Chapter 2: Valuation of Stocks and Bonds

1. Chapter 2: Valuation of Stocks and Bonds

2. What is Value? • In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller • Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset

3. Several Kinds of “Value” • There are several types of value, of which we are concerned with three: • Book Value - The asset’s historical cost less its accumulated depreciation • Market Value - The price of an asset as determined in a competitive marketplace • Intrinsic Value - The present value of the expected future cash flows discounted at the decision maker’s required rate of return

4. Determinants of Intrinsic Value • There are two primary determinants of the intrinsic value of an asset to an individual: • The size and timingof the expected future cash flows • The individual’s required rate of return(this is determined by a number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.) • Note that the intrinsic value of an asset can be, and often is, different for each individual (that’s what makes markets work)

5. Chapter 2: Valuation of Stocks and Bonds 2.3 Valuation of Preferred Stocks

6. Preferred Stock Features • Preferred stock differs from common stock because it has preference over common stock on payment of dividends and in the distribution of corporation assets in the event of liquidation. • Preferred stock is a form of equity from a legal, tax, and regulatory standpoint. • Holders of preferred stock generally have no voting privileges. • However, holders of preferred stock are often granted voting and other rights if preferred dividends have not been paid for some time. • Preferred stock have a stated liquidating value. • The cash dividend is described in dollars per share. • A preferred dividend is not like bond interest • Dividends on preferred stock are either cumulative or non-cumulative. • Dividends not declared on cumulative preferred stock are carried forward and must be paid before common shareholders can receive anything

7. Features of preferred stock • A hybrid security • May be perpetuity or redeemable • Paid before common dividends. • Cumulative or Non-cumulative dividends • Dividends not a liability • Protective provisions (voting) • Call provisions & sinking funds • Convertible or Non-convertible • Usually non-voting and non-participative. • Priority-lower than debt, higher than stock.

8. D V = p k p Preferred Stock Valuation Preferred stocks can usually be valued like a perpetuity:

9. 4.125 V = = $43.42 p .095 Example: Xerox preferred that pays $4.125 dividend per year. Suppose our required rate of return on Xerox preferred is 9.5%

10. D D k k = = p p V Po p Expected Rate of Return on Preferred Just adjust the valuation model:

11. D 4.125 k .1031 = = = p Po 40 Example If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

12. Valuation of redeemable preferred stock • The value of a preferred stock equals the present value of all future dividends

13. Chapter 2: Valuation of Stocks and Bonds 2.4 Valuation of Common Stocks

14. Features of common stock • Residual income and asset claimants • Unlimited upside • First to suffer • Priority • Debt • Preferred Stock • Common Stock • A firm cannot go bankrupt for not declaring dividends • Dividends and Taxes • Dividend payments are not considered a business expense, therefore, they are not tax deductible • Dividends received by individuals are taxed as ordinary income

15. Features of Common Stock • The term common stock usually implies the shareholder has no special preference either in dividends or in bankruptcy. • Shareholders, however, control the corporation through their right to elect the directors. The directors in turn hire management to carry out their directives. • Directors are elected at an annual shareholders’ meeting by a vote of the holding of a majority of shares present and entitled to vote.

16. Common Stock Features • Shareholders usually have the following rights also: • The right to share proportionally in dividends paid. • The right to share proportionally in assets remaining after liabilities and preferred shareholders have been paid in a liquidation. • The right to vote on stockholder matters of great importance, such as a merger or new share issuance.

17. Common Stock Features Dividends • Dividend payments are at the discretion of the BoD. • Dividends are not a liability of the corporation until declared by the BoD. • Dividends are not tax deductible for the issuing corporation.

18. Common Stock Features Classes of Stock • Some firms have more than one class of common stock; often, the classes are created with unequal voting rights. • Non-voting shares must receive dividends no lower than dividends on voting shares. • A primary reason for creating dual classes of stock has to do with control of the firm.

19. Common Stock Valuation • Just like with bonds, the first step in valuing common stocks is to determine the cash flows • For a stock, there are two: • Dividend payments • The future selling price • Again, finding the present values of these cash flows and adding them together will give us the value

20. Cash flows for stockholders • If you buy a share of stock, you can receive cash in two ways • The company pays dividends • You sell your shares, either to another investor in the market or back to the company • As with bonds, the price of the stock is the present value of these expected cash flows

21. Common Stock Valuation Unlike bonds, valuing common stock is more difficult. Why? • The timing and amount of future cash flows is not known. • The life of the investment is essentially forever. • There is no way to observe the rate of return that the market requires.

22. Some Notes About Common Stock • In valuing the common stock, we have to make two assumptions: • We know the dividends that will be paid in the future • We know how much you will be able to sell the stock for in the future • Both of these assumptions are unrealistic, especially knowledge of the future selling price • Furthermore, suppose that you intend on holding on to the stock for twenty years, the calculations would be very tedious!

