Successfully reported this slideshow.
We use your LinkedIn profile and activity data to personalize ads and to show you more relevant ads. You can change your ad preferences anytime.

Chapter 7

997 views

Published on

Published in: Business, Economy & Finance
  • Be the first to comment

  • Be the first to like this

Chapter 7

  1. 1. Chapter 7 Equity Markets and Stock Valuation
  2. 2. Key Concepts and Skills <ul><li>Understand how stock prices depend on future dividends and dividend growth </li></ul><ul><li>Be able to compute stock prices using the dividend growth model </li></ul><ul><li>Understand how corporate directors are elected </li></ul><ul><li>Understand how stock markets work </li></ul><ul><li>Understand how stock prices are quoted </li></ul>
  3. 3. Feature of Common Stock <ul><li>Voting Rights </li></ul><ul><li>Proxy voting </li></ul><ul><li>Other Rights </li></ul><ul><ul><li>Share proportionally in declared dividends </li></ul></ul><ul><ul><li>Share proportionally in remaining assets during liquidation </li></ul></ul><ul><ul><li>Preemptive right – first shot at new stock issue to maintain proportional ownership if desired </li></ul></ul>
  4. 4. Dividend Characteristics <ul><li>Firm cannot go bankrupt for not declaring dividends </li></ul><ul><li>Dividends and Taxes </li></ul><ul><ul><li>Dividend payments are not considered a business expense, therefore, they are not tax deductible </li></ul></ul><ul><ul><li>Dividends received by individuals are taxed as ordinary income </li></ul></ul><ul><ul><li>Dividends received by corporations have a minimum 70% exclusion from taxable income </li></ul></ul>
  5. 5. Features of Preferred Stock <ul><li>Dividends </li></ul><ul><ul><li>Stated dividend that must be paid before dividends can be paid to common stockholders </li></ul></ul><ul><ul><li>Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely </li></ul></ul><ul><ul><li>Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid </li></ul></ul><ul><li>Preferred stock generally does not carry voting rights </li></ul>
  6. 6. Stock Markets <ul><li>New York Stock Exchange (NYSE) </li></ul><ul><ul><li>Huge room with electronic “trading posts” </li></ul></ul><ul><ul><li>Each stock assigned to single “specialist” </li></ul></ul><ul><ul><li>Specialists = Employed by exchange to be “market makers” </li></ul></ul><ul><ul><li>Hold inventory of stocks, advertise prices to buy (bid) and sell (ask) at: </li></ul></ul><ul><li>Stock Bid Ask </li></ul><ul><li>YWEE $28.65 $28.75 </li></ul>
  7. 7. Specialists <ul><li> Bid Ask </li></ul><ul><li>YWEE $28.65 $28.75 </li></ul><ul><li>Specialist buys low, sells high </li></ul><ul><li>Specialists buys at $28.65, so you sell at $28.65. </li></ul><ul><li>Specialist sells at $28.75, so you buy at $28.75 </li></ul><ul><li>$28.75 - $28.65 = $0.10 = “spread” </li></ul>
  8. 8. Stock Markets <ul><li>NASDAQ </li></ul><ul><ul><li>Not a physical exchange – computer based quotation system </li></ul></ul><ul><ul><li>National Association of Securities Dealers Automated Quotation </li></ul></ul><ul><ul><li>Multiple dealers acting as “market makers” – Hold inventory of stock, post bid & ask prices </li></ul></ul><ul><ul><li>Large portion of technology stocks </li></ul></ul>
