Equity markets and share valuation Chapter 7

Key concepts and skills Understand how stock prices depend on future dividends and dividend growth Be able to compute stock prices using the dividend growth model Understand how corporate directors are elected Understand how stock markets work Understand how stock prices are quoted Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline Ordinary share valuation Some features of ordinary and preference shares The share markets Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Cash flows for stockholders If you own a share of stock, you can receive cash in two ways: 1. The company pays dividends. 2. You sell your shares, either to another investor in the market or back to the company. As with bonds, the price of the stock is the present value of these expected cash flows. Dividends → cash income Selling → capital gains Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

One-period example Suppose you are thinking of purchasing the stock of Moore Oil Inc. You expect it to pay a $2 dividend in one year. You believe you can sell the stock for $14 at that time. You require a return of 20% on investments of this risk. What is the maximum you would be willing to pay? Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

One-period example (cont.) D1 = $2 dividend expected in one year R = 20% P1 = $14 CF1 = $2 + $14 = $16 Compute the PV of the expected cash flows Calculator: 16 [FV]; 20 [I/Y]; 1 [N]; [CPT] [PV] = -13.33 Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Two-period example Now, what if you decide to hold the share for two years? In addition to the dividend in one year, you expect a dividend of $2.10 and a share price of $14.70 at the end of year 2. Now how much would you be willing to pay? Calculator: CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; [NPV]; I = 20; [CPT][NPV] = $13.33 Note the use of Cash Flow key in calculator. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Three-period example 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 $2.205 at the end of year 3 and a share price of $15.435. Now how much would you be willing to pay? Calculator: CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; [NPV]; I = 20; [CPT] [NPV] = $13.33 Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Developing the model You could continue to push back when you would sell the share. You would find that the price of the share is really just the present value of all expected future dividends. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Stock value = PV of dividends (1+R)1 (1+R)2 (1+R)3 (1+R)∞ D1 D2 D3 D∞ + +…+ How can we estimate all future dividend payments? Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Estimating dividends: Special cases Constant dividend The firm will pay a constant dividend forever This is like a preference share The price is computed using the perpetuity formula Constant dividend growth The firm will increase the dividend by a constant percentage every period Supernormal growth Dividend growth is not consistent initially, but settles down to constant growth eventually Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Zero growth If dividends are expected at regular intervals forever, this is like a preference share and is valued as a perpetuity P0 = D/R Suppose a share is expected to pay a $0.50 dividend every half-year and the required return is 10% with half-yearly compounding. What is the price? P0 = .50 / (0.1 / 2) = $10 Remind students to adjust the rate to the period, i.e. if the dividend is paid quarterly then the discount rate must be a quarterly rate. Here D1=D2=D3=... D = constant. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Constant growth stock Dividends are expected to grow at a constant percentage per period. D1 = D0(1+g)1 D2 = D0(1+g)2 Dt = Dt(1+g)t D0 = Dividend JUST PAID D1 – Dt = Expected dividends Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Dividend growth model (DGM) P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + … P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + … (‘with a constant dividend growth’ g) Dividend growth model—A model that determines the current price of a share as its dividend next period divided by the discounted rate less the dividend growth rate. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

DGM—Example 1 Suppose Outback Ltd just paid a dividend of $0.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the share be selling for? D0= $0.50 g = 2% R = 15% Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

