Chapter 3 Stock Valuation

7/27/2019 Chapter 3 Stock Valuation

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Chapter 3STOCK VALUATION


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Key Differences Between Debt &Equity

TYPE OF CAPITAL

DEBT EQUITYVoice in Management No Yes

Claims on Income & Assets Senior to Equity Subordinate to DebtMaturity Stated None


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The Nature of Equity Capital:Voice in Management

Unlike bondholders and other creditholders, holders of equity capital areowners of the firm.

Common equity holders have votingrightsthat permit them to elect the firmsboard of directors and to vote on specialissues.

Bondholders and preferred stockholdersreceive no such privileges.


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The Nature of Equity Capital:Claims on Income & Assets

Equity holders are have a residual claim on thefirms income and assets.

Their claims can not be paid until the claims of

all creditors, including both interest and principlepayments on debt have been satisfied.

Because equity holders are the last to receive

distributions, they expect greater returns tocompensate them for the additional risk theybear.


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The Nature of Equity Capital:Maturity

Unlike debt, equity capital is a permanentform of financing.

Equity has no maturity date and never hasto be repaid by the firm.


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Common Stock

Common stockholders, who are sometimesreferred to as residual owners orresidualclaimants, are the true owners of the firm.

As residual owners, common stockholdersreceive what is leftthe residualafter all otherclaims on the firms income and assets havebeen satisfied.

Because of this uncertain position, commonstockholders expect to be compensated withadequate dividends and ultimately, capital gains.


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Common Stock: Ownership

The common stock of a firm can be privatelyowned by an individual, closely owned by asmall group of investors, orpublicly owned bya broad group of investors.

Typically, small corporations are privately orclosely owned and if their shares are traded, thisoccurs infrequently and in small amounts.

Large corporations are typically publicly ownedand have shares that are actively traded onmajor securities exchanges.


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Common Stock: Preemptive Rights

A preemptive right allows commonstockholders to maintain their proportionateownership in a corporation when new shares areissued.

This allows existing shareholders to maintainvoting control and protect against the dilutionof their ownership.

In a rights offering, the firm grants rights to itsexisting shareholders, which permits them topurchase additional shares at a price below thecurrent price.


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Common Stock: Authorized,Outstanding, and Issued Shares

Authorized shares are the number of shares ofcommon stock that a firms corporate charterallows.

Outstanding shares are the number of sharesof common stock held by the public.

Treasury stock is the number of outstandingshares that have been purchased by the firm.

Issued shares are the number of shares thathave been put into circulation and includes bothoutstanding shares and treasury stock.


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Common Stock: Voting Rights

Each share of common stock entitles its holder toone vote in the election ofdirectors and on specialissues.

Votes are generally assignable and may be cast atthe annual stockholders meeting.

Many firms have issued two or more classes ofstock differing mainly in having unequal voting

rights. Usually, class A common stock is designated as

nonvoting while class B is designated as voting.


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Common Stock: Voting Rights(cont.)

Because most shareholders do not attendthe annual meeting to vote, they may signa proxy statement giving their votes to

another party.

Occasionally, when the firm is widelyowned, outsiders may wage a proxybattle to unseat existing management andgain control.


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Common Stock: Dividends

Payment ofdividends is at the discretion of theboard of directors.

Dividends may be made in cash, additional

shares of stock, and even merchandise. Because stockholders are residual claimants

they receive dividend payments only after allclaims have been settled with the government,creditors, and preferred stockholders.


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Preferred Stock

Preferred stock is an equity instrument thatusually pays a fixed dividend and has a priorclaim on the firms earnings and assets in caseof liquidation.

The dividend is expressed as either a dollaramount or as a percentage of its par value.

Therefore, unlike common stock a preferred

stocks par value may have real significance. If a firm fails to pay a preferred stock dividend,the dividend is said to be in arrears.


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Preferred Stock (cont.)

In general, and arrearage must be paid before commonstockholders receive a dividend.

Preferred stocks which possess this characteristic arecalled cumulative preferred stocks.

Preferred stocks are also often referred to as hybridsecurities because they possess the characteristics ofboth common stocks and bonds.

Preferred stocks are like common stock because they

are perpetual securities with no maturity date.


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Preferred Stock (cont.)

Preferred stocks are like bonds because they arefixed income securities. Dividends never change.

