S TOCK (E QUITY ) V ALUATION

Common Stock vs. Preferred Stock

C OMMON S TOCK  Common stockholders are the owners of the firm.  In general, common shareholders are the only security holders given the right to vote.  They elect the firm’s board of directors, who in turn appoint the firm’s top management team.  Claim on Assets  In case of liquidation, common stockholders have residual claim on assets.  However, bankrupt firms rarely have enough assets to satisfy the claims of bondholders. 3

T HREE S TEP P ROCEDURE FOR V ALUING C OMMON S TOCK 1. Estimate the amount and timing of future cash flows the common stock is expected to provide. 2. Evaluate the riskiness of the future dividends, and determine the rate of return an investor might expect to receive from a comparable risky investment, which becomes the investor’s required rate of return. 3. Calculate the present value of the expected dividends by discounting them back to the present at the investor’s required rate of return. 4

B ASIC C ONCEPT OF THE S TOCK V ALUATION Example 10.1 Consider a situation in which we are valuing a share of common stock that we plan to hold for only one year. What will be the value of the stock today if it pays a dividend of $2.00, is expected to have a price of $75 and the investor’s required rate of return is 12%? 5 FIN3000, Liuren Wu

B ASIC C ONCEPT OF THE S TOCK V ALUATION Value of Common stock = Present Value of future cash flows = Present Value of (dividend + expected selling price) = ($2+$75) ÷ (1.12) 1 = $ FIN3000, Liuren Wu

B ASIC C ONCEPT OF THE S TOCK V ALUATION Example 10.2 Continue example What will be the value of common stock if you hold the stock for two years and sell it for $82? Assume the dividend payment is fixed at $2 per year. Value of Common stock = Present Value of future cash flows = Present Value of (dividends + expected selling price) = {($2) ÷ (1.12) 1 } + {($2+$82) ÷ (1.12) 2 } = $

Dividends are not expected to grow over time. Value of a zero growth stock: The expected rate of return: B ASIC C ONCEPT OF THE S TOCK V ALUATION (V ALUING STOCK WITH ZERO GROWTH )

B ASIC C ONCEPT OF THE S TOCK V ALUATION  Since stocks do not have a maturity period, we can consider the value of stock to be equal to the present value of future expected dividends over a certain period and an expected selling price.  Valuing common stocks using general discounted cash flow model is made difficult as analyst has to forecast each of the future dividends. This problem is greatly simplified if we assume that dividends grow at a fixed or constant rate. 9

T HE C ONSTANT D IVIDEND G ROWTH R ATE M ODEL If the firm’s cash dividend grow by a constant rate each year, then the common stock can be valued as follows: +…(forever) 10

T HE C ONSTANT D IVIDEND G ROWTH R ATE M ODEL  V cs = Value of a share of common stock  D 0 = Annual cash dividend in the year of valuation (paid already)  g = annual growth rate in the dividend  r cs = the common stockholder’s required rate of return 11

C HECKPOINT 1 Valuing Common Stock Consider the valuation of a share of common stock that paid a $2 dividend at the end of last year and is expected to pay a cash dividend every year from now to infinity. Each year, the dividends are expected to grow at a rate of 10%. Based on an assessment of the riskiness of the common stock, the investor’s required rate of return is 15%. What is the value of this common stock? 12

C HECKPOINT 1: S OLUTION 13

C HECKPOINT 2: C HECK Y OURSELF What is the value of a share of common stock that paid $6 dividend at the end of last year and is expected to pay a cash dividend every year from now to infinity, with that dividend growing at a rate of 5 percent per year, if the investor’s required rate of return is 12% on that stock? What will be the stock value if the growth rate is 10%? How about a dividend growth rate of 13%? Answers: 90;330;inf. 14

W HAT C AUSES S TOCK P RICES TO G O U P AND D OWN ?  Prior equation indicates that there are three variables that drive share value:  The most recent dividend (D 0 ): The more, the higher.  Expected rate of growth in future dividends (g): The higher, the higher.  Investor’s required rate of return (r cs ): The higher, the lower.  Since most recent dividend (D 0 ) has already been paid, it cannot be changed. Thus, variations in the other two variables, r cs and g, can lead to changes in stock prices. 15

D ETERMINANTS OF THE I NVESTOR ’ S R EQUIRED R ATE OF R ETURN  The investor’s required rate of return is determined by two key factors: 1. The level of interest rates in the economy; and 2. The risk of the firm’s stock.  determinants of investor required rate of return.  Or,  Expected rate of return= Dividend yield + Capital gain yield = (D1/P0) + ((P1-P0)/P0) 16

D ETERMINANTS OF G ROWTH R ATE OF F UTURE D IVIDENDS  Firm’s growth opportunities relate to:  The rate of return the firm expects to earn when they reinvest earnings (the return on equity, ROE), and  The proportion of firm’s earnings that they reinvest. This is known as the retention ratio, b, = 1- dividend payout ratio.  The growth rate can be formally expressed as follows:  g = the expected rate of growth of dividends  D 1 /E 1 = the dividend payout ratio  ROE = the return on equity earned when the firm reinvests a portion of its earning back into the firm. 17

18 N ONCONSTANT G ROWTH M ODEL Find the present value of the dividends during the period of non-constant growth. Find the price of the stock at the end of the non- constant growth period, at which point it has become a constant growth stock, and discount this price back to the present. Add these two components to find the stock’s present value. P 0 = PV of DIV during constant growth period + PV of DIV after the constant growth period to infinity

P REFERRED S TOCK  Dividend:  In general, size of preferred stock dividend is fixed, and it is either stated as a dollar amount or as a percentage of the preferred stock’s par value.  Unlike common stockholders, preferred stockholders receive the same fixed dividend regardless of how well the firm does.  Multiple Classes:  If a company chooses, it can issue more than one class of preferred stock, and each class can have different characteristics.  For example, Public Storage (PSA) has 16 different issues of preferred stock outstanding that vary in terms of dividend, convertibility, seniority. FIN3000, Liuren Wu 19

V ALUING P REFERRED S TOCK  Since preferred stockholders generally receive a fixed dividend and the stocks are perpetuities (non-maturing), it can be valued using the present value of perpetuity equation introduced in chapter 6. FIN3000, Liuren Wu 20

V ALUING P REFERRED S TOCK  Estimating the Market Yield:  The market yield on a share of preferred stock is typically estimated using the market prices of similar shares of preferred stock which can be observed in the financial market. We can use the following equation to solve for market yield. FIN3000, Liuren Wu 21

V ALUING P REFERRED S TOCK Example 10.3 What will be the yield on XYZ’s preferred stock if the company has promised annual dividend of $1.20 per share and each share is currently selling for $32.50? FIN3000, Liuren Wu 22

C HECKPOINT 2 Valuing Preferred Stock Consider Con Edison’s (ED) preferred stock issue, which pays an annual dividend of $5.00 per share, does not have a maturity date, and on which the market’s required yield or promised rate of return (rps) for similar shares of preferred stock is 6.02%. What is the value of the Con Edison preferred stock? FIN3000, Liuren Wu 23

C HECKPOINT 3: C HECK Y OURSELF What is the present value of a share of preferred stock that pays a dividend of $12 per share if the market’s yield on similar issues of preferred stock is 8%? FIN3000, Liuren Wu 24