23. Common Stock: Some Assumptions • We cannot value common stock without making some simplifying assumptions • If we make the following assumptions, we can derive a simple model for common stock valuation: • Assume: • Your holding period is infinite (i.e., you will never sell the stock) • The dividends will grow at a constant rate forever (this is only one example of assumption that simplifies the problem) • Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend

24. Common Stock Valuation: Dividend Discount Model

25. Single-Period Valuation Model • Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? • Remember, the cash flows to the stockholder is simply the dividends received + the future sales price

26. ? 5.50 + 120 0 1 Single Holding Period You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time. If you require a 15% rate of return, what would you pay for the stock now? Ans: $ 109.13

27. What happens if ? The price of common stock is expected to grow at the rate of g % annually ? The current price P0 becomes Po(1+g) a year hence.

28. Example The expected dividend per share on the equity share of Roadking Limited is Rs 2.00. The dividend per share of Roadking Limited has grown over the past five years at the rate of 5 % per year. This growth rate will continue in future. Further, the market price of the equity share of Roadking Limited, too, is expected to grow at the same rate. What is a fair istimate of the intrinsic value of the equity share of Roadking Limited if the required rate is 15% ?

29. Expected Rate of Return What rate of return can the investor expect, given the current market price and forecasted values of dividend and share price ? Kc = (D1 / Po)+ g

30. Multi-period Valuation Model • The value of a stock today (its current price) is in theory equal to the present value of all future dividends plus that of the selling price.

31. Multi-period Valuation Model But common shares have no maturity period – they may be expected to bring a dividend stream of infinite duration

32. Multi-period Valuation Model • That was the generalized multi-period valuation formula – which is general enough to permit any dividend pattern – constant, rising, declining or randomly fluctuating. • For practical applications, it is helpful to make simplifying assumptions about the pattern of dividend growth.

33. Commonly used assumptions types: • The dividend per share remains constant forever, implying that the growth rate is nil (THE ZERO GROWTH MODEL) • The dividend per share grows at a constant rate per year forever (THE CONSTANT GROWTH MODEL) • The dividend per share grows at a constant rate for a finite period, followed by a constant normal rate of growth forever thereafter (THE TWO STAGE MODEL) • The dividend per share, currently growing at an above-normal rate, experiences a gradually declining rate of growth for a while. Thereafter it grows at a constant normal rate (THE “H” MODEL)

34. Zero Growth Model Assuming that the dividend per share remains constant year after year, at a value of D, the valuation model becomes as that of the perpetual preference stock;

35. Example Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

36. Constant Growth model Assumes that the dividend per share grows at a constant rate (g) With a little algebra, this reduces to:

37. Example 1 Suppose Big K, Inc. just paid a dividend of $5. 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?

38. Example 2 Suppose Comolli, 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? Ans: $ 13.33

39. Example 3 Griggs Inc. last dividend (D0) was $2. The dividend growth rate (g) is a constant 5%. If the required return (kc) = 10%, what is P0?

40. Example 4 Overton Corp. just paid a $2 dividend. If the dividends will grow at a constant rate of 5% in the future, what is the stock price in 4 years (at t = 4) assuming a required rate of return = 10%?

41. What drives growth ? • Most stock valuation models are based on the assumption that dividends grow over time. • What drives this growth ? • The two major drivers of growth are : • Plough-back or Retention Ratio • Return on Equity (ROE) • Growth = Retention Ratio x Return on Equity • Illustration: Omega limited has an equity (net worth) base of 100 at the beginning of year 1. It earns a ROE of 20 %. It pays out 40 % of its equity earnings and ploughs back 60 % of its equity earnings

42. Financials of Omega Limited What is the growth Rate of Dividend ?

43. Financials of Omega Limited Growth Rate = RE x ROE = 0.60 x 20 %= 12 %

44. What is this growth actually ? Sustainable growth rate =ROE  Retention ratio Return on equity (ROE) = Net income / Equity Retention ratio = 1 – Payout ratio

45. Estimation of Growth • The growth rate in dividends (g) can be estimated in a number of ways. • Using the company’s historical average growth rate. • Using an industry median or average growth rate. • Using the sustainable growth rate.

46. Two Stage Growth Model The simplest extension of the constant growth model assumes that the extraordinary growth will continue for a finite number of years and thereafter the normal growth rate will prevail indefinitely.

47. Two Stage Growth Model (contd….) The first term on the right hand side of above equation is the PV of a growing annuity, and its value is equal to:

48. Reminder: Present Value of a Growing annuity

49. Two Stage Growth Model (contd….) The first term on the right hand side of above equation is the PV of a growing annuity, and its value is equal to:

50. Two Stage Growth Model (contd….) Hence,