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Chapter 8 Stock Valuation

Chapter 8 Stock Valuation. Overview. Preferred Stock Characteristics and Valuation Common Stock Characteristics Common Stock as a Financing Tool Common Stock Valuation Dividend Discount Model. Preferred Stock Characteristics. Unlike common stock, no ownership interest

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Chapter 8 Stock Valuation

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  1. Chapter 8 Stock Valuation

  2. Overview • Preferred Stock Characteristics and Valuation • Common Stock Characteristics • Common Stock as a Financing Tool • Common Stock Valuation • Dividend Discount Model

  3. 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.

  4. Preferred Stock Valuation • Promises to pay the same dividend year after year forever, never matures. • A perpetuity. • Vps = D/kps • Example: GM preferred stock has a $25 par value with a 8% dividend yield. What price would you pay if your required return is 9%? • D = $25(0.08) = $2 • Vps = $2/0.09 = $22.22

  5. D Po kps = Expected Rate of Return on Preferred • Just adjust the valuation model:

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

  7. D Po 4.125 40 kps = = = Example • If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

  8. D Po 4.125 40 kps = = = .1031 Example • If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

  9. The Financial Pages:Preferred Stocks 52 weeks Yld Vol Hi Lo Sym Div % PE 100s Close 2788 2506 GM 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%.

  10. Facts about Common Stock: • Claim on Income after interest and dividend payments to creditors and preferred stockholders. • Represents ownership. • Ownership implies control. • Limited liability. • Stockholders elect directors. = Voting Rights • Directors elect management. • Management’s goal: Maximize stock price.

  11. Advantages of Financing with Stock: • No required fixed payments. • No maturity. • Improves debt ratio, coverage.

  12. Disadvantages of Financing with Stock: • Controlling shareholders may lose some ownership control. • Preemptive Right • Future earnings shared with new stockholders. Possible EPS Dilution. • Higher flotation costs vs. debt. • Higher component cost of capital. • Too little debt may encourage a takeover bid.

  13. Common Stock Valuation(Single Holding Period) • 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?

  14. ? 5.50 + 120 0 1 Common Stock Valuation(Single Holding Period) • 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?

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

  16. Common Stock Valuation(Single Holding Period) Financial Calculator solution: P/Y =1, I = 15, n=1, FV= 125.50 CPT PV = -109.13 or: P/Y =1, I = 15, n=1, FV= 120, PMT = 5.50 CPT PV = -109.13

  17. The Financial Pages:Common Stocks 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Close Chg 126 87 IBM .56 0.6 23 77995 98.12 +0.29 63 42 WalMart .28 0.5 47 119515 62.01 -0.24 • IBMs Dividend Yield = $0.56/$98.12 = 0.6% • PE Ratio = Close Price/Earnings Per Share(EPS) • IBMs Latest EPS = Close/PE = $98.12/23 = $4.27

  18. Stock Valuation Multiple Holding Periods Stock Value = PV of Future Expected Dividends

  19. 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 • “Supernormal” (non-constant) growth rate in dividends(see Chapter 8 notes in Syllabus book)

  20. Doh! Doughnuts Stock Valuation Example: Basic Information • We have found the following information for Doh! Doughnuts: • current dividend = $2, • beta of 0.9 • T-bill (risk-free) rate = 1.75% • the market risk premium is 9.5% • Using the SML equation to find Doh!’s required return = krf +(krp)b = 1.75% +(9.5%)0.9 = 10.3% = kcs

  21. 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%). • Moe Homer Simpson & Bernard expect 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.

