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Chapter 7


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Chapter 7

  1. 1. Chapter 7 Stock Valuation <ul><li>Common Stock Basics </li></ul><ul><li>Stock Valuation – Future Cash Flows </li></ul><ul><li>Dividend Pricing Models </li></ul><ul><li>Dividend Growth Models </li></ul><ul><li>Changing Dividend Patterns </li></ul><ul><li>Preferred Stock </li></ul><ul><li>CAPM </li></ul><ul><li>Beta </li></ul><ul><li>Common Stock Features </li></ul>
  2. 2. Common Stock Basics <ul><li>Common Stock – Ownership of Company </li></ul><ul><ul><li>Equity financing </li></ul></ul><ul><ul><li>Major financing source for companies </li></ul></ul><ul><li>Voting Rights </li></ul><ul><ul><li>Pick the management team of the company </li></ul></ul><ul><ul><li>Determine charter and changes to charter </li></ul></ul><ul><li>Receive Dividends </li></ul><ul><ul><li>Payment of “profits” </li></ul></ul><ul><ul><li>Principal not repaid until shareholder sells stock </li></ul></ul>
  3. 3. Stock Valuation <ul><li>Just like a bond…the value is all future cash flows received </li></ul><ul><li>Final payment (when stock is sold) is the same as principal repayment </li></ul><ul><li>Dividends are the same as coupons </li></ul>
  4. 4. Dividend Pricing Models <ul><li>Four Models </li></ul><ul><ul><li>Two assumptions </li></ul></ul><ul><ul><ul><li>Growth, constant or no-growth dividend or dividend growing at a constant rate </li></ul></ul></ul><ul><ul><ul><li>Horizon, finite or infinite </li></ul></ul></ul><ul><li>Constant Dividend and Infinite Horizon </li></ul><ul><ul><li>Priced as a perpetuity </li></ul></ul><ul><ul><li>Price = Dividend / r </li></ul></ul><ul><ul><li>r is the desired rate of return on investment </li></ul></ul>
  5. 5. Dividend Pricing Models <ul><li>Constant Dividend with Finite Horizon </li></ul><ul><ul><li>Assumption on final payment </li></ul></ul><ul><ul><ul><li>Dividends Only – Only annuity stream formula </li></ul></ul></ul><ul><ul><ul><li>Dividends and Final Sale at end of horizon – Annuity Stream and Lump Sum formula </li></ul></ul></ul><ul><ul><li>TVM equations </li></ul></ul><ul><li>Finding Bond Selling Price </li></ul><ul><ul><li>New owner buys remaining dividend stream </li></ul></ul><ul><ul><li>Perpetuity for new owner? </li></ul></ul>
  6. 6. Dividend Growth Models <ul><li>Common practice to raise dividends each year </li></ul><ul><ul><li>Example, Coca-Cola </li></ul></ul><ul><ul><li>Dividend changes range </li></ul></ul><ul><ul><ul><li>$0.04 to $0.08 </li></ul></ul></ul><ul><ul><ul><li>5.88% to 14.71% </li></ul></ul></ul><ul><ul><li>Not constant…but… </li></ul></ul><ul><ul><li>Smooth out pattern for constant percentage change each year </li></ul></ul><ul><li>Constant percentage change allows for a simplified pricing model </li></ul>
  7. 7. Dividend Growth Models <ul><li>First Constant Growth Model – Infinite Horizon </li></ul><ul><ul><li>Need g, the dividend growth rate </li></ul></ul><ul><ul><li>Need r, the require rate of return </li></ul></ul><ul><ul><li>Both stated on annual basis </li></ul></ul>
  8. 8. Dividend Growth Models <ul><li>Finding g, </li></ul><ul><ul><li>Averaging annual dividend changes </li></ul></ul><ul><ul><li>g = (Last Dividend / First Dividend) 1/n </li></ul></ul><ul><ul><ul><li>n is the number of dividend changes </li></ul></ul></ul><ul><ul><ul><li>Example of Johnson and Johnson, g = 13.8% </li></ul></ul></ul><ul><li>Select r, example J&J, r = 15% </li></ul>
