Chapter 10 Stock Valuation

1. Chapter 10Stock Valuation

2. Slide Contents • Learning Objectives • Principles Applied in This Chapter • Common Stock • The Comparables Approach to Valuing Common Stock • Preferred Stock • The Stock Market • Key Terms

3. Learning Objectives • Identify the basic characteristics and features of common stock and use the discounted cash flow model to value common shares. • Use the price-to-earnings (P/E) ratio to value common stock. • Identify the basic characteristics and features of preferred stock and value preferred shares. • Use the secondary markets for common stock.

4. Principles Applied in This Chapter • Principle 1: Money Has a Time Value. • Principle 2: There is a Risk-Reward Tradeoff. • Principle 3: Cash Flows are the Source of Value. • Principle 4: Market Prices Reflect Information. • Principle 5: Individuals Respond to Incentives.

5. 10.1 Common Stock

6. Common Stock Common stockholders are the owners of the firm. They elect the firm’s board of directors who in turn appoint the firm’s top management team. The firm’s management team then carries out the day-to-day management of the firm.

7. Common Stock Characteristics Claim on Income Common stockholders have the right to the firm’s income after bondholders and preferred stockholders have been paid. The common stockholders either receive dividends or any increase in value that results from the reinvested earnings.

8. Common Stock Characteristics (cont.) • Claim on Assets In case of liquidation, common stockholders have residual claim on assets. • Voting Rights In general, common shareholders are the only security holders given the right to vote. Most shareholders vote by proxy.

9. Common Stock Characteristics (cont.) Agency Costs and Common Stock Shareholders elect the board. In reality, board members are nominated by the management. As a result, management effectively elects the board. This may lead to agency problems.

10. Valuing Common Stock Using the Discounted Dividend Model Like bonds, common stock’s value is equal to the present value of all future cash flows that the stockholder expects to receive from owning the shares of stock. However, unlike bonds, the future cash flows in the form of dividends are not fixed and there is no maturity date.

11. Three Step Procedure for Valuing Common Stock Step 1: Estimate the amount and timing of the receipt of the future cash flows the common stock is expected to provide. Step 2: Evaluate the riskiness of the common stock’s future dividends to determine the stock’s required rate of return.

12. Three Step Procedure for Valuing Common Stock (cont.) Step 3: Calculate the present value of the expected dividends by discounting them back to the present at the stock’s required rate of return. • The three steps show that the value of a common stock is equal to the present value of all future dividends.

13. The Constant Dividend Growth Rate Model If a firm’s cash dividend grow by a constant rate, then the common stock can be valued as follows:

14. Valuing Common Stock CHECKPOINT 10.1: CHECK YOURSELF

15. The Problem What is the value of a share of common stock that paid $6 dividend at the end of last year and is expected to pay a cash dividend every year from now to infinity, with that dividend growing at a rate of 5 percent per year, if the investor’s required rate of return is 12% on that stock?

16. Step 1: Picture the Problem With a perpetuity, a timeline goes on for ever with the growing cash flow occurring every period. i=12% Years Cash flows $6 $6(1.05) $6(1.05)2 0 1 2 … … Value of common stock = Present Value of Expected Dividends. The growing dividends go on forever

17. Step 2: Decide on a Solution Strategy • The value of a share of stock can be viewed as a the present value of a growing perpetuity. • Here we know the expected dividends, the growth rate, and investor’s required rate of return. • We can use equation 10-2 to determine the value of a share of common stock.

18. Step 3: Solve • We need to first determine D1, the dividend next period. • Since dividends at the end of last year was $6 and dividends are expected to grow at a rate of 5%, dividends for next period will be: • D1 = D0 (1+g) = $6 (1.05) = $6.30

19. Step 3: Solve (cont.) • Vcs = $6.30 ÷ (0.12-0.05) = $6.30 ÷ 0.07 = $90

20. Step 4: Analyze Equation 10-2 is based on the assumption that dividends will grow at a constant rate for ever. While not a realistic assumption, it enables us to determine the value of common stock easily and also helps us to identify the factors that move the stock prices.

21. What Causes Stock Prices to Go Up and Down? Equation 10-2 indicates that there are three variables that drive share value: • The most recent dividend (D0), • Investor’s required rate of return (rcs ), and • Expected rate of growth in future dividends (g).

22. What Causes Stock Prices to Go Up and Down? (cont.) Since most recent dividend (D0) has already been paid, it cannot affect price. Thus the other two variables, rcs and g, can vary and lead to changes in stock prices.

23. Determinants of the Investor’s Required Rate of Return The investor’s required rate of return is determined by two key factors: • The level of interest rates in the economy; • The risk of the firm’s stock.

24. Determinants of the Investor’s Required Rate of Return (cont.) CAPM suggests that if risk-free rate and/or systematic risk (beta) rises, the investor’s required rate of return will rise and the stock price will fall.

