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CHAPTER 7. Stocks, Stock Valuation, and Stock Market Equilibrium Omar Al Nasser, Ph.D. FIN 6352. D 2. D 1. D ∞. Value Stock = + + +. (1 + r s ) 1. (1 + r s ) 2. (1 + r s ) ∞. The Big Picture: The Intrinsic Value of Common Stock. Free cash flow

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Chapter 7

CHAPTER 7

Stocks, Stock Valuation, and

Stock Market Equilibrium

Omar Al Nasser, Ph.D.

FIN 6352


D2

D1

D∞

ValueStock = + + +

(1 + rs )1

(1 + rs)2

(1 + rs)∞

The Big Picture:

The Intrinsic Value of Common Stock

Free cash flow

(FCF)

Dividends (Dt)

...

Firm’s debt/equity mix

Market interest rates

Cost of

equity (rs)

Firm’s business risk

Market risk aversion


Key concepts and skills
Key Concepts and Skills

  • Understand how stock prices depend on future dividends and dividend growth.

  • Be able to compute stock prices using the dividend growth model.

  • Preferred stock


Common stocks
Common Stocks

  • Securities representing equity ownership in a corporation, providing voting rights, and pay the shareholders dividends and/or capital appreciation.

  • In the event of liquidation, common stockholders have rights to a company's assets only after bondholders, other debt holders, and preferred stockholders have been satisfied.


Common stock s facts
Common Stock’s Facts

  • Control of the Firm

    • Represents ownership

    • Ownership implies control

    • Stockholders elect directors

    • Directors elect management

    • Management’s goal: Maximize the stock price

  • Preemptive right

    • This means that common shareholders with preemptive rights have the right but not the obligation to purchase as many new shares of the stock as it would take to maintain their ownership in the company.


Common stock valuation
Common Stock Valuation

  • As with any other security, the first step in valuing common stocks is to determine the expected future cash flows.

  • Finding the present values of these cash flows and adding them together will give us the stock’s value:

  • For a stock, there are two cash flows:

    • The dividend expected each year.

    • The future selling price


One period example
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?

    • Compute the PV of the expected cash flows

    • Price = (14 + 2) / (1.2) = $13.33

    • Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33


Two period example
Two-Period Example

  • Now, what if you decide to hold the stock for two years? In addition to the $2 dividend in one year, you expect a dividend of $2.10 and a stock price of $14.70 both at the end of year 2. Now how much would you be willing to pay?

    • PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

    • Or CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; NPV; I = 20; CPT NPV = 13.33


Three period example
Three-Period Example

  • Finally, what if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 and a stock price of $15.435 both at the end of year 3. Now how much would you be willing to pay?

    • PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33

    • Or CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33


Developing the model
Developing The Model

  • You would find that the price of the stock is really just the present value of all expected future dividends

  • So, how can we estimate all future dividend payments?


Estimating dividends special cases
Estimating Dividends: Special Cases

  • Constant Dividend (zero growth)

    • The firm will pay a constant dividend forever

  • Constant Dividend Growth

    • The firm will increase the dividend by a constant percent every period

  • Supernormal Growth

    • Dividend growth is not consistent initially, but settles down to constant growth eventually


Zero growth
Zero Growth

  • If dividends are expected at regular intervals forever, then the stock price can be valued as

  • P0 = D / RS

  • Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price in one year?

    • P0 = .50 / (.1 / 4) = .50 / .025 = $20


Dividend growth stock

^

D0(1+g)

D1

P0 =

=

rs - g

rs - g

Dividend Growth Stock

If g is constant and less than rs, then:

D1 = D0(1+g)1

D2 = D0(1+g)2

Dt = D0(1+g)t


Projected dividends
Projected Dividends

  • D0 = 2 and constant g = 6%

  • D1 = D0(1+g) = 2(1.06) = 2.12

  • D2 = D1(1+g) = 2.12(1.06) = 2.2472

  • D3 = D2(1+g) = 2.2472(1.06) = 2.3820


Stock value d 0 2 00 r s 13 g 6

^

D0(1+g)

D1

$2.12

$2.12

P0 =

=

= = $30.29.

rs - g

rs - g

0.13 - 0.06

0.07

Stock Value: D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:


Expected value price at the end of year 1

D2

^

$2.2427

P1 =

=

= $32.10

rs - g

0.07

Expected value (price) at the end of year 1:

  • D1 will have been paid, so expected dividends are D2, D3, D4 and so on.


Expected dividend yield and capital gains yield today

D1

$2.12

Dividend yield = = = 7.0%.

P0

$30.29

^

P1 - P0

$32.10 - $30.29

CG Yield = =

P0

$30.29

= 6.0%.

Expected Dividend Yield and Capital Gains Yield (today)

  • Dividend yield: A financial ratio that shows how much a company pays out in dividends each year relative to its share price.

    • It is equal to the expected dividend divided by the current price.

  • Capital gain yield is the capital gain during a given year divided by the current price.


Constant growth model conditions
Constant Growth Model Conditions

  • The expected dividend yield is a constant.