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

  23. First Analyst: Zero Growth Stock Valuation • No growth in dividends, so Doh! Doughnuts will remain at the current dividend of $2 forever. • Estimated Value (Vcs)= PV(perpetuity) = D0/kcs • Doh! Kcs = 10.3% • NEDFlanders Estimate P0 = $2/.103 = $19.42

  24. Constant Growth Stock Valuation Model • Dividends are expected to grow at an annual constant rate, g, forever. • D1 = D0(1+g) • Dt = D0(1+g)t • Vcs = D0(1+g) = D1 kcs – g kcs – g

  25. Constant Growth Stock Valuation Model Terms • D0 = today’s (or current) dividend • D1 = expected dividend at the end of this year(year 1) • kcs = stock’s required rate of return • g = the constant growth rate in dividends

  26. 2nd Analyst: Constant Growth in Dividends • Current Dividend = $2 • Projected Constant Growth Rate = 8% or 0.08 • Kcs = 10.3%

  27. What happens if g > kcs? • If kcs< g, get negative stock price, which is nonsense. • We can’t use model unless (1) kcs> g and (2) g is expected to be constant forever.

  28. Doh! A good buy? • Assume Doh! Doughnuts current stock price is $100. • Required return = 1.75% + 9.5%(0.9) = 10.3% • Let’s assume the 2nd analyst is correct and Doh! Has a constant growth rate of 8% and its current dividend is $2. • What is the stock’s expected return? • Is Doh! Doughnuts’ current stock price in equilibrium?

  29. Expected Return of Constant Growth Stocks • Expected Rate of Return = Expected Dividend Yield + Expected Capital Gains Yield • D1/P0 = D0(1+g)/P0 = Expected Dividend Yield • g = Expected Capital Gains Yield • From our example, D1=$2(1.08) = 2.16, P0=$100, g = 8% or 0.08 DOH! Doh! Doughnuts

  30. Stock Market Equilibrium • The stock price when the stock’s expected return = stock’s required return (CAPM) • D1/P0 + g = krf +(km - krf)b Expected Return = Required Return

  31. The Effect On the Stock Price • Expected Return needs to rise to the required return of 10.3%. This means the stock price must fall to the the equilibrium price which yields the required return of 10.3% • New Price = D1/(kcs- g)=$2.16/(.103 - .08)= $93.91 • At the current price of $100, Doh! has NPV of $93.91 - $100 = -$6.09

  32. “Supernormal” 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(gc). 0 g1 1 g2 2 g3 3 gc 4 gc 5 gc… D1 D2 D3 “Supernormal” Growth Period Constant Growth

  33. Supernormal Growth Valuation Process 3 Step Process • Estimate Dividends during “supernormal” growth period. • Estimate Price, which is the PV of the constant growth dividends, at the end of “supernormal” growth period which is also the beginning of the constant growth period. • Find the PV of “supernormal” dividends and constant growth price. The total of these PVs = Today’s estimated stock value.

  34. 3rd Analyst:“Supernormal” Growth Stock Valuation for Doh! • “supernormal” growth rate g for years 1-3 = 20% or 0.2 • After year 3, Doh! Has constant growth rate gc = 8% or 0.08 • D0 = $2.00 • kcs = 10.3% or .103

  35. Finally, the Answer! 0 g = 20% 1g = 20%2 g = 20% 3 gc = 8% $2.40 $2.88 $3.46 PV= P0$162.28 = P3 10.3%,1 $165.74 2.17 10.3%,2 2.37 10.3%,3 123.51 128.05 = $128.05 = P0 Fin’l Calculator Solution: CF0=0,C01= 2.40 C02 = 2.88 C03 = 165.74 I = 10.3 NPV=128.05 = P0 P0 = $2.40(PVIF10.3%,1)+$2.88(PVIF10.3%,2)+$3.46(PVIF10.3%,3) + $162.28(PVIF10.3%,3) = $128.05

  36. Summary of Doh! Doughnuts Stock Price Estimates • NEDFlanders: 0% constant growth: P0 = $19.42 • Barton Kruston Simpson: 8% constant growth: P0 = $93.91 • Moe Homer Simpson & Bernard: 20%, 3-year supernormal growth followed by 8% constant growth: P0 = $128.05

  37. Other Valuation Approaches • Our dividend discount models are best for established dividend paying companies, which makes it difficult to apply to non-dividend paying start-up companies. • PE Multiple Approach: Forecast a company’s earnings per share and multiply this forecast times the company’s PE ratio. • Value entire firm by finding PV of future expected Free Cash Flows available to stockholders, then divide by number of shares. (Chapter 13)

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