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 9.1 Reading stock listings 9.2 The discounted dividend model 9.3 Earning and investment opportunity 9.4 A reconsideration of the price multiple approach 9.5 Does dividend policy affect shareholder wealth?

3 Reading Stock Listings

4 Present Value of Dividends

5 Expected Rate of Return The price and dividend next year are expected prices, soThe price and dividend next year are expected prices, so –The expected rate of return in any period equals the market capitalization rate, k

6 Rate Relationship This relationship tells you that next year’s expected dividend yield + the expected capital gain yield is equal to the required rate of returnThis relationship tells you that next year’s expected dividend yield + the expected capital gain yield is equal to the required rate of return

7 Price 0 Is Discounted Expected (Dividend 1 + Price 1 ) Price is the present value of the expected dividend plus the end-of-year price discounted at the required rate of returnPrice is the present value of the expected dividend plus the end-of-year price discounted at the required rate of return

8 Ease of Use Recall from chapter 4 that, for a perpetuity, the present value is the real value of the first cash flow divided by the real rateRecall from chapter 4 that, for a perpetuity, the present value is the real value of the first cash flow divided by the real rate

9 Putting This Together

10 Solving for K

11 G = Capital Gains Yield G = Capital Gains Yield Comparing prior results:Comparing prior results:

12 Earning and Investment Opportunity To simplify the analysis, suppose that no new shares are issues, and no taxesTo simplify the analysis, suppose that no new shares are issues, and no taxes Dividends = earnings - net new investment “D = E - I”. The formula for valuing stock is

13 Growth Stock Original wealth Kept Reinvested Wealth Multiplier

14 Growth Stock

15 Generalize Let theLet the –V = value of the shares without reinvestment –G = the growth from new investment –R = retention ratio –M = wealth multiplier = g/i –Wealth g = wealth 0 *(1-r)/(1-w*r)

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

17 Illustration: Dividends

18 Illustration: Dividend Payment Was 2Was 10 Were 12

19 Illustration: Share Repurchase

20 Illustration: Share Repurchase Was 2Was 10 Were 12