25. Determinants of the Growth Rate of Future Dividends The growth rate of future dividends (g) can also change and lead to a change in the stock price. The two key determinants of a firm’s growth opportunities relate to: • the return on equity (ROE), and • the retention ratio (b)

26. Determinants of Growth Rate of Future Dividends (cont.) The growth rate is formally expressed as follows: • g = the expected rate of growth of dividends • D1/E1 = the dividend payout ratio • b = the proportion of firm’s earnings that are retained and reinvested in the firm. • ROE = the return on equity earned when the firm reinvests a portion of its earning back into the firm.

27. 10.2 THE COMPARABLES APPROACH TO VALUING COMMON STOCK

28. The Comparables Approach to Valuing Common Stock This method estimates the value of the firm’s stock as a multiple of some measure of firm’s performance. The most common metric is earnings per share. Thus values are determined from the price-to-earnings ratio of comparable firms.

29. Defining the P/E Ratio Valuation Model • Vcs = the value of common stock of the firm. • P/E1 = the price earnings ratio for the firm based on the current price per share divided by earnings for end of year 1. • E1 = estimated earnings per share of common stock for the end of year 1.

30. Valuing Common Stock Using the P/E Ratio CHECKPOINT 10.2: CHECK YOURSELF

31. The Problem After some careful analysis and reflection on the valuation of the Heals’ shares the company CFO suggested that the earnings projection are too conservative and earnings for the coming year could easily jump to $2.00. What does this do for your estimate of the value of Heals’ shares?

32. Step 1: Picture the Problem EPS = $2.00 P/E Multiple StockPrice

33. Step 2: Decide on a Solution Strategy • The common stock value can be computed by multiplying the firm’s estimated earnings per share for the coming year by what the analyst estimates to be an appropriate P/E ratio. • We can use equation 10-4 to estimate the value of common stock.

34. Step 3: Solve Vcs = 18.20 × $2 = $36.40

35. Step 4: Analyze • We estimated the value of Heales’ shares based on the P/E ratios of three comparable firms. However, this estimate is contingent on the appropriateness of the comparable set of companies to the Heals Shoe Company. • Furthermore, if the market conditions change by the time the shares are sold in the market, the price estimate will not be appropriate.

36. What Determines the P/E Ratio for a Stock? Using Equation 10-5a and 10-5b, there are two fundamental determinants of a firm’s P/E ratio: • Growth Rate in Dividends (higher the growth rate, higher the P/E ratio), and • Investor-Required Rates of Return (higher the required rate, lower the P/E ratio)

37. 10.3 Preferred Stock

38. Features of Preferred Stock • Dividend: In general, size of preferred stock dividend is fixed, and it is either stated as a dollar amount or as a percentage of the preferred stock’s par value. • Multiple Classes: A company can issue more than one class of preferred stock, and each class can have different characteristics.

39. Features of Preferred Stock (cont.) • Claims on Assets and Income: Preferred stockholders have priority over those of common stockholders for payment of dividends and in settlement of claims at bankruptcy. Most preferred stock carry a cumulative feature i.e. all past unpaid dividends must be paid before any common stock dividends can be declared.

40. Features of Preferred Stock (cont.) Preferred Stock as a Hybrid Security: • Like common stocks, preferred stocks do not have a fixed maturity date. Also, like common stocks, nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. • Like debt, preferred stocks have a fixed dividend. Also, most preferred stocks are periodically retired even though there is no stated maturity date.

41. Valuing Preferred Stock Because preferred stocks are perpetuities (non-maturing), and because the cash dividend is the same every period, they can be valued using the present value of perpetuity equation introduced in chapter 6 (equation 6-5).

42. Valuing Preferred Stock (cont.) • Vps = the value of a share of preferred stock • Dps = the annual preferred stock dividend • rps = the market yield or the rate of return on the preferred stock’s promised dividend

43. Estimating the Market’s Required Yield Estimating the Market Yield: We can use equation 10-6 to solve for the market’s required yield. rps = Dps ÷Vps

44. Valuing Preferred Stock What is the present value of a share of preferred stock that pays a dividend of $12 per share if the market’s yield on similar issues of preferred stock is 8%? CHECKPOINT 10.3: CHECK YOURSELF

45. Step 1: Picture the Problem Preferred stocks are constant for all years and form a level perpetuity. rps=8% Years Dividends $12 $12$12 $12 0 1 2 3 … … Value of Preferred Stock = Present Value of promised dividends. The annual $12 dividends go on forever.

46. Step 2: Decide on a Solution StrategyStep 3: Solve We can determine the present value of share of preferred stock using equation 10-6. Vps = $12 ÷ 0.08 = $150

47. Step 4: Analyze Since preferred stock is a level perpetuity, its value on any future date will be the same as its present value today as long as the promised rate of return on the share remains the same.

48. 10.4 The Stock Market

49. The Stock Market As discussed in chapter 2, new securities trade in the primary market while currently outstanding securities trade in the secondary market. There are two types of secondary markets: organized exchanges and over-the-counter markets.

50. Organized Exchanges The New York Stock Exchange (NYSE), also called the “Big Board,” is the oldest of all organized exchanges. While the NYSEis considered an organized exchange because of its physical location, the majority of its trades are done electronically without a face-to-face meeting of traders.