  9. 9. NASDAQ <ul><li>DULL Computers: three dealers </li></ul><ul><li>Joe Bob Englebert </li></ul><ul><li>Bid Ask Bid Ask Bid Ask </li></ul><ul><li>8.00 8.50 7.75 8.25 7.50 8.50 </li></ul><ul><li>NASDAQ reports: Bid Ask 8.00 8.25 </li></ul>
  10. 10. Cash Flows to Stockholders <ul><li>If you buy a share of stock, you can receive cash in two ways </li></ul><ul><ul><li>The company pays dividends </li></ul></ul><ul><ul><li>You sell your shares, either to another investor in the market or back to the company </li></ul></ul><ul><li>Value = PV of expected future CF’s </li></ul>
  11. 11. Estimating Dividends: Special Cases <ul><li>Constant dividend </li></ul><ul><ul><li>The firm will pay a constant dividend forever, like preferred stock </li></ul></ul><ul><ul><li>Perpetuity formula </li></ul></ul><ul><li>Constant dividend growth </li></ul><ul><ul><li>The firm will increase the dividend by a constant percent every period </li></ul></ul><ul><li>Nonconstant growth </li></ul><ul><ul><li>Dividend growth is not consistent initially, but settles down to constant growth eventually </li></ul></ul>
  12. 12. Zero Growth <ul><li>If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity </li></ul><ul><li>P 0 = D / R </li></ul><ul><li>Suppose stock is expected to pay a $2 dividend every year and the required return is 10%. What is the price? </li></ul><ul><ul><li>P 0 = 2 / .1 = $20 </li></ul></ul>
  13. 13. Dividend Growth Model <ul><li>Dividends grow at a constant rate g… </li></ul><ul><li>D1 = D0 * (1 + g) </li></ul><ul><li>D2 = D1 * (1 + g) </li></ul><ul><li> </li></ul><ul><li>D2 = D0 * (1 + g) * (1 + g) = D0 * (1 + g) 2 </li></ul><ul><li>Dt = D0 * (1 + g) t </li></ul><ul><li>D43 = D0 * (1 + g) 43 </li></ul>
  14. 14. Dividend Growth Model (DGM) <ul><li>Dividends are expected to grow at a constant percent per period. </li></ul><ul><ul><li>P 0 = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + … </li></ul></ul><ul><ul><li>P 0 = D 0 (1+g)/(1+R) + D 0 (1+g) 2 /(1+R) 2 + D 0 (1+g) 3 /(1+R) 3 + … </li></ul></ul><ul><li>With a little algebra, this reduces to: </li></ul>
  15. 15. DGM – Example 1 <ul><li>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? </li></ul><ul><li>What variable is $.50? </li></ul><ul><li>P 0 = .50*(1+.02) / (.15 - .02) = $3.92 </li></ul>
  16. 16. DGM – Example 2 <ul><li>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? </li></ul><ul><ul><li>P 0 = 2 / (.2 - .05) = $13.33 </li></ul></ul><ul><ul><li>Why isn’t the $2 in the numerator multiplied by (1.05) in this example? </li></ul></ul>
  17. 17. Example <ul><li>Gordon Growth Company is expected to pay a dividend of $2 next year and dividends are expected to grow at 6% per year. The required return is 15%. </li></ul><ul><li>What is the current price? </li></ul>
  18. 18. Using the DGM to Find R <ul><li>Start with the DGM: </li></ul>
  19. 19. Components of R <ul><li>You can get your R in two forms: </li></ul><ul><ul><li>Dividend yield = D 1 /P 0 </li></ul></ul><ul><ul><li>Capital gains yield = g </li></ul></ul><ul><li>R = D 1 /P 0 + g </li></ul>
  20. 20. Example <ul><li>Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? </li></ul><ul><ul><li>R = $1*(1.05)/$10.50 + .05 = 15% </li></ul></ul><ul><li>What is the dividend yield? </li></ul><ul><ul><li>$1*(1.05)/$10.50 = 10% </li></ul></ul><ul><li>What is the capital gains yield? </li></ul><ul><ul><li>g =5% </li></ul></ul>
