Chap 007

Chapter 7

Equity Markets and Stock Valuation

1 McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter Outline • Common Stock Valuation • Some Features of Common and Preferred Stocks • The Stock Markets

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Stock Valuation • As with bonds, the price of the stock is the present value of these expected cash flows • If you buy a share of stock, you can receive cash in two ways – The company pays dividends – You sell your shares, either to another investor in the market or back to the company (selling price) 3

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One Period Example • Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? – Compute the PV of the expected cash flows – Price (P0) = (D1 + P1)/(1+r) = (2 + 14) / (1.2) = $13.33 4

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Two Period Example • Now what if you decide to hold the stock for two years? In addition to the dividend in one year, you expect a dividend of $2.10 and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay?

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Three Period Example • Finally, what if you decide to hold the stock for three periods? 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 stock price of $15.435. Now how much would you be willing to pay?

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Developing The Model • You could continue to push back when you would sell the stock • Hold for N-period: – P0=D1/(1+r)+D2/(1+r)2+...+(Dn+Pn)/(1+r)n

• You would find that the price of the stock is really just the present value of all expected future dividends • So, how can we estimate all future dividend payments? 7

Estimate Div: Special Cases

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• 1) Constant dividend – The firm will pay a constant dividend forever

• 2) Constant dividend growth – The firm will increase the dividend by a constant percent every period, forever

• 3) Supernormal growth – Dividend growth is not consistent initially, but settles down to constant growth eventually

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1) Constant Div (zero growth) • If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity • P0 = D / r • Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

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2) Constant Dividend Growth (Div Growth Model)

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• Dividends are expected to grow at a constant percent (g%) per period, forever. – 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 little algebra, this reduces to:

D 0 (1 + g) D1 P0 = = r -g r -g

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Example 1 • Suppose Big D, Inc. just paid a dividend of $.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 stock be selling for?

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Stock Price Sensitivity to Dividend Growth, g

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250

D1 = $2; r = 20%

Stock Price

200 150 100 50 0 0

0.05

0.1

0.15

0.2

Growth Rate 12

Stock Price Sensitivity to Required Return, r

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250

D1 = $2; g = 5%

Stock Price

200 150 100 50 0 0

0.05

0.1

0.15

0.2

0.25

0.3

Required Rate of return 13

Example 3

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• 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?

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Continued…Example

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• What is the price expected to be in year 4? • What is the implied return given the change in price during the four year period?

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3) Super Normal Growth (Non-constant Growth)

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• Suppose a firm is expected to increase dividends by 20% in one year and by 15% in second year. 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 stock? • Remember that we have to find the PV of all expected future dividends. 16

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Nonconstant Growth – Example

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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%? (P0=$13.33) • What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15%. (P0 =$17.17) 18

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Using the DGM to Find r • Start with the DGM: D1 P0 = r -g rearrange and solve for r D1 r= +g P0 r = Dividend Yield + Capital gains Yield 19

Finding the Required Return

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• Suppose a firm’s stock is 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?

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Features of Common Stock • • • •

Voting Rights Proxy voting Classes of stock Other Rights – Share proportionally in declared dividends – Share proportionally in remaining assets during liquidation – Preemptive right – first shot at new stock issue to maintain proportional ownership if desired 21

Dividend Characteristics

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• Dividends are not a liability of the firm until a dividend has been declared by the Board • Consequently, a firm cannot go bankrupt for not declaring dividends • Dividends and Taxes – Dividend payments are not considered a business expense, therefore, they are not tax deductible – Dividends received by individuals are taxed as ordinary income 22

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Features of Preferred Stock • Dividends – Stated dividend that must be paid before dividends can be paid to common stockholders – Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely – Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid

• Preferred stock generally does not carry voting rights 23

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Stock Market • Dealers vs. Brokers – A Dealer maintains inventory and stands to buy & sell at any time • Dealers market • NASDAQ

– A Broker brings buyer & seller together, but does not maintain an inventory • Auction market • NYSE • Bursa Malaysia 24

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Quick Quiz •

Suppose that sales and profits of ABC Bhd. are growing at a rate of 30% per year. At the end of four years the growth rate will drop to a steady 6%. At the end of year 5, the company will issue its first dividend in the amount of RM3 per share. If the required return is 15%, what is the value of a share of stock? Assume dividends grow at the same rate as earnings after year 4. (P0 = $19.06)

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Tutorial •

Problem 2, 4, 14, 16 & 18 from page 225

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