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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 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. 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 Expected Rate of Return on Preferred Just adjust the valuation model: kps = D Po Example If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: Example kps If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: D = Po 4.125 = = 40 Example kps If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: D = Po 4.125 = = .1031 40 The Financial Pages: Preferred Stocks 52 weeks Yld Vol Hi Lo Sym Div % PE 100s 2788 2506 GM pfG 2.28 8.9 … 86 Close 25 53 Dividend: $2.28 on $25 par value = 9.12% dividend rate. Expected return: 2.28 / 25.53 = 8.9%. 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. Advantages of Financing with Stock: No required fixed payments. No maturity. Improves debt ratio, coverage. 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. 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? 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? ? 5.50 + 120 0 1 Common Stock Valuation (Single Holding Period) Solution: Vcs = (5.50/1.15) + (120/1.15) = 4.783 + 104.348 = $109.13 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 The Financial Pages: Common Stocks 52 weeks Hi Lo Sym 126 87 IBM Div .56 63 42 WalMart .28 Yld Vol Net % PE 100s Close Chg 0.6 23 77995 98.12 +0.29 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 Stock Valuation Multiple Holding Periods Stock Value = PV of Future Expected Dividends D3 D1 D2 D Vcs ... 1 2 3 1 kcs 1 kcs 1 kcs 1 kcs 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) 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 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. Our Task: Valuation Estimates What should be each analyst’s estimated value of Doh! Doughnuts? 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 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 = V cs = D0(1+g) = kcs – g D0 (1 + g ) k cs - g D1 kcs – g = D 1 k cs - g 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 2nd Analyst: Constant Growth in Dividends Current Dividend = $2 Projected Constant Growth Rate = 8% or 0.08 Kcs = 10.3% What happens if g > kcs? D1 Vcs requires kcs g. kcs g 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. 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? 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 D1 $2.16 k cs g 8% 2.16% 8% 10.16% P0 $100 ^ DOH! Doh! Doughnuts 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 The Effect On the Stock Price Return SML 1.75 0.9 Beta 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 “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 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. 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 Finally, the Answer! 0 g = 20% 1 g = 20% 2 g = 20% 3 gc = 8% $2.40 $2.88 PV= P0 10.3%,1 2.17 10.3%,2 2.37 123.51 128.05 = $128.05 = P0 $3.46 Fin’l Calculator $162.28 = P3 Solution: $165.74 CF0=0,C01= 2.40 C02 = 2.88 10.3%,3 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 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 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)