1. , Prentice Hall, Inc. Ch. 8: Stock Valuation

2. Security Valuation 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.

3. Preferred Stock A hybrid security: it’s like common stock - no fixed maturity.

4. Preferred Stock A hybrid security: it’s like common stock - no fixed maturity. –technically, it’s part of equity capital.

5. Preferred Stock A hybrid security: it’s like common stock - no fixed maturity. –technically, it’s part of equity capital. it’s like debt - preferred dividends are fixed.

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

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

8. Firms may have multiple classes of preferreds, each with different features. Priority: lower than debt, higher than common stock. Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared. Preferred Stock Features

9. Protective provisions protect preferred stockholders. Convertibility: many preferreds are convertible into common shares. Adjustable rate preferreds have dividends tied to interest rates. Participation: some (very few) preferreds have dividends tied to the firm’s earnings. Preferred Stock Features

10. PIK Preferred: Pay-in-kind preferred stocks pay additional preferred shares to investors rather than cash dividends. Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares. Preferred Stock Features

11. Preferred Stock Valuation A preferred stock can usually be valued like a perpetuity:

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

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

14. Example: Xerox preferred pays an 8.25% dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%. V ps = 4.125.095.095 =

15. Example: Xerox preferred pays an 8.25% dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%. V ps = 4.125.095.095 = $43.42

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

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

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

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

20. Example If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: DPoDPo k ps = = =.1031 4.125 40

21. The Financial Pages: Preferred Stocks 52 weeks Yld Vol Hi Lo Sym Div % PE 100s Close 27 88 25 06 GenMotor pfG 2.28 8.9 … 86 25 53 Dividend: $2.28 on $25 par value = 9.12% dividend rate. Expected return: 2.28 / 25.53 = 8.9%.

22. Common Stock is a variable-income security. –dividends may be increased or decreased, depending on earnings. represents equity or ownership. includes voting rights. Limited liability: liability is limited to amount of owners’ investment. Priority: last.

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

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

25. 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. If you require a 15% rate of return, what would you pay for the stock now? Common Stock Valuation (Single Holding Period) 0 1 ? 5.50 + 120

26. Common Stock Valuation (Single Holding Period) Solution: Vcs = (5.50/1.15) + (120/1.15) = 4.783 + 104.348 = $109.13

27. The Financial Pages: Common Stocks 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 135 80 IBM.52.5 21 142349 99 93 94 96 -3 43 82 18 CiscoSys … 47 1189057 21 19 20 25 -1 13

28. Common Stock Valuation As said before, value of a stock is the present value of future cash flows. I f a stock is expected to pay $1.00 dividend at the end of this year, $2.00 next year and $2.50 in the third year. You expect to hold the stock for three years and then expect to sell it for $50. How much will you pay for this if your required rate of return is 10%?

29. Multiple Holding Periods V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return 0 1 2 3  D1D1 D2D2 D3D3 D0D0 not An investor purchasing stock at time 0 does not get D 0 DD Valuing Common Stock

30. Multiple Holding Periods V cs = + + +···+ D 1 (1+ k cs ) D 2 (1+ k cs ) 2 V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return D 3 (1+ k cs ) 3 D N (1+ k cs ) N 0 1 2 3  D1D1 D2D2 D3D3 D0D0 DD

31. Valuing Common Stock Multiple Holding Periods V cs = + + +···+ D 1 (1+ k cs ) D 2 (1+ k cs ) 2 V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return D 3 (1+ k cs ) 3 D N (1+ k cs ) N 0 1 2 3  D1D1 D2D2 D3D3 D0D0 DD

32. Valuing Common Stock Multiple Holding Periods V cs = + + +···+ D 1 (1+ k cs ) D 2 (1+ k cs ) 2 V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return D 3 (1+ k cs ) 3 D N (1+ k cs ) N 0 1 2 3  D1D1 D2D2 D3D3 D0D0 DD

33. Valuing Common Stock Multiple Holding Periods V cs = + + +···+ D 1 (1+ k cs ) D 2 (1+ k cs ) 2 V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return D 3 (1+ k cs ) 3 D  (1+ k cs )  0 1 2 3  D1D1 D2D2 D3D3 D0D0 DD

34. Valuing Common Stock Multiple Holding Periods V cs = + + +···+ D 1 (1+ k cs ) D 2 (1+ k cs ) 2 V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return D 3 (1+ k cs ) 3 Not like Preferred Stock where: D 0 = D 1 = D 2 = D 3 = D N, therefore no longer a Perpetuity Not like Preferred Stock where: D 0 = D 1 = D 2 = D 3 = D N, therefore no longer a Perpetuity 0 1 2 3  D1D1 D2D2 D3D3 D0D0 DD D  (1+ k cs ) 

35. Valuing Common Stock Multiple Holding Periods Investors do not know the values of D 1, D 2,...., D N. The future dividends must be estimated. V cs = + + +···+ D 1 (1+ k cs ) D 2 (1+ k cs ) 2 V cs = PV of ALL received dividends discounted at investor’s Required Rate of Return D 3 (1+ k cs ) 3 0 1 2 3  D1D1 D2D2 D3D3 D0D0 DD D  (1+ k cs ) 

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

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

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

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

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

41. Example 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%?

42. Example 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

43. Example 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 =

44. Example 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

45. Example 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 5.50 k cs - g.15 -.10

46. Example 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 1 5.50 k cs - g.15 -.10

47. Expected Return on Common Stock Just adjust the valuation model

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

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

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

51. Example 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%.

52. Example 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

53. Example 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 = 3.00 27

54. Example 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% 3.00 27