Stock Valuation


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  • Stock Valuation

    1. 1. Stock Valuation Corporate Finance Dr. A. DeMaskey
    2. 2. Learning Objectives <ul><li>Questions to be answered: </li></ul><ul><ul><li>What are the rights and privileges of stock ownership? </li></ul></ul><ul><ul><li>What types of common stock exist? </li></ul></ul><ul><ul><li>How can stock market transactions be classified? </li></ul></ul><ul><ul><li>How are stocks valued? </li></ul></ul><ul><ul><li>What is the total return on stocks? </li></ul></ul><ul><ul><li>What does stock market equilibrium mean and how is it established? </li></ul></ul><ul><ul><li>What is preferred stock and how is it valued? </li></ul></ul>
    3. 3. Facts About Common Stock <ul><li>Represents ownership. </li></ul><ul><li>Ownership implies control. </li></ul><ul><li>Stockholders elect directors. </li></ul><ul><li>Directors hire management. </li></ul><ul><li>Management’s goal: Maximize stock price. </li></ul>
    4. 4. Basics of Common Stock <ul><li>Preemptive Right </li></ul><ul><ul><li>Right to purchase new shares in proportion to current holdings. </li></ul></ul><ul><li>Classified Stock </li></ul><ul><ul><li>Founders’ shares, with voting rights but dividend restrictions. </li></ul></ul><ul><ul><li>New shares might be called “Class A” shares, with voting restrictions but full dividend rights. </li></ul></ul>
    5. 5. The Market for Common Stock <ul><li>Secondary Market </li></ul><ul><li>Primary Market </li></ul><ul><li>Initial Public Offering (IPO) Market </li></ul>
    6. 6. The Dividend Valuation Model <ul><li>Stock Value = PV of Expected Dividends </li></ul>
    7. 7. Return on Stocks <ul><li>Total return = Dividend yield + Capital gains yield </li></ul><ul><ul><li>Dividend yield = D 1 /P 0 </li></ul></ul><ul><ul><li>Capital gains yield = (P 1 – P 0 )/P 0 </li></ul></ul><ul><li>If dividends are paid quarterly, the annual return is </li></ul><ul><ul><li>(1 + quarterly return) 4 – 1.0 </li></ul></ul>
    8. 8. Zero Growth Model <ul><li>Dividends are not expected to grow over time. </li></ul><ul><li>Value of a zero growth stock: </li></ul><ul><li>The expected rate of return: </li></ul>
    9. 9. Constant Growth Model <ul><li>Dividends are expected to grow at some normal, or constant rate forever. </li></ul><ul><li>For a constant growth stock, </li></ul><ul><li>D t = D 0 (1 + g) t </li></ul><ul><li>If g is constant, then </li></ul>
    10. 10. $ 0.25 Years (t) 0
    11. 11. <ul><li>If k s < g, get negative stock price, which is nonsense. </li></ul><ul><li>We cannot use the model unless (1) g  k s and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be  k s . </li></ul>What happens if g > k s ?
    12. 12. Growth Rate of Dividends <ul><li>The growth rate, g, can be stated in terms of the dividend payout ratio: </li></ul><ul><ul><li>The greater k s , the higher the expected growth rate of dividends. </li></ul></ul><ul><ul><li>The greater the dividend payout ratio, the lower the expected growth rate of dividends. </li></ul></ul>
    13. 13. Total Expected Return on a Constant Growth Stock <ul><li>Rearrange the constant growth model to rate of return form: </li></ul>
    14. 14. Nonconstant Growth Model <ul><li>Find the present value of the dividends during the period of non-constant growth. </li></ul><ul><li>Find the price of the stock at the end of the non-constant growth period, at which point it has become a constant growth stock, and discount this price back to the present. </li></ul><ul><li>Add these two components to find the stock’s present value. </li></ul><ul><li>P 0 = PV of DIV during constant growth period + </li></ul><ul><li>PV of DIV after the constant growth period to </li></ul><ul><li> infinity </li></ul>
    15. 15. Summary of Dividend Valuation Model <ul><li>The greater the current dividend, the grater the value of a share of stock. </li></ul><ul><li>The greater the expected growth in dividends, the greater the value of a share of stock. </li></ul><ul><li>The greater the uncertainty of dividends, the greater the discount rate and the lower the value of a share of stock. </li></ul>
    16. 16. Stock Market Equilibrium <ul><li>In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. </li></ul><ul><li>The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. </li></ul>^
    17. 17. Stock Market Equilibrium <ul><li>If the expected rate of return is less than the required rate of return, investors will desire to sell the stock. </li></ul><ul><li>If the expected rate of return is greater than the required rate of return, investors will try to purchase the stock. </li></ul><ul><li>Only at the equilibrium price, where the expected returns and the required returns are equal, will the stock be stable. </li></ul>k s = D 1 /P 0 + g = k s = k RF + (k M - k RF )b. ^
    18. 18. How is stock market equilibrium established? <ul><li>If k s = (D 1 /P 0 ) + g > k s , then P 0 is “too low.” </li></ul><ul><li>If the price is lower than the fundamental value, then the stock is a “bargain.” </li></ul><ul><li>Buy orders will exceed sell orders, the price will be bid up, and D 1 /P 0 falls until </li></ul><ul><li>D 1 /P 0 + g = k s = k s . </li></ul>^ ^ ^
    19. 19. Why do stock prices change? <ul><li>k i = k RF + (k M - k RF )b i could change </li></ul><ul><ul><li>Inflation expectations </li></ul></ul><ul><ul><li>Risk aversion </li></ul></ul><ul><ul><li>Company risk </li></ul></ul><ul><li>g could change </li></ul>^
    20. 20. Preferred Stock <ul><li>Hybrid security. </li></ul><ul><li>Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. </li></ul><ul><li>However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy. </li></ul>
    21. 21. Valuation of Preferred Stock <ul><li>The value of preferred stock is found as: </li></ul><ul><ul><li>The greater the preferred dividend, the greater the value of a share of preferred stock. </li></ul></ul><ul><ul><li>The greater the required rate of return, the lower the value of preferred stock. </li></ul></ul>