DGM—Example 2 Suppose Deep Pirates Ltd is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price? D1 = $2.00 g = 5% r = 20% Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Share price sensitivity to dividend growth (g) D1 = $2; R = 20% As the growth rate approaches the required return, the stock price increases dramatically. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Share price sensitivity to required return (R) D1 = $2; g = 5% As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Example 7.3—Gordon Growth Company I Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%. What is the current price? Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Example 7.3—Gordon Growth Company II What is the price expected to be in year 4? P4 = D4(1 + g) / (R – g) = D5 / (R – g) P4 = 4(1+.06)4 / (.16 - .06) = 50.50 What is the implied return given the change in price during the 4-year period? 50.50 = 40(1+return)4; return = 6% -40[PV]; 50.50[FV]; 4[N]; [CPT][I/Y] = 6% The price grows at the same rate as the dividends. Point out that the formula is completely general. The dividend in the numerator is always for one period later than the price we are computing. This is because we are computing a present value, so we have to start with a future cash flow. This is very important when discussing supernormal growth. We know the dividend in one year is expected to be $4 and it will grow at 6% per year for four more years. So, D5 = 4(1.06)(1.06)(1.06)(1.06) = 4(1.06)4 Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Constant growth model conditions Dividend expected to grow at g forever. Stock price expected to grow at g forever. Expected dividend yield is constant. Expected capital gains yield is constant and equal to g. Expected total return, R, must be > g. Expected total return (R): = expected dividend yield (DY) + expected growth rate (g) = dividend yield + g Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Non-constant growth problem statement 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 $1 and the required return is 20%, what is the price of the share? Remember that we have to find the PV of all expected future dividends. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Non-constant growth problem—Solution Compute the dividends until growth levels off D1 = 1(1.2) = $1.20 D2 = 1.20(1.15) = $1.38 D3 = 1.38(1.05) = $1.449 Find the expected future price P2 = D3 / (R – g) = 1.449 / (.2 - .05) = $9.66 Find the present value of the expected future cash flows P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = $8.67 Point out that P2 is the value, at year 2, of all expected dividends from year 3 on. The final step is exactly the same as the 2-period example at the beginning of the chapter. We can look at it as if we buy it today, receive the $1.20 dividend in 1 year, receive the $1.38 dividend in 2 years and then immediately sell it for $9.66. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Non-constant + Constant growth Basic PV of all future dividends formula Dividend growth model Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Non-constant + Constant growth (cont.) Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Non-constant growth followed by constant growth 1 2 3 rs=20% g = 20% g = 15% g = 5% D0 = 1.00 1.20 1.38 1.449 1.0000 0.9583 The example from the textbook with its time line can also be used to explain this slide. P2 = ^ 0.20 – 0.05 = $9.66 $1.449 6.7083 8.6667 = P0 Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Quick quiz: Part 1 What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%? What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return remains at 15%. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Using the DGM to find R Start with the DGM: Rearrange and solve for R: Point out that D1 / P0 is the dividend yield and g is the capital gains yield. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Finding the required return— Example Suppose a firm’s shares are selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? R = [1(1.05)/10.50] + .05 = 15% What is the dividend yield? 1(1.05) / 10.50 = 10% What is the capital gains yield? g = 5% Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Summary of share valuation Table 7.1 Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Features of ordinary shares Voting rights Stockholders elect directors Cumulative voting vs straight voting Proxy voting Classes of share ‘One share, one vote’ Shareholders have the right to vote for the board of directors and on other important issues. Cumulative voting increases the likelihood of minority shareholders getting a seat on the board. Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote. Different classes of stock can have different rights. Owners may want to issue a non-voting class of stock if they want to make sure that they maintain control of the firm. Australian and New Zealand stock markets do not allow for more than one type of ordinary share and each share has one vote. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Features of ordinary shares (cont.) Other rights Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Pre-emptive right Right of first refusal to buy new stock issue to maintain proportional ownership if desired Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Dividend characteristics Dividends are not a liability of the firm until declared by the Board of Directors A firm cannot go bankrupt for not declaring dividends Dividends and taxes Dividends are not tax deductible for a firm Taxed as ordinary income for individuals Dividends received by corporations have a minimum 100% exclusion from taxable income Dividend exclusion: If corporation A owns less than 20% of corporation B stock, then 30% of the dividends received from corporation B are taxable. If A owns between 20% and 80% of B, then 20% of the dividends received are taxable. If A owns more than 80%, a consolidated statement can be filed and dividends received from B are essentially untaxed. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Features of preference shares Dividends Stated dividend must be paid before dividends can be paid to ordinary shareholders Dividends are not a liability of the firm and preference dividends can be deferred indefinitely Most preference dividends are cumulative— any missed preference dividends have to be paid before ordinary dividends can be paid Preference shares generally do not carry voting rights Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The share markets Primary vs secondary markets Dealers vs brokers Primary = new-issue market Secondary = existing shares traded among investors Dealers vs brokers Dealer: Maintains an inventory Ready to buy or sell at any time Think ‘Used car dealer’ Broker: Brings buyers and sellers together Think ‘Real estate broker’ Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Australian Stock Exchange (ASX) Result of amalgamation of state-based exchanges 1987—Introduction of Stock Exchange Automated Trading System (SEATS) 1998—Demutualisation of ASX 2006—Merger with Sydney Futures Exchange and now called Australian Securities Exchange New Zealand Stock Exchange Created in 1974 1991—Introduction of Computer Based Trading System Demutualised in 2002 SEATS—The computer network allowing brokers to place buy and sell orders and to execute transactions electronically. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

ASX and NZX operations Operational goal = Attract order flow Both ASX and NZX are auction markets Agency trading—Brokers buying and selling for clients Principal trading—Brokers buying and selling their own accounts Orders Limit order—specified sell/buy price Market order—at best market price Trading in both ASX and NZX takes place on computer network The term order flow means the flow of customer orders to buy and sell shares. The customers of the ASX are the millions of individual investors and tens of thousands of institutional investors who place their orders to buy and sell shares in ASX-listed companies. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Share market reporting Figure 7.2 Sample share market quote from Sydney Morning Herald’s website <www.smh.com.au>. The quote on the left reports the last sale price, the change in last sale price from the previous closing price with date and time of the price and a graph showing change in price over the day. The middle column reports the opening price and the high and low price of the day. The final column gives the other fundamentals of the stock, such as volume, or number of shares sold over the day, and value, or total value of shares traded over the day, followed by ratios such as Price to earning and EPS. A good website at which to get share prices is <www.au.finance.yahoo.com>. Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Work the Web Click on the information icon to go to <http://markets.smh.com.au/apps/qt/index.ac> Search for other equities like the one in the last example Understand the reported figures Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Quick quiz: Part 2 You observe a share price of $18.75. You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return? What are some of the major characteristics of ordinary shares? What are some of the major characteristics of preference shares? r = [1.5(1.05)/18.75] + .05 = 13.4% Copyright  2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E. Allen and Abhay K. Singh.

Chapter 7 END