  • The dividend is expected to grow forever at a constant rate, g.

  • The expected capital gains yield is a constant, and it is equal to g.

    • Capital gains yield = 6% = g.

  • The expected stock price is expected to grow at the same rate.


Dgm example 1
DGM – Example 1

  • Suppose Big D, Inc. just paid a dividend of $.50. 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?

  • P0 = .50(1+.02) / (.15 - .02) = $3.92


Dgm example 2
DGM – Example 2

  • Suppose TB Pirates, 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 today?

    • P0 = 2 / (.2 - .05) = $13.33

    • Why isn’t the $2 in the numerator multiplied by (1.05) in this example?

    • Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g


Dgm example 3
DGM – Example 3

  • Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.

  • What is the current price?

    • P0 = 4 / (.16 - .06) = $40

    • Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g


Nonconstant growth problem statement
Nonconstant Growth Problem Statement

  • Suppose a firm is expected to increase dividends by 20% in one year and by 15% in 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?

  • Remember that we have to find the PV of all expected future dividends.


Nonconstant growth example solution
Nonconstant Growth – Example Solution

  • Compute the dividends until growth levels off

    • D1 = 1(1.2) = $1.20

    • D2 = 1.20(1.15) = $1.38

    • D3 = 1.38(1.05) = $1.449

  • Find the expected future price

    • P2 = D3 / (RS – g) = $1.449 / (.2 - .05) = $9.66

  • Use the cash flows in the financial calculator.


Financial calculator solution
Financial Calculator Solution

  • Input in “CFLO” register:

    • CF0 = 0

    • CF1 = 1.2

    • CF2 = 1.38 + 9.66 = 11.04

  • Press NPV, Enter I = 20%, pressing the down arrow, and then computing NPV

  • NPV = 8.6667 (Here NPV = PV.)


Example
Example

  • Lets assume that growth for the company is expected to be 30 percent for the first three years, after which the growth rate is expected to fall to 8 percent forever. The most recent dividend (D0) was $1.15. If the required rate of return, rs, is equal to 13.4%, What is the current price of company's stock?


Nonconstant growth example solution1
Nonconstant Growth – Example Solution

  • Compute the dividends until growth levels off

    • D0 $1.15

    • D1 = 1.15 (1.3) = $1.4950

    • D2 = 1.4950(1.30) = $1.9435

    • D3 = 1.9435 (1.30) = $2.5266

    • D4 = 2.5266 (1.08) = $2.7287

  • Find the expected future price

    • P3 = D4 / (RS – g) = $2.7287 / (13.4% - .8%) =

      $50.5310

  • Use the cash flows in the financial calculator.


Financial calculator solution1
Financial Calculator Solution

  • Input in “CFLO” register:

    • CF0 = 0

    • CF1 = 1.4950

    • CF2 = 1.9435

    • CF3 = 2.5266 + 50.5310 = 53.0576

  • Press NPV, Enter I = 13.4%, pressing the down arrow, and then computing NPV

  • NPV = 39.2135 (Here NPV = PV.)


Nonconstant growth followed by constant growth d 0 2
Nonconstant growth followed by constant growth (D0 = $2):

0

1

2

3

4

rs = 13%

g = 30%

g = 25%

g = 15%

g = 6%

2.6000 3.2500 3.7375 3.9618

2.3009

2.5452

2.5903

$3.9618

^

= $56.5971

P3 =

39.2246

0.13 – 0.06

^

46.6610 = P0


If g 6 would anyone buy the stock if so at what price
If g = -6%, would anyone buy the stock? If so, at what price?

Firm still has earnings and still pays

dividends, so P0 > 0:

^

D0(1 + g)

D1

^

P0 =

=

rs – g

rs – g

$2.00(0.94)

$1.88

= = = $9.89.

0.13 – (-0.06)

0.19


Using the dgm to find r
Using the DGM to Find R price?

  • Start with the DGM:


Finding the required return example
Finding the Required Return - Example price?

  • Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return?

    • R = [$1(1.05)/$10.50] + .05 = 15%

  • What is the dividend yield?

    • $1(1.05) / $10.50 = 10%

  • What is the capital gains yield?

    • g =5%


Comprehensive problem
Comprehensive Problem price?

  • 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 is 12% and the growth rate is 6%, what would be the current stock price, and what would be the dividend yield?


Preferred stock
Preferred Stock price?

  • A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock in the event of liquidation.

  • Similar to bonds in that preferred stocks has a par value and preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock.

  • However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.


Preferred stock1
Preferred Stock price?

  • Preferred stocks pay fixed dividend payments. If the payements last forever, then the value of preferred stocks, Vp , can be found as follows:

    Vp = Dp / rp

  • If the preferred stock pays dividend of $10 per year and if its required rate of return is 10.3%, what is the value of preferred stock??

    Vp = 10/10.3% = $97.09


Expected return given v ps 50 and annual dividend 5

$5 price?

Vps

= $50 =

^

rps

$5

^

rps

= 0.10 = 10.0%

=

$50

Expected return, given Vps = $50 and annual dividend = $5


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