Fundamentals of corporate finance 10e ROSS JORDAN chap008

Chapter Outline• Bond and Stock Differences • Common Stock Valuation • Features of Common Stock • Features of Preferred Stock • The Stock Markets... Chapter Outline• Bond and Stock Diffe

Stock Valuation

Chapter 8

Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation

• Features of Common Stock

• Features of Preferred Stock

• The Stock Markets

Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation

• Features of Common Stock

• Features of Preferred Stock

• The Stock Markets

Bonds and Stocks: Similarities

• Both provide long-term funding for the organization

• Both are future funds that an investor must

consider

• Both have future periodic payments

• Both can be purchased in a marketplace at a price

“today”

Bonds and Stocks: Differences

• From the firm’s perspective: a bond is a long-term debt and stock is equity

• From the firm’s perspective: a bond gets paid off at the maturity date; stock continues indefinitely.

• We will discuss the mix of bonds (debt) and stock

(equity) in a future chapter entitled capital structure

Bonds and Stocks: Differences

• A bond has coupon payments and a lump-sum payment; stock has dividend payments forever

• Coupon payments are fixed; stock dividends change or “grow” over time

A visual representation of a bond with a coupon payment (C) and a maturity value (M)

$M

A visual representation of a share of

Common Stock

0

Notice these differences:

• The “C’s” are constant and equal

• The bond ends (year 5 here)

• There is a lump sum at the end

$M

Notice these differences:

• The dividends are different

• The stock never ends

• There is no lump sum

∞

∞

Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation

• Features of Common Stock

• Features of Preferred Stock

• The Stock Markets

Our Task:

To value a share of

Common Stock

And how will we accomplish our task?

B A E F E I P V

Bring All

Expected Future

Earnings Into

Present Value

Just remember:

Cash Flows for Stockholders

If you buy a share of stock, you can

receive cash in two ways:

1. The company pays dividends

2 You sell your shares, either to

another investor in the market or back to the company

One-Period Example

Receiving one future dividend and one future selling price of a share of

common stock

One-Period Example

Suppose you are thinking of purchasing the stock

of Moore Oil, Inc 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?

Visually this would look like:

1

D1 = $2 P1 = $14

R = 20%

Compute the Present Value

1

D1 = $2 P1 = $14

R = 20%

$1.67

$11.67

PV =$13.34

1 year = N 20% = Discount rate

$14 = FV

1 year = N

$2 = Payment (PMT)20% = Discount rate

PV = ?

-13.34

HP 12-C

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 in two years and

a stock price of $14.70 at the end of year Now how much would you be willing to pay?

Visually this would look like:

Compute the Present Value

What is the Observed Pattern?

We value a share of stock by bring back all expected future dividends into present

value terms

Future Dividends

So the key is to determine the

future dividends when given the

growth rate of those dividends,

whether the growth is zero ,

then levels off to a constant

growth rate

So how do you compute the future

dividends?

Three scenarios:

1.A constant dividend (zero growth)

2.The dividends change by a constant growth rate

3.We have some unusual growth periods and then level off to a constant growth rate

So how do you compute the future

dividends?

Three scenarios:

1. A constant dividend (zero growth)

2. The dividends change by a constant growth rate

3. We have some unusual growth periods and then

level off to a constant growth rate

1 Constant Dividend –

Zero Growth

• The firm will pay a constant dividend forever

• This is like preferred stock

• The price is computed using the perpetuity formula:

So how do you compute the future

dividends?

Three scenarios:

1. A constant dividend (zero growth)

2. The dividends change by a constant growth rate

3. We have some unusual growth periods and then

level off to a constant growth rate

2 Constant Growth Rate of

Dividends

Dividends are expected to grow at a constant percent per period.

P0 = D1 /(1+R) + D2 /(1+R) 2 + D 3 /(1+R) 3 + … P0 = D0(1+g)/(1+R) + D0(1+g) 2/(1+R)2 + D 0(1+g) 3/(1+R)3 + …

2 Constant Growth Rate of

Dividends

With a little algebra this reduces to:

g -

R

D g

R

-g) 1

(

D

2 Constant Growth Rate of

Dividends

Student caution:

g - R

D g

R

-g) 1

(

D

Dividend Growth Model (DGM)

Assumptions

To use the Dividend Growth Model (aka the Gordon Model), you must meet all three requirements :

1.The growth of all future dividends must be constant ,

2.The growth rate must be smaller than the discount rate ( g

< R), and

3.The growth rate must not be equal to the discount rate (g

≠ R)

DGM – Example 1

Suppose Big D, Inc., just paid a dividend (D0)

of $0.50 per share 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?

DGM – Example 1 Solution

P0 = .50 ( 1 + 02) .15 - 02

P0 = 51 = $3.92

g - R

D g

R

-g) 1

(

D

DGM – Example 2

Suppose Moore Oil Inc., is expected to pay a $2 dividend in one year If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?

DGM – Example 2 Solution

P0 = 2.00 .20 - 05

P0 = 2.00 = $13.34

g - R

D g

R

-g) 1

(

D

So how do you compute the future

dividends?

