FIN 360: Corporate Finance

1. FIN 360: Corporate Finance Topics 10: Stocks and their Valuation Larry Schrenk, Instructor

2. Stock Valuation • Stock Basics • Valuing Common Stock • Valuing Preferred Stock • ‘Implied’ Required Rate of Return

3. Stock Basics

4. Common Equity • Dividends • Required Rate of Return • Ownership • Residual Status • Absolute Priority Rule

5. Preferred Shares (PS) Features • Dividend (d) • Two Types of Dividends • Required Rate of Return • History • Uses

6. Common Stock:Owners, Directors, and Managers Represents Ownership Ownership Implies Control Stockholders Elect Directors Directors Hire Management Since Managers are ‘Agents’ of Shareholders, their Goal Should Be: Maximize Stock Price

7. Ownership of Common Stock • Mostly owned (70%) by institutional investors • Institutional investors include: • Pension Plan Funds (CALPERS) • Insurance Companies • Mutual Funds • Hedge Funds

8. Pros of Equity Financing • No obligation to pay dividends. • Risk averse management doesn’t like debt • Reduces financial risk (e.g. total debt ratio) • This may be a more important advantage to firms that already are relatively risky due to the kind of business they do (e.g. high tech has high business risk)

9. Cons of Equity Financing • Dilution of ownership and power due to more shares of stock outstanding. • Lower earnings per share/stock price • More work than debt offering • Flotation costs (expensive) • Fees paid to investment bankers, lawyers, accountants, printers • Usually much higher than for debt issues.

10. Comparison

11. Valuing Common Stock

12. Valuing Common Stock • Methods • Discounted Dividend Model (DDM) • P/E Ratio Methodologies • Other Ratio Methodologies • Capital Asset Pricing Model (CAPM) • Relative Valuation • Free Cash Flow

13. Stock Valuation Issues • Stock cash flows are less certain than that of bond cash flows because: • Bond cash flows are fixed and defined by contract • Whereas stock cash flows are: • Dividends: residual and determined by the Board of Director’s vote • Proceeds from sale of stock: Not guaranteed • Difficulties in Stock Valuation: • Dividend cash flows are not known in advance • Life of stock is essentially forever • No easy way to observe the rate of return required for a stock

14. Discounted Dividend Model (DDM)

15. Capital Gains vs. Dividends▪

16. Discounted Dividend Model (DDM) • Motivation • Dividends are the cash flows derived from common stock. • The price is the present value of cash flows. • Thus, the price of a common share should be the present value of its dividends • Problems • Dividends (especially far future ones) are not easily estimated.

17. Discounted Dividend Model (DDM) • Constant Model • Dividends remain constant • Growth Model • Dividends change at a constant rate • Mixed Model • Dividends change at different rates.

18. Constant Model • If dividend is constant, then stock is a perpetuity.

19. Constant Model • If a stock is always expected to pay an annual dividend of $4.00 and r = 7%, then

20. Growth Model • If dividend is changing at a constant rate, then stock is a growing perpetuity.

21. Growth Model • If a stock has just paid an annual dividend of $4.00, and the dividend is expected to increase (infinitely) at 2% (r = 7%), then

22. Growth Model • The same methodology applies if the dividend is expected to decline. • If a stock has just paid an annual dividend of $4.00, and the dividend is expected to decrease (infinitely) at 2% (r = 7%), then

23. Mixed Model • Both patterns possible, • but not likely to apply to very many firms. • Generally, expect the firm’s dividend to change at different rates over time. • A high growth firm might increase is cash flows at 30% for a few years, but this could not be sustained for any extended period.

24. Mixed Model Problem • Estimate year-by-year dividends for an extended period, e.g., ten years, • this would become a pure, unfounded guess at values. • What will the dividend be for IBM 8 years from now?