Because preferred stocks are perpetual, many havecall features which give the issuing firm the option

to retire them should the need or advantage arise. In addition, some preferred stocks have mandatorysinking funds which allow the firm to retire theissue over time.

Finally, participating preferred stock allows

preferred stockholders to participate with commonstockholders in the receipt of dividends beyond aspecified amount.


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Common Stock Valuation

Stockholders expect to be compensated for theirinvestment in a firms shares through periodicdividends and capital gains.

Investors purchase shares when they feel theyare undervalued and sell them when theybelieve they are overvalued.

This section describes specific stock valuationtechniques after first discussing the concept ofmarket efficiency.


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Common Stock Valuation:Market Efficiency

Investors base their investment decisionson their perceptions of an assets risk.

In competitive markets, the interaction of

many buyers and sellers results in anequilibrium pricethe market valueforeach security.

This price is reflective of all informationavailable to market participants in makingbuy or sell investment decisions.


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Common Stock Valuation: MarketAdjustment to New Information

The process of market adjustment to new informationcan be viewed in terms ofrates of return.

Whenever investors find that the expected return is not

equal to the required return, price adjustment willoccur.

Ifexpected return is greater than required return,investors will buy and bid up price until new

equilibrium price is reached. The opposite would occur if required return is greater

than expected return.


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COMMON STOCK

VALUATION


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Stock Valuation Models:The Basic Stock Valuation Equation

Single-Period P0= D1 + P1

(1 + rs) (1 + rs)

Where:

P0= value of common stock

P1= market priceD1= year 1 dividend

rs= required return on common stock


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How to calculate D1

D1= D0(1+g)

Where:

D0= dividend received in year 0

G = growth rate


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Example

Suppose an investor is contemplating thepurchase of CPQ common stock at the

beginning of this year. The dividend atyear end is expected to be RM0.60, andthe market price by the end of the year isprojected to be RM3.00. If the investorsrequired rate of return is 6%, the value ofthe security would be


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P0 = RM0.60 + RM3.00

(1 + 0.06) (1 + 0.06)

= RM3.40

St k V l ti M d l


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Stock Valuation Models:The Basic Stock Valuation Equation

Multiple Holding Period


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Stock Valuation Models:The Zero Growth Model

The zero dividend growth modelassumes that the stock will pay the samedividend each year, year after year.

P0 = D1 / rs


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Stock Valuation Models:The Zero Growth Model (cont.)

The dividend of Denham Company, an established textile

manufacturer, is expected to remain constant at $3 per

share indefinitely. What is the value of Denhams stock

if the required return demanded by investors is 15%?

P0 = $3/0.15 = $20

Note that the zero growth model is also theappropriate valuation technique for valuingpreferred stock.


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Stock Valuation Models:Constant Growth Model

The constant dividend growth modelassumes that the stock will pay dividendsthat grow at a constant rate each year

year after year forever.


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Stock Valuation Models:Constant Growth Model (cont.)

Lamar Company, a small cosmetics

company, paid the following per share

dividends:


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Growth?

Using Table A-1 & A-2 and time valuetechniques, we can determine that the growthin dividends is 7%.

$1.40 /$1.00 = 1.400; refer to Table A-1 (n=5;

factor 1.400). Growth is 7%

$1.00 /$1.40 = 0.7142; refer to Table A-2 (n=5;

factor 0.7142). Growth is 7%


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P0 = $1.50/(0.15 0.07) = $18.75

Assuming the values of D1, rs, and g areaccurately estimated, Lamar Companysstock value is $18.75 per share.


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Growth based on ROE & retentionrate

If XYZ Bhd's ROE is 16% and themanagement plans to retain 60% of earningsfor investment purposes, what will be the firm's

growth rate?

g = return on equ i ty X retent ion rate

= 16% x 60%

= 9.6%

E t d R t f R t


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Expected Rate of Return on aConstant Growth Stock

Stock Returns are derived from both dividends andcapital gains, where the capital gain results fromthe appreciation of the stocks market price due

to the growth in the firms earnings.Mathematically, the expected return may beexpressed as follows:

Expected rate of return = (D1/P0) + g


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Channel Inc. currently pays $2.00 per sharein common stock dividends. The firms

dividends are expected to grow at a constantrate of 5% per year to infinity. The currentmarket price of the stock is $2.10. Calculate

the expected rate of return for this stock.