  9. 9. Dividend Growth Models <ul><li>Adjusted for Finite Horizon </li></ul><ul><ul><li>Dividend stream for a fixed period of time but still has constant growth, g>0 </li></ul></ul><ul><ul><li>Shareholder only gets a portion of infinite dividend stream </li></ul></ul><ul><li>Add portion adjustment to model </li></ul>
  10. 10. Changing Dividend Patterns <ul><li>What happens when g is not constant or the dividends are not constant? </li></ul><ul><li>Look for patterns inside the overall dividend stream </li></ul><ul><ul><li>Series of dividends with constant dividends </li></ul></ul><ul><ul><li>Series of dividends with constant growth </li></ul></ul><ul><li>Apply models within the series finding PV of the series </li></ul><ul><li>Add up all present value pieces for price </li></ul>
  11. 11. Preferred Stock <ul><li>Preferred stock has stated annual dividend </li></ul><ul><ul><li>Constant dividend each period </li></ul></ul><ul><ul><li>Dividend = dividend rate x par value </li></ul></ul><ul><li>Preferred stock has no maturity date </li></ul><ul><ul><li>Infinite horizon </li></ul></ul><ul><ul><li>No payment of par value </li></ul></ul><ul><li>Fits constant dividend model with infinite horizon </li></ul>
  12. 12. CAPM <ul><li>Capital Asset Pricing Model – CAPM </li></ul><ul><li>Future cash flows (dividends) </li></ul><ul><ul><li>Difficult to predict </li></ul></ul><ul><ul><li>May not follow nice patterns </li></ul></ul><ul><li>More encompassing model </li></ul><ul><li>CAPM – Expected return is directly related to risk (Chapter 5, Risk and Return) </li></ul><ul><li>Model works with returns </li></ul>
  13. 13. CAPM <ul><li>Assumptions </li></ul><ul><ul><li>#1 – There is a reward for waiting </li></ul></ul><ul><ul><li>#2 – The greater the risk the greater the expected reward </li></ul></ul><ul><ul><li>#3 – There is a constant tradeoff between risk and reward </li></ul></ul><ul><li>E(return) = risk-free rate + slope (level of risk) </li></ul><ul><li>Trick is to find the level of risk for an investment </li></ul>
  14. 14. Beta <ul><li>Beta – A measure of risk </li></ul><ul><ul><li>The systematic risk of an individual asset in a well-diversified portfolio </li></ul></ul><ul><ul><li>Correlation between an asset’s returns and the market in general </li></ul></ul><ul><ul><li>Estimated with OLS regression </li></ul></ul><ul><li>Beta’s </li></ul><ul><ul><li>Less than 1, 1 or greater than 1 </li></ul></ul><ul><ul><li>Less risk than market, same risk as market, greater risk than the market </li></ul></ul>
  15. 15. Beta <ul><li>Using Beta </li></ul><ul><ul><li>Security Market Line </li></ul></ul><ul><ul><li>All firms plot on SML (ex-ante) </li></ul></ul><ul><ul><ul><li>Firms above the line are under priced </li></ul></ul></ul><ul><ul><ul><li>Firms below the line are over priced </li></ul></ul></ul><ul><li>Security Market Line estimates expected returns </li></ul>
  16. 16. Common Stock Features <ul><li>Claim on Assets and Cash Flows (Residual) </li></ul><ul><li>No Maturity Date </li></ul><ul><li>Vote (Voice in Management) </li></ul><ul><li>Tax Issues – Dividends Taxable </li></ul><ul><li>Other Issues </li></ul><ul><ul><li>Authorized, Outstanding, Treasury Shares </li></ul></ul><ul><ul><li>Pre-emptive Rights </li></ul></ul>
  17. 17. Problems <ul><li>Problem 1 – Constant Dividend, Infinite Horizon </li></ul><ul><li>Problem 2 – Constant Dividend, Infinite Horizon </li></ul><ul><li>Problem 3 – Constant Dividend, Infinite Horizon </li></ul><ul><li>Problem 5 – Constant Growth, Infinite Horizon </li></ul><ul><li>Problem 7 – Constant Growth, Finite Horizon </li></ul><ul><li>Problem 11 – Preferred Stock </li></ul><ul><li>Problem 15 – Security Market Line </li></ul><ul><li>Problem 17 – Expected Returns </li></ul>