25. Mixed Model Strategy • To alleviate this problem, we divide the forecast of dividends into two periods: • Short Term Prediction/Horizon • Long Term Prediction/Horizon Short Term Long Term 0 1 2 3 t d0 d1 d2 d3 dt

26. Mixed Model: Short Term • Period over which we can reasonably estimate the expected dividends: • As specific dollar amounts, or • E.g., $4.00 $4.15 $4.25 $4.90 • As subject to some growth forecast • E.g., $4.00 growing at 10% for 4 years • Dividend ‘Smoothing’

27. Mixed Model: Long Term • Period over which we cannot predict dividends. • We cannot ignore the long term, • For many firms the long term provides much of the value of the firm. • NOTE: The more value is derived from the future, the harder to use the DDM as a method.

28. The Long Term Solution • Estimate the long term dividends as growing at a reasonable, constant growth rate. • Estimate as growing perpetuity. • Infinite growth rate cannot be very large. • One good estimate is the long term growth for the economy, perhaps 3 or 4%.

29. Calculations • Value of the short term dividends is PV of the individual dividends. 2) Value of the long term dividends is a delayed growing perpetuity. • NOTE: It is a delayed growing perpetuity because the long term dividends do not begin until after the short term dividends end. 3) Stock price = PVshort term + PVlong term

30. Mixed Model Example • EXAMPLE • A firm has just paid an annual dividend of $2.00. That dividend is expected to grow at a rate of 30% for one year, 20% for the next two years, then level off to a long term growth rate of 3%. If the discount rate is 12%, what should be the price of the stock?

31. Mixed Model Example • Data: • d0 = 2 • g1 = 30% • g2-3 = 20% • g4+ = 3% • r = 12%

32. Mixed Model Example • Data • d0 = 2; g1 = 30%; g2-3 = 20%; g4+ = 3%; r = 12% • Dividends Calculation d1 = 2(1.30) = 2.60 d2 = 2(1.30)(1.20) = 3.12 d3 = 2(1.30)(1.20)2 = 3.74 d4 = 2(1.30)(1.20)2 (1.03) = 3.85 etc.

33. Mixed Model Example • The Timeline Short Term Long Term 0 1 2 3 4 d0 d1 d2 d3 d4 2.00 2.60 3.12 3.74 3.85

34. Mixed Model Example • EXAMPLE • Data: d0 = 2; g1 = 30%; g2-3 = 20%; g4+ = 3%; r = 12% • Short Term d1 = 2.60 d2 = 3.12 d3 = 3.74

35. Mixed Model Example • EXAMPLE • Data: d0 = 2; g1 = 30%; g2-3 = 20%; g4+ = 3%; r = 12% • Long Term d4 = 3.85

36. Mixed Model Example • EXAMPLE • Data: d0 = 2; g1 = 30%; g2-3 = 20%; g4+ = 3%; r = 12% or Short Term Long Term

37. Mixed Model Formula

38. Valuing Preferred Stock

39. Valuing Preferred Stock • Unlike common stock, the cash flows on preferred stock are typically of the form of a perpetuity, so we can use that formula for pricing:

40. Valuing Preferred Stock • EXAMPLE • If a preferred share pays an annual dividend of $3.00 and r = 15%, then

41. The ‘Implied’ Required Rate of Return

42. ‘Implied’ Required Rate of Return • The term ‘implied’ sometimes has a semi-technical meaning. • Recall implied future interest rates • Normally • We use a formula of the form: Price = … to determine the price of an asset. • Then compare the predicted price with the asset’s market value

43. ‘Implied’ Required Rate of Return • An alternative • Use the market price to estimate what the ‘market’ assumes to be one of the ‘implied’ input variables • We have already used this in the YTM of bonds. • Given the market price of a bond, what ‘implied’ discount rate, i.e., YTM • What discount rate must the market apply to arrive at the market price. • YTM is the implied required rate of return on a bond.

44. ‘Implied’ Required Rate of Return • If the stock (common or preferred) is modeled as a (growing) perpetuity, • Solve the equation for i) the ‘implied’ required rate of return or ii) the ‘implied’ growth rate:

45. ‘Implied’ Required Rate of Return • Example • If a share is selling for $75 and it is paying a constant, annual dividend of $6.00, then

46. ‘Implied’ Required Rate of Return • If the stock dividends are not constant, • Then the implied rate of return is internal rate of return (IRR) • The IRR calculation (in a later topic) is analogous to finding the YTM of a bond.