Expected rate of return = ($2.00/$2.10) + 0.05

= 10%


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Stock Valuation Models:Variable-Growth Model

The non-constant dividend growth

orvariable-growth or supernormal-growth model assumes that the stock

will pay dividends that grow at one rate

during one period, and at another rate

in another year or thereafter.


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We will use a four-step procedure to

estimate the value of a share ofstock assuming that a single shift in

growth rates occurs at the end of

year N.

We will use g1 to represent the initial

growth rate and g2 to represent thegrowth rate after the shift.


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Stock Valuation Models:Variable-Growth Model (cont.)

Step 1. Find the value of the cash dividends

at the end of each year, Dt, during the

initial growth period, years 1 though N.


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Step 2. Find the present value of the

dividends expected during the initial

growth period.

Stock Valuation Models:


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Step 3. Find the value of the stock at the end ofthe initial growth period, PN = (DN+1)/(rs-g2),

which is the present value of all dividends

expected from year N+1 to infinity, assuming aconstant dividend growth rate, g2.

St k V l ti M d l


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Step 4. Add the present value componentsfound in Steps 2 and 3 to find the value of

the stock, P0, given in Equation 7.6.

Stock Valuation Models:


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The most recent annual (2009) dividend payment of

Warren Industries, a rapidly growing boat

manufacturer, was $1.50 per share. The firms

financial manager expects that these dividends willincrease at a 10% annual rate, g1, over the next

three years. At the end of three years (the end of

2012), the firms mature is expected to result in aslowing of the dividend growth rate to 5% per year,

g2, for the foreseeable future. The firms required

return, rs, is 15%.


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Steps 1 and 2. See table below.

Calculation of Present Value of Warren

Industries Dividends (20102012)


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Step 3. The value of the stock at the end of the

initial growth period (N = 2012) can be found by

first calculating DN+1 = D2013.

D2013 = D2012 X (1 + 0.05) = $2.00 X (1.05) = $2.10

By using D2013 = $2.10, a 15% required return,

and a 5% dividend growth rate, we can calculate

the value of the stock, P2012, at the end of 2012 asfollows:

P2012 = D2013 / (rs-g2) = $2.10 / (.15 - .05) = $21.00


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Step 3 (continued). Finally, in Step 3, the

share value of $21 at the end of 2012

must be converted into a present (end of2009) value.

= PVIF15%,3 X P2012= 0.658 X $21.00= $13.82


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Step 4. Adding the PV of the initial

dividend stream (found in Step 2) to the

PV of the stock at the end of the initial

growth period (found in Step 3), we get:

P2009 = $4.14 + $13.82

= $17.96 per share


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This example can be summarized using

the time line below:

f f


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Features of preferred stock

1. Owners of preferred stock receive

dividends instead of interest.

2.Most preferred stocks are perpetuities

(non-maturing).

3.Multiple classes, each having differentcharacteristics, can be issued.

4.Preferred stock has priority over commonstock with regard to claims on assets inthe case of bankruptcy.


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5. Most preferred stock carries acumulative feature that requires all past

unpaid preferred stock dividends to bepaid before any common stock dividendsare declared.

6.Preferred stock may contain otherprotective provisions.

7. Preferred stock contains provisions toconvert to a predetermined number ofshares of common stock.


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8. Retirement features for preferredstock are frequently included.

a.Callable preferred refers to a featurewhich allows preferred stock to be

called or retired, like a bond.

b. A sinking fund provision requires thefirm periodically to set aside anamount of money for the retirement ofits preferred stock.


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Preferred Stock Valuation

The value of a preferred stock equals thepresent value of all future dividends. If thestock is nonmaturing, where dividends are

expected in equal amount each year inperpetuity, the value may be calculated asfollows:

Vps = Annual dividend / required rate of

return

= D / Kps


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Example

United Electric & Power Co. has an issue ofpreferred stock outstanding that pays a yearlydividend of $5.40. Investors require a 12%return on this preferred stock. What is theintrinsic value for this preferred stock?

Vps = D / Kps

= $5.40/ 0.12

= $45.00

E d R f R


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Expected Rate of Return on aPreferred Stock

If the present market price of preferredstock is $5.00 and it pays $0.30 dividend,the expected rate of return implicit in the

present market price is;

= D/Vps

= $0.30/$5.00

= 6%

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Chapter 3 Stock Valuation