1. Chapter 5 Valuing Stocks

2. 2 Topics Covered Preferred Stock and Common Stock Properties Valuing Preferred Stocks Valuing Common Stocks - the Dividend Discount Model  No growth  Constant growth  Variable growth Valuing the Enterprise (the Firm) – Free Cash Flow Approach

3. 3 Debt vs. Equity: Debt Debt securities represent a legally enforceable claim. Debt securities offer fixed or floating cash flows. Bondholders don’t have any control over how the company is run.

4. 4 Debt vs. Equity: Equity Debt and equity have substantially different marginal benefits and marginal costs. Common stockholders are residual claimants. No claim to earnings or assets until all senior claims are paid in full High risk, but historically also high return Stockholders have voting rights on important company decisions.

5. 5 Rights of Common Stockholders Common stockholders’ voting rights can be exercised in person or by proxy. Most US corporations have majority voting, with one vote attached to each common share. Cumulative voting gives minority shareholders greater chance of electing one or more directors. Shareholders have no legal rights to receive dividends.

6. 6 Preferred Stock Characteristics Unlike common stock, no ownership interest Second to debt holders on claim on company’s assets in the event of bankruptcy. Annual dividend yield as a percentage of par value Preferred dividends must be paid before common dividends If cumulative preferred, all missed past dividends must be paid before common dividends can be paid.

7. 7 Preferred Stock Valuation Promises to pay the same dividend year after year forever, never matures. A perpetuity. PS 0 = D P /r P Expected Return: r = D P /PS 0 Example: GM preferred stock has a $25 par value with a 8% dividend yield. What price would you pay if your required return is 7%?

8. 8 The Financial Pages: Common & Preferred Stocks Yld Vol Sym Div % PE 100s Close GM 1.00 4.6 n/a 111187 21.41 GM pfG 2.28 9.5 … 86 24.00 For GM pfG (preferred stock) Dividend: $2.28 on $25 par value = 9.12% dividend rate. Yld% = Expected return: 2.28 / 24.00 = 9.5%.

9. 9 What do investors in common stock want? Periodic cash flows: dividends, and… To sell the stock in the future at a higher price Management to maximize their wealth

10. 10 Valuing Common Stocks: Expected Return Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR).

11. 11 Expected Return The formula can be broken into two parts. Dividend Yield + Capital Gains Yield

12. 12 Example Lisa Simpson buys Grease Gougers stock for $25 per share. In a year she expects the receive $1 in dividends and the price of the stock to be $28. What is Lisa’s expected return?

13. 13 Stock Valuation Stock Value = PV of Future Expected Dividends

14. 14 Stock Valuation: Dividend Patterns For Valuation: we will assume stocks fall into one of the following dividend growth patterns.  Constant growth rate in dividends  Zero growth rate in dividends, like preferred stock  Variable (non-constant) growth rate in dividends

15. 15 Stock Valuation Case Study: Doh! Doughnuts We have found the following information for Doh! Doughnuts: current dividend = $2.00 = Div 0 Required return = 14% = r

16. 16 Analysts Estimates for Doh! Doughnuts NEDFlanders predicts a constant annual growth rate in dividends and earnings of zero percent (0%) Barton Kruston Simpson predicts a constant annual growth rate in dividends and earnings of 8 percent (8%). Homer Co. expects a dramatic growth phase of 20% annually for each of the next 3 years followed by a constant 8% growth rate in year 4 and beyond.

17. 17 Our Task: Valuation Estimates What should be each analyst’s estimated value of Doh! Doughnuts?

18. 18 Valuing Common Stocks: No Growth If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Assumes all earnings are paid to shareholders.

19. 19 Ned Flanders’ Valuation Div 0 = $2.00, r = 14% or 0.14, g = 0%

20. 20 Constant Growth Valuation Model Assumes dividends will grow at a constant rate (g) that is less than the required return (r) If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next year’s dividend as D 1 : Commonly called the Gordon growth model

21. 21 Barton Kruston Simpson’s Valuation Div 0 = $2.00, g = 8%, r = 14%

22. 22 Expected Return of Constant Growth Stocks Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains Yield Div 1 /P 0 = Expected Dividend Yield g = Expected Capital Gains Yield r = Div 1 /P 0 + g = Div 0 (1+g)/P 0 + g

23. 23 Example Burns International’s stock sells for $80 and their expected dividend is $4. The market expects a return of 14%. What constant growth rate is the market expecting for Burns International?

24. 24 Homer Co. Valuation Variable (non-constant) growth Years 1-3 expect 20% growth After year 3: constant growth of 8%

25. 25 Variable Growth Stock Valuation Framework: Assume Stock has period of non-constant growth in dividends and earnings and then eventually settles into a normal constant growth pattern (g n ). 0 g 1 1 g 2 2 g 3 3 g n 4 g n 5 g n... D 1 D 2 D 3 Non-constant Growth Period Constant Growth

26. 26 Variable Growth Valuation Process 3 Step Process Estimate Dividends during non-constant growth period. Estimate Price, which is the PV of the constant growth dividends, at the end of non-constant growth period which is also the beginning of the constant growth period. Find the PV of non-constant dividends and constant growth price. The total of these PVs = Today’s estimated stock value.

27. 27 Back to Homer Co’s Valuation: Step 1 D 0 = $2.00, g = 20% or 0.2 for next 3 years

28. 28 Homer Co’s Valuation: Step 2

29. 29 Homer Co’s Valuation: Step 3