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Stock Valuation

Stock Valuation. Corporate Finance. Dr. A. DeMaskey. 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?

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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 = D1/P0 • Capital gains yield = (P1 – P0)/P0 • 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, Dt = D0(1 + g)t • If g is constant, then

  10. $ 0.25 0 Years (t)

  11. What happens if g > ks? • If ks< g, get negative stock price, which is nonsense. • We cannot use the model unless (1) g  ks and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be  ks.

  12. Growth Rate of Dividends • The growth rate, g, can be stated in terms of the dividend payout ratio: • The greater ks, 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. P0 = 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. ^ ks = D1/P0 + g = ks = kRF + (kM - kRF)b.

  18. How is stock market equilibrium established? ^ ^ • If ks = (D1/P0) + g > ks, then P0 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 D1/P0 falls until D1/P0 + g = ks = ks. ^

  19. Why do stock prices change? • ki = kRF + (kM - kRF)bi 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.

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