  21. 21. Criticisms of P0 = D1  (R – g) <ul><li>Constant g </li></ul><ul><li>g > R  P < 0 </li></ul><ul><li>D1 = 0  P = 0 </li></ul><ul><li>Sensitive to R & g: </li></ul><ul><ul><li>1,2,&3 can be fixed (young firms) </li></ul></ul>
  22. 22. Stock Price Sensitivity to Dividend Growth D 1 = $2; R = 20%
  23. 23. Stock Price Sensitivity to Required Return D 1 = $2; g = 5%
  24. 24. Firms with D1 = $0 <ul><li>Firm expects to pay no divds until year 5 </li></ul><ul><li>That divd expected = $1 </li></ul><ul><li>g = 12%, R = 15% P=? </li></ul><ul><li>Solution: Throw D, R , & g into equation </li></ul>
  25. 25. Firms with D1 = $0 <ul><li>P = $1  (.15 - .12) = $33.33? </li></ul><ul><li>Formula  D1  (R – g) = P0 </li></ul><ul><li>What we did  D5  (R – g) = ???? </li></ul><ul><li>D = always one period ahead of P </li></ul><ul><li>(D5  P4) </li></ul><ul><ul><li>Stock Value = PV (expected divd payments) </li></ul></ul>
  26. 26. Firms with D1 = $0 <ul><li>P4 = $33.33  P0 = ??? </li></ul><ul><li>P4 = FV  P0 = PV </li></ul><ul><li>P0 = PV(P4) @ R% </li></ul><ul><li>4 N, 15 I/YR, 33.33 FV, PV=??? </li></ul><ul><li>P0 = $19.06 </li></ul>
  27. 27. Nonconstant Growth <ul><li>1. Compute PV(dividends that experience nonconstant growth) </li></ul><ul><li>2. Find the P stock the end of the nonconstant growth period, and discount P back to the present </li></ul><ul><li>3. Add these two components to find the value of the stock. </li></ul>
  28. 28. Nonconstant Growth <ul><li>TannerHater.com recently paid a dividend of $1.00. Analysts expect that dividend to grow at 20% annually for 3 years, then grow at 10% indefinitely. If R = 15%, what is the stock’s intrinsic value? </li></ul>
  29. 29. Nonconstant Growth <ul><li>1. Compute PV(dividends that experience nonconstant growth) </li></ul><ul><li>D1 = D0 * (1 + g) = $1.00*1.2 = $1.20 </li></ul><ul><li>D2 = D1 * (1 + g) = $1.20*1.2 = $1.44 </li></ul><ul><li>D3 = D2 * (1 + g) = $1.44*1.2 = $1.73 </li></ul><ul><li>Need PV of D1  D3? </li></ul>
  30. 30. Nonconstant Growth <ul><li>Use CFj button on calculator: </li></ul><ul><li>0 CFj (CF in year 0) </li></ul><ul><li>1.2 CFj (CF in year 1) </li></ul><ul><li>1.44 CFj (CF in year 2) </li></ul><ul><li>1.73 CFj (CF in year 3) </li></ul><ul><li>15 I/YR </li></ul><ul><li><color> NPV </li></ul><ul><li>$3.27 = PV (D1  D3) </li></ul>
  31. 31. Nonconstant Growth <ul><li>2. Find the P stock the end of the nonconstant growth period, and discount P back to the present. </li></ul><ul><li>D4 = D3 * (1 + g) = $1.73 * 1.10 = $1.90 </li></ul><ul><li>$1.90  (R – g) = $1.90  (.15 - .10) = $38 = P???? </li></ul>
  32. 32. Nonconstant Growth <ul><li>$38.06 = D4  (r– g) = P3 = FV3 </li></ul><ul><li>3 N </li></ul><ul><li>15 I/YR </li></ul><ul><li>38 FV </li></ul><ul><li>PV = ? </li></ul><ul><li>PV = $24.99 = PV(D4  D  ) </li></ul>
  33. 33. Nonconstant Growth <ul><li>P0 = PV(D1  D  ) </li></ul><ul><li>PV(D1  D3) = $3.27 </li></ul><ul><li>+ PV(D4  D  ) = $24.99 </li></ul><ul><li>PV(D1  D  ) = $28.26 = P0 </li></ul>
  34. 34. Nonconstant Growth Problem <ul><li>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? </li></ul><ul><li>Remember that we have to find the PV of all expected future dividends. </li></ul>

×