(1.15)2 = RM2.17 = RM16.54

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+ RM2.27 + RM12.10

Common Stock Valuation

(Three Holding Period)
y What if you decide to hold the stock for three years? In

addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of RM4.00 at the end of year 3 and the stock price is expected to be RM17.50 in year 3. Now how much would you be willing to pay today?
VCS = RM2.50/(1.15) + RM3/(1.15)2 + (RM4 + RM17.50) / (1.15)3 = RM2.17 + RM2.27 + RM14.14 = RM18.58

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y You could continue to push back when you

would sell the stock

y You would find that the price of the stock is

really just the present value of all expected future dividends

y So, how can we estimate all future dividend

payments?
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The Growth Factor

y Growth is an expansion of a company as a result of

investment through : I. External Financing

y y

Borrowing money Issuing new shares

II. Internal Financing

y

Internal Funds ~(i.e reinvestment through retained earnings)

INTERNAL GROWTH (g) = ROE x r

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Common Stock Valuation

(Multiple Holding Period)
y Constant dividend y The firm will pay a constant dividend forever y This is like preferred stock The price is computed using the perpetuity formula y Constant dividend growth y The firm will increase the dividend by a constant percent every period y Supernormal growth y Dividend growth is not consistent initially, but settles down to constant growth eventually
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Constant Dividend
(Zero Growth)
y Assume that dividends will remain at the same level

forever

Div 1 ! Div 2 ! Div 3 ! .

y Since future cash flows are constant, the value of a zero

growth stock is the present value of a perpetuity:

Div 1 Div 2 Div 3 VCS !   . 1 2 3 (1  kcs ) (1  kcs ) (1  kcs) Div VCS ! kcs
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Zero Growth
y If dividends are expected at regular intervals forever, then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formula
y

P0 = D / kcs

y Suppose stock is expected to pay a RM0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

P0 = RM0.50 / 0.025= RM20

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Constant Growth
(Dividend Growth Model)
Assume that dividends will grow at a constant rate, g, forever, i.e.,

Div 1 ! Div 0 (1  g )

Div 2 ! Div 1 (1  g ) ! Div 0 (1  g )

Div 3 ! Div 2 (1  g ) ! Div 0 (1  g )

2 3

. . . Dividends are expected to grow at a constant percent per period.

Vcs = D1 /(1+kcs) + D2 /(1+kcs)2 + D3 /(1+kcs)3 + Vcs= D0(1+g)/(1+kcs) + D0(1+g)2/(1+kcs)2 + D0(1+g)3/(1+kcs)3 +
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Constant Growth
(Dividend Growth Model)
Assumes common stock dividends will grow at a constant rate into the future.

D1 Vcs ! kcs  g

D0 (1  g ) Vcs ! kcs  g
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Constant Growth
(Dividend Growth Model)
y Assumes common stock dividends will grow at a

constant rate into the future.

y D1 = the dividend at the end of period 1. y kcs = the required return on the common stock. y g = the constant, annual dividend growth rate.
y provided kcs > g

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Constant Growth
(Dividend Growth Model)
Example 1:
y XYZ stock recently paid a RM5.00 dividend. The

dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Vcs =

D0(1+g) kcs - g

5(1.10)

.15 - .10

RM110
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Constant Growth
(Dividend Growth Model)
Example 2: y Suppose ABC is expected to pay a RM2 dividend in one year. If the dividend is expected to grow at 5% per year and the market required return is 20%, what is the price?

y P0 = 2 / (.2 - .05) = RM13.33

**Notice that the RM2 in the numerator is already an expected dividend (i.e. D1),
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Stock Price Sensitivity to Dividend Growth, g

As the growth rate approaches the required return, the stock price increases dramatically.
250

D1 = RM2; kcs = 20%

200 Stock Price 150 100 50 0 0 0.05 0.1 Growth Rate
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0.15

0.2

Stock Price Sensitivity to Required Return, kcs

As the required return approaches the growth rate, the price increases dramatically.
250

D1 = RM2; g = 5%
200 Stock Price 150 100 50 0 0 0.05 0.1 0.15 Growth Rate
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0.2

0.25

0.3

Nonconstant Growth
(Supernormal growth)
Example:
y Suppose a firm is expected to increase dividends by 20%

in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was RM1 and the required return is 20%, what is the price of the stock?
y Remember that we have to find the PV of all expected

future dividends!!!

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Nonconstant Growth Example Solution

y Compute the dividends until growth levels off y D1 = 1(1.2) = RM1.20 y D2 = 1.20(1.15) = RM1.38 y D3 = 1.38(1.05) = RM1.449 y Find the expected future price y P2 = D3 / (kcs g) = 1.449 / (.2 - .05) = RM9.66 y Find the present value of the expected future cash flows y P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = RM8.67
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Expected Return on Common Stock

Just adjust the valuation model!

D Vcs = kcs - g

k =

D1 Po

+ g
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Example 1:
y If you purchase a stock that will pay a RM3.00 dividend at

time 1, at a price of RM27 and an expected growth rate of 5%. How much is your expected return on this stock?

kcs =
kcs

D1 Po

) + g

=(

3.00 27

+ .05 = 16.11%
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Example 2:
y If you purchase a stock that paid a RM3.00 dividend

recently, at a price of RM27 and an expected growth rate of 5%. How much is your expected return on this stock?

kcs =
kcs = ( 27

D1 Po

) + g
+ .05 = 16.67%
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3.00 (1.05)

Example 3:
y If you purchase a stock that will pay a fixed dividend of

RM3.00 (i.e. growth =0), at a price of RM27. How much is your expected return on this stock?

kcs =
kcs = 3.00 27

D1 Po
= 11.11%
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