Ch. 8: Stock Valuation

1. Ch. 8: Stock Valuation  2002, Prentice Hall, Inc.

2. Security Valuation • In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

3. Preferred Stock A hybrid security: • it’s like common stock - no fixed maturity.

4. Preferred Stock A hybrid security: • it’s like common stock - no fixed maturity. • technically, it’s part of equity capital.

5. Preferred Stock A hybrid security: • it’s like common stock - no fixed maturity. • technically, it’s part of equity capital. • it’s like debt - preferred dividends are fixed.

6. Preferred Stock A hybrid security: • it’s like common stock - no fixed maturity. • technically, it’s part of equity capital. • it’s like debt - preferred dividends are fixed. • missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

7. Preferred Stock • Usually sold for $25, $50, or $100 per share. • Dividends are fixed either as a dollar amount or as a percentage of par value. • Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. • $4.125 is the fixed, annual dividend per share.

8. Preferred Stock Features • Firms may have multiple classes of preferreds, each with different features. • Priority: lower than debt, higher than common stock. • Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared.

9. Preferred Stock Features • Protective provisions protect preferred stockholders. • Convertibility: many preferreds are convertible into common shares. • Adjustable rate preferreds have dividends tied to interest rates. • Participation: some (very few) preferreds have dividends tied to the firm’s earnings.

10. Preferred Stock Features • PIK Preferred: Pay-in-kind preferred stocks pay additional preferred shares to investors rather than cash dividends. • Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.

11. Preferred Stock Valuation • A preferred stock can usually be valued like a perpetuity:

12. D V = ps k ps Preferred Stock Valuation • A preferred stock can usually be valued like a perpetuity:

13. Example: • Xerox preferred pays an 8.25% dividend on a $50 par value. • Suppose our required rate of return on Xerox preferred is 9.5%.

14. 4.125 V = = ps .095 Example: • Xerox preferred pays an 8.25% dividend on a $50 par value. • Suppose our required rate of return on Xerox preferred is 9.5%.

15. 4.125 V = = $43.42 ps .095 Example: • Xerox preferred pays an 8.25% dividend on a $50 par value. • Suppose our required rate of return on Xerox preferred is 9.5%.

16. Expected Rate of Return on Preferred • Just adjust the valuation model:

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

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

19. 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:

20. 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:

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

22. Common Stock • is a variable-income security. • dividends may be increased or decreased, depending on earnings. • represents equity or ownership. • includes voting rights. • Limited liability: liability is limited to amount of owners’ investment. • Priority: last.

23. Common Stock Characteristics • Claim on Income - a stockholder has a claim on the firm’s residual income. • Claim on Assets - a stockholder has a residual claim on the firm’s assets in case of liquidation. • Preemptive Rights - stockholders may share proportionally in any new stock issues. • Voting Rights - right to vote for the firm’s board of directors.

24. 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?

25. ? 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?

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

27. The Financial Pages:Common Stocks 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 135 80 IBM .52 .5 21 142349 99 93 9496 -343 82 18 CiscoSys … 47 1189057 21 19 2025 -113

28. Common Stock Valuation • As said before, value of a stock is the present value of future cash flows. I f a stock is expected to pay $1.00 dividend at the end of this year, $2.00 next year and $2.50 in the third year. You expect to hold the stock for three years and then expect to sell it for $50. How much will you pay for this if your required rate of return is 10%?

29. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 An investor purchasing stock at time 0 does not get D0

30. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 D1 (1+ kcs ) D2 (1+ kcs )2 D3 (1+ kcs )3 DN (1+ kcs )N Vcs = + + +···+

31. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 D1 (1+ kcs ) D2 (1+ kcs )2 D3 (1+ kcs )3 DN (1+ kcs )N Vcs = + + +···+

32. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 D1 (1+ kcs ) D2 (1+ kcs )2 D3 (1+ kcs )3 DN (1+ kcs )N Vcs = + + +···+

33. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 D1 (1+ kcs ) D2 (1+ kcs )2 D3 (1+ kcs )3 D¥ (1+ kcs )¥ Vcs = + + +···+

34. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 D1 (1+ kcs ) D2 (1+ kcs )2 D3 (1+ kcs )3 D¥ (1+ kcs )¥ Vcs = + + +···+ Not like Preferred Stock where: D0 = D1 = D2 = D3 = DN , therefore no longer a Perpetuity

35. 0 1 2 3 ¥ Valuing Common Stock Multiple Holding Periods Vcs = PV of ALL received dividends discounted at investor’s Required Rate of Return D1 D2 D3 D¥ D0 D1 (1+ kcs ) D2 (1+ kcs )2 D3 (1+ kcs )3 D¥ (1+ kcs )¥ Vcs = + + +···+ Investors do not know the values of D1, D2, .... , DN. The future dividends must be estimated.

36. Common Stock Valuation(Multiple Holding Periods • Constant Growth Model • Assumes common stock dividends will grow at a constant rate into the future.

37. D1 kcs - g Vcs = Common Stock Valuation(Multiple Holding Periods) • Constant Growth Model • Assumes common stock dividends will grow at a constant rate into the future.

38. Constant Growth Model • Assumes common stock dividends will grow at a constant rate into the future.

39. D1 kcs - g Vcs = • Constant Growth Model • Assumes common stock dividends will grow at a constant rate into the future.

40. D1 kcs - g Vcs = • Constant Growth Model • Assumes common stock dividends will grow at a constant rate into the future. • D1 = the dividend at the end of period 1. • kcs= the required return on the common stock. • g = the constant, annual dividend growth rate.

41. Example • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

42. Example • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%? D0 = $5, so D1 = 5 (1.10) = $5.50

43. Vcs = Example • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

44. D1 kcs - g Vcs = = Example • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

45. D15.50 kcs - g .15 - .10 Vcs = = = Example • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

46. D1 5.50 kcs - g .15 - .10 Vcs = = = $110 Example • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

47. Expected Return on Common Stock • Just adjust the valuation model

48. D kcs - g Vcs = Expected Return on Common Stock • Just adjust the valuation model

49. D kcs - g Vcs = D1 Vcs k = ( ) + g Expected Return on Common Stock • Just adjust the valuation model

50. D kcs - g Vcs = D1 Po k = ( ) + g Expected Return on Common Stock • Just adjust the valuation model