Three scenarios:

1.A constant dividend (zero growth)

2.The dividends change by a constant growth rate

3.We have some unusual growth periods and then level off to a constant growth rate

3 Unusual Growth;

Then Constant Growth

Just draw the time line with the unusual growth rates identified and determine if/when you can use the Dividend Growth Model

Deal with the unusual growth dividends separately.

Non-constant Growth Problem Statement

Suppose a firm is expected to increase dividends

by 20% in one year and by 15% for two years

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?

Non-constant Growth Problem Statement

Draw the time line and compute each dividend using the corresponding growth rate:

Non-constant Growth Problem Statement

Draw the time line and compute each dividend using the corresponding growth rate:

Non-constant Growth Problem Statement

Draw the time line and compute each dividend using the corresponding growth rate:

Non-constant Growth Problem Statement

Draw the time line and compute each dividend using the corresponding growth rate:

Non-constant Growth Problem Statement

Now we can use the DGM starting with the period of the constant growth rate at our time frame of year 3:

Non-constant Growth Problem Statement

Now we can use the DGM starting with the period of the constant growth rate at our time frame of year 3:

Non-constant Growth Problem Statement

We now have all of the dividends accounted for and we can compute the present value for a share of common stock:

Non-constant Growth Problem Statement

Stock Price Sensitivity to Dividend

Growth, gD1 = $2; R = 20%

0 50 100 150 200 250

Stock Price Sensitivity to Required

Return, RD1 = $2; g = 5%

50 100 150 200 250

Using the DGM to Find R

Start with the DGM and then algebraically rearrange the equation to solve for R:

g P

D g

P

g) 1

(

D R

g - R

D g

R

-g) 1

(

D P

1 0

1

0 0

+

= +

+

=

= +

=

Finding the Required Return -

Stock Valuation Alternative

But my company doesn’t pay dividends!

How can I value the stock?

Valuation Using Multiples

We can use the PE ratio and/or the sales ratio:

price-Pt = Benchmark PE ratio X EPSt

Pt = Benchmark price-sales ratio X Sales per sharet

Stock Valuation Summary

Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation

• Features of Common Stock

• Features of Preferred Stock

• The Stock Markets

Features of Common Stock

• Voting Rights

• Proxy voting

• Classes of stock

Features of Common 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

Dividend Characteristics

• 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

Dividend Characteristics

Dividends and Taxes

• Dividend payments are not considered

a business expense; therefore, they are not tax deductible

• The taxation of dividends received by individuals

depends on the holding period

• Dividends received by corporations have a minimum

Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation

• Features of Common Stock

• Features of Preferred Stock

• The Stock Markets

Features of Preferred Stock

Features of Preferred Stock

Dividends

• Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid

Features of Preferred Stock

• Preferred stock generally does not carry voting rights

Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation

• Features of Common Stock

• Features of Preferred Stock

• The Stock Markets

Stock Market, Dealers vs Brokers

Dealer : trades with inventory for bid and ask prices

Broker : matches buyers and sellers for a fee

Stock Market

• New York Stock Exchange (NYSE)

• Largest stock market

• Not a physical exchange – it is a computer-based quotation system

• Multiple market makers

• Electronic Communications Networks

• Level 1 – median quotes, registered representatives

• Level 2 – view quotes, brokers & dealers

• Level 3 – view and update quotes, dealers only

each day on NASDAQ

Work the Web

• Electronic Communications Networks provide trading in NASDAQ securities

• Click on the web surfer and visit Instinet

Reading Stock Quotes

Work the Web

• Click on the web surfer to go to Bloomberg for current stock quotes.

Ethics Issues

 The status of pension funding (i.e., over- vs under-funded) depends

heavily on the choice of a discount rate When actuaries are choosing the appropriate rate, should they give greater priority to future

pension recipients, management, or shareholders ?

 How has the increasing availability and use of the internet impacted

the ability of stock traders to act unethically?

Quick Quiz

 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%?

 What if the company starts increasing dividends by 3% per year,

beginning with the next dividend? The required return stays at 15%.

Comprehensive Problem

 XYZ stock currently sells for $50 per share The next expected annual

dividend is $2, and the growth rate is 6% What is the expected rate of return on this stock?

 If the required rate of return on this stock were 12%, what would the

stock price be, and what would the dividend yield be?

Stock Market – NYSE

Electronic Exchange – NASDAQ

P0 = D R

Value of a Perpetuity:

Value of a Share of Common Stock using the DGM:

g

D g

g) 1

(

D R

g - R

D g

R

-g) 1

(

D P

10

1

00

+

= +

+

=

= +

=

Value of a Share of Common Stock

using Multiples

Pt = Benchmark PE ratio X EPSt

Pt = Benchmark price-sales ratio X Sales per sharet

Key Concepts and Skills

• Compute the future dividend stream based on dividend growth

• Use the Dividend Growth Model (DGM) to

determine the price of stock

• Explain how stock markets work

• Describe the workings of a stock exchange

1. A stock’s value is the present value of all

expected future earnings.

2 Computing the future dividends of a stock is the

key to understanding its value

3 Issuing stock provides the firm long-term funding

What are the most important topics

of this chapter?

4. The Dividend Growth Model (DGM) provides us

help with infinite dividend streams

5 Stocks are bought and sold each business day

with reporting via stock quotes

What are the most important topics of this chapter?

Questions?