1 Chapter 9: Valuation of Common Stocks Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objective Explain equity evaluation using discounting Dividend policy and wealth

2 Chapter 9 Contents 1. Reading stock listings 2. The discounted dividend model 3. Earning and investment opportunity 4. A reconsideration of the price multiple approach 5. Does dividend policy affect shareholder wealth ?

3 Reading Stock Listings

4  Dividend yield: the annualized dollar dividend divided by the stock’s price  Price/earnings ratio: the ratio of the current stock price to earnings during the most recent four quarters  Round lots of 100 shares  Odd lots requires higher commissions

5 Discounted Dividend Model  Computes the value of a share of stock as the present value of its expected future cash dividends.  Any investor in common stock expects a return consisting of cash dividends and the change in price.  Risk adjusted discount rate: the expected rate of return that investors require in order to be willing to invest in the stock.

6 DDM Model  Thus

7 DDM Model

8 The Constant-Growth-Rate DDM When the dividends grow at a constant rate g:

9 The Constant-Growth-Rate DDM Stock price is expected to grow at the same rate as dividends:

10 Future Dividends and Price YearPrice start of Year Expected Dividend Exp. Dividend Yield Exp. Rate of Price Increase 1$100$5.005%10% 2$110$5.505%10% 3$121$6.055%10%

11 Earning and Investment Opportunities  To simplify the analysis, suppose that no new shares are issued, and no taxes Dividends = Earnings - Net New Investment “D = E - I”. The formula for valuing stock is

12 Earning and Investment Opportunities Partition the firm value into two parts: 1. The present value of the current level of earnings as a perpetuity 2. The net present value of any future investment opportunities

13 Earning and Investment Opportunities  Example: Nogrowth Corporation  Earnings per share: $15  Net investment: zero  Capitalization rate: 15%

14 Earning and Investment Opportunities  Example: Growthstock Corporation  Earnings per share: $15  Reinvesting rate:60%  Yield on new investments: 20%

15 Earning and Investment Opportunities Growthstock  g: Growth rate of dividends and earnings per share

16 Earning and Investment Opportunities Growthstock CGR DDM:

17 Earning and Investment Opportunities  Example: Normalprofit  Earnings per share: $15  Reinvesting rate: 60%  Yield on new investments: 15%

18 Earning and Investment Opportunities Normalprofit  g: Growth rate of dividends and earnings per share

19 Earning and Investment Opportunities Normalprofit, CGR DDM:

20 Reinvestment Under Normal Growth Retention Ratio Growth Rate Cost of Capital

21 Nogrowth YearPrice start of Year Exp. Earnings Exp. Dividend Exp. Dividend Yield Exp. Rate of Price Increase 1$100$ %0% 2$100$ %0% 3$100$ %0%

22 Normalprofit YearPrice start of Year Exp. Earnings Exp. Dividend Exp. Dividend Yield Exp. Rate of Price Increase 1$100$15.00$6.006%9% 2$109$16.35$6.546%9% 3$118.8$17.82$7.136%9%

23 Dividend Policy A corporation’s policy regarding paying out cash to its shareholders holding constant its investment and borrowing decisions

24 Dividend Policy Cash dividend  All shareholders receive cash in amounts proportional to the number of shares they own  We assume that when cash is distributed, all else the same, the share price declines immediately by the amount of the dividend

25 Dividend Policy Share repurchase  The company pays cash to buy shares of its stock in the stock market  Only those shareholders who choose to sell some of their shares will receive cash  Assumption: all else the same, the share price remains unchanged

26 Dividend Policy Original Balance Sheet

27 Dividend Policy, Cash Dividend After Payment of Cash Dividends

28 Dividend Policy, Share Repurchase After Share Repurchase

29 Dividend Policy Stock splits  A two-for-one stock split means that each old share will counted as two shares  The market price of a share will immediately drop to half

30 Dividend Policy Stock dividend  The corporation distributes additional shares of stock to each stockholder  Can be seen as distributing a cash dividend to existing shareholders, and then requiring them to immediately use the cash to buy additional shares  No tax effect

31 Dividend Policy Original Balance Sheet

32 Dividend Policy, Cash Dividend After Payment of Cash Dividends

33 Dividend Policy, Stock Dividend After Stock Dividends

34 Dividend Policy in Frictionless Environment (M&M)  M&M 1961: In a frictionless environment, in which there are no taxes and no costs of issuing new shares or repurchasing existing shares, a firm’s dividend policy can have no effect on the wealth of its current shareholders

35 Dividend Policy in a Frictionless Environment (M&M) Example(paying cash dividend or not?)  the Cashrich company decide not to pay out the $2 million in cash, but invest it in a project that leaves the total market value of the firm unchanged. A shareholder who owns 100 shares and would have preferred a cash dividend of $2 per share, can sell 10 shares, then he winds up with stock worth $1800 and cash $200.

36 Dividend Policy in a Frictionless Environment (M&M) o Suppose Cashrich pays out a cash dividend of $2 per share, and the shareholder does not want the cash. After the payment of the dividend, he has $200 in cash and $1800 in stock. He can reestablish his position by using the $200 in cash to buy more shares at the price of $18.

37 Dividend Policy in the Real World  Taxes  Regulations  The costs of external financing  Informational content of dividend

38 Tax  If a corporation distributes cash by paying dividends, it forces all of its shareholders to pay taxes. If instead the firm distributes the cash by repurchasing shares, it does not create a tax liability for all of its shareholders.

39 Regulations  In US there are laws that prevent corporations from using share repurchase as an alternative to dividends as a regular mechanism.  There are also laws that prevent corporations from retaining cash in the business that is not needed to run.

40 Cost of External Financing  Favoring the nonpayment of cash to shareholders, either in the form of cash or repurchase of shares.  The investment bankers who intermediate the sale of new shares to outside investors have to be paid, and the current shareholders bear the cost.

41 Cost arising from asymmetry of information  Differences in information that is available to the firm’s management (insiders) and the potential buyers of new stock issued by the firm (outsiders)  The outsiders may be skeptical about the reasons for issuing new stock, therefore, have to be offered a bargain price to induce them to buy new shares.

42 The Informational Content of Dividends  Outside investors may interpret an increase in a corporation’s cash dividend as a positive sign and, therefore, a dividend increase might cause a rise in the stock’s price, and conversely.  Corporate management is cautious about making changes in dividend payouts and usually offers an explanations to the investing public.