Chapter 8

Valuation and Characteristics of Stock

Security Valuation n 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.

Preferred Stock A hybrid security: n it’s like common stock - no fixed maturity. u technically, it’s part of equity capital. n it’s like debt - preferred dividends are fixed. u missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

n Usually sold for $25, $50, or $100 per share. n Dividends are often quoted as a percentage of par. Preferred Stock

n Usually sold for $25, $50, or $100 per share. n Dividends are often quoted as a percentage of par. u Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. Preferred Stock

n Usually sold for $25, $50, or $100 per share. n Dividends are often quoted as a percentage of par. u Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. u $4.125 is the fixed, annual dividend per share. Preferred Stock

n May be callable and convertible. n Is usually non-voting. n Priority: lower than debt, higher than common stock. n Usually includes protective provisions. n May include a sinking fund provision. Preferred Stock

Preferred Stock Valuation n A preferred stock can usually be valued like a perpetuity: V = D k ps

Example: n Xerox preferred pays an 8.25% dividend on a $50 par value. n Suppose our required rate of return on Xerox preferred is 9.5%.

Example: n Xerox preferred pays an 8.25% dividend on a $50 par value. n Suppose our required rate of return on Xerox preferred is 9.5%. V ps = =

Example: n Xerox preferred pays an 8.25% dividend on a $50 par value. n Suppose our required rate of return on Xerox preferred is 9.5%. V ps = = $43.42

Expected Rate of Return on Preferred n Just adjust the valuation model:

Expected Rate of Return on Preferred n Just adjust the valuation model: DPoDPo k ps =

Example n If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

Example n If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: DPoDPo k ps = = =

Example n If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: DPoDPo k ps = = =

The Financial Pages: Preferred Stocks 52 weeks Yld Vol Hi Lo Sym Div % PE 100s Close 29 3 / / 8 GenMotor pfG … / 8 n Dividend: $2.28 on $25 par value = 9.12% dividend rate. n Expected return: 2.28 / = 8.8%.

Common Stock n is a variable-income security. u dividends may be increased or decreased, depending on earnings. n represents equity or ownership. n includes voting rights. n Priority: lower than debt and preferred.

Common Stock Characteristics n Claim on Income - a stockholder has a claim on the firm’s residual income. n Claim on Assets - a stockholder has a residual claim on the firm’s assets in case of liquidation. n Preemptive Rights - stockholders may share proportionally in any new stock issues. n Voting Rights - right to vote for the firm’s board of directors.

n 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. n If you require a 15% rate of return, what would you pay for the stock now? Common Stock Valuation (Single Holding Period)

n 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. n If you require a 15% rate of return, what would you pay for the stock now? Common Stock Valuation (Single Holding Period) 0 1 ?

Common Stock Valuation (Single Holding Period) Financial Calculator solution: P/Y =1, I = 15, n=1, FV= solve: PV = or: P/Y =1, I = 15, n=1, FV= 120, PMT = 5.50 solve: PV =

The Financial Pages: Common Stocks 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg IBM / MSFT … / / 4

Common Stock Valuation (Multiple Holding Periods) n Constant Growth Model n Assumes common stock dividends will grow at a constant rate into the future.

Common Stock Valuation (Multiple Holding Periods) n Constant Growth Model n Assumes common stock dividends will grow at a constant rate into the future. V cs = D 1 k cs - g

n Constant Growth Model n Assumes common stock dividends will grow at a constant rate into the future.

n Constant Growth Model n Assumes common stock dividends will grow at a constant rate into the future. V cs = D 1 k cs - g

n Constant Growth Model n Assumes common stock dividends will grow at a constant rate into the future. n D 1 = the dividend at the end of period 1. n k cs = the required return on the common stock. n g = the constant, annual dividend growth rate. V cs = D 1 k cs - g

Example n XYZ stock recently paid a $5.00 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%?

Example n XYZ stock recently paid a $5.00 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%? D 0 = $5, so D 1 = 5 (1.10) = $5.50

Example n XYZ stock recently paid a $5.00 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%? V cs =

Example n XYZ stock recently paid a $5.00 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%? V cs = = D 1 k cs - g

Example n XYZ stock recently paid a $5.00 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%? V cs = = = D k cs - g

Example n XYZ stock recently paid a $5.00 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%? V cs = = = $110 D k cs - g

Expected Return on Common Stock n Just adjust the valuation model

Expected Return on Common Stock n Just adjust the valuation model V cs = D k cs - g

Expected Return on Common Stock n Just adjust the valuation model V cs = D k cs - g k = ( ) + g D 1 V cs

Expected Return on Common Stock n Just adjust the valuation model V cs = D k cs - g k = ( ) + g D1PoD1Po

Example n We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%.

Example n We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%. k cs = ( ) + g D1PoD1Po

Example n We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%. k cs = ( ) + g D1PoD1Po k cs = ( ) +.05 =

Example n We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%. k cs = ( ) + g D1PoD1Po k cs = ( ) +.05 = 16.11%