Stock Valuation

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  • 1. Stock Valuation Corporate Finance Dr. A. DeMaskey
  • 2. Learning Objectives
    • Questions to be answered:
      • What are the rights and privileges of stock ownership?
      • What types of common stock exist?
      • How can stock market transactions be classified?
      • How are stocks valued?
      • What is the total return on stocks?
      • What does stock market equilibrium mean and how is it established?
      • What is preferred stock and how is it valued?
  • 3. Facts About Common Stock
    • Represents ownership.
    • Ownership implies control.
    • Stockholders elect directors.
    • Directors hire management.
    • Management’s goal: Maximize stock price.
  • 4. Basics of Common Stock
    • Preemptive Right
      • Right to purchase new shares in proportion to current holdings.
    • Classified Stock
      • Founders’ shares, with voting rights but dividend restrictions.
      • New shares might be called “Class A” shares, with voting restrictions but full dividend rights.
  • 5. The Market for Common Stock
    • Secondary Market
    • Primary Market
    • Initial Public Offering (IPO) Market
  • 6. The Dividend Valuation Model
    • Stock Value = PV of Expected Dividends
  • 7. Return on Stocks
    • Total return = Dividend yield + Capital gains yield
      • Dividend yield = D 1 /P 0
      • Capital gains yield = (P 1 – P 0 )/P 0
    • If dividends are paid quarterly, the annual return is
      • (1 + quarterly return) 4 – 1.0
  • 8. Zero Growth Model
    • Dividends are not expected to grow over time.
    • Value of a zero growth stock:
    • The expected rate of return:
  • 9. Constant Growth Model
    • Dividends are expected to grow at some normal, or constant rate forever.
    • For a constant growth stock,
    • D t = D 0 (1 + g) t
    • If g is constant, then
  • 10. $ 0.25 Years (t) 0
  • 11.
    • If k s < g, get negative stock price, which is nonsense.
    • 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 .
    What happens if g > k s ?
  • 12. Growth Rate of Dividends
    • The growth rate, g, can be stated in terms of the dividend payout ratio:
      • The greater k s , the higher the expected growth rate of dividends.
      • The greater the dividend payout ratio, the lower the expected growth rate of dividends.
  • 13. Total Expected Return on a Constant Growth Stock
    • Rearrange the constant growth model to rate of return form:
  • 14. Nonconstant Growth Model
    • Find the present value of the dividends during the period of non-constant growth.
    • 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.
    • Add these two components to find the stock’s present value.
    • P 0 = PV of DIV during constant growth period +
    • PV of DIV after the constant growth period to
    • infinity
  • 15. Summary of Dividend Valuation Model
    • The greater the current dividend, the grater the value of a share of stock.
    • The greater the expected growth in dividends, the greater the value of a share of stock.
    • The greater the uncertainty of dividends, the greater the discount rate and the lower the value of a share of stock.
  • 16. Stock Market Equilibrium
    • In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell.
    • The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price.
    ^
  • 17. Stock Market Equilibrium
    • If the expected rate of return is less than the required rate of return, investors will desire to sell the stock.
    • If the expected rate of return is greater than the required rate of return, investors will try to purchase the stock.
    • Only at the equilibrium price, where the expected returns and the required returns are equal, will the stock be stable.
    k s = D 1 /P 0 + g = k s = k RF + (k M - k RF )b. ^
  • 18. How is stock market equilibrium established?
    • If k s = (D 1 /P 0 ) + g > k s , then P 0 is “too low.”
    • If the price is lower than the fundamental value, then the stock is a “bargain.”
    • Buy orders will exceed sell orders, the price will be bid up, and D 1 /P 0 falls until
    • D 1 /P 0 + g = k s = k s .
    ^ ^ ^
  • 19. Why do stock prices change?
    • k i = k RF + (k M - k RF )b i could change
      • Inflation expectations
      • Risk aversion
      • Company risk
    • g could change
    ^
  • 20. Preferred Stock
    • Hybrid security.
    • Similar to bonds in that 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.
  • 21. Valuation of Preferred Stock
    • The value of preferred stock is found as:
      • The greater the preferred dividend, the greater the value of a share of preferred stock.
      • The greater the required rate of return, the lower the value of preferred stock.