Chapter 7 Introduction

1
Chapter 7 Introduction

• This chapter introduces common stocks including
  unique features that differentiate common stock
  from other securities and basic common stock
  valuation models.

2
Organization of Chapter 7

• Common stock as a residual ownership claim on a
  corporation
• The difficulty in estimating the value of common
  stock relative to bonds and preferred stock.
• Common stock features
• Basic common stock valuation
• Relationship between investor required rate of
  return, earnings and dividend growth, and common
  stock value

3
Common Stock as Residual Ownership

• Common stock is quite different than bonds and
  preferred stock
• Return is dependent upon success of firm
• Provides a residual claim on firms assets
• Ownership rights to cash flows remaining after
  all other claims are paid
• Not a contractual obligation and no stated
  maturity

4
Difficulty of Estimating Common Stock Value

• The value of a security is the sum of the present
  values of its future expected cash flows. Common
  stock is difficult to value because future cash
  flows are uncertain.
• Future common stock dividends are difficult to
  forecast accurately.
• The future common stock selling price is
  difficult to forecast.

5
Common Stock Features

• The defining features of common stock include
• A residual claim on assets and cash flow
• Variable return
• Voting rights
• No set maturity

6
Common Stock Features

• A corporations board of directors controls the
  firm.
• Members are elected by stockholders.
• Has the power to hire, fire, and set compensation
  for corporate executives
• Determines corporate policy and strategy
• Makes major corporate decisions

7
Common Stock FinancingPros and Cons

• Pros
• It has lower risk than debt or preferred stock
  financing due to the lack of a fixed dividend.
• Fewer restrictions than debt financing a debt
  contract generally includes many restrictions on
  future corporate actions.
• Expansion of a firms equity generally increases
  a firms debt capacity.

8
Common Stock FinancingPros and Cons

• Cons
• The costs of issuing common stock are generally
  much higher than the costs of issuing debt and
  preferred stock.
• Common stock is a riskier investment than bonds
  or preferred stock. Investors require a higher
  rate of return which translates into a higher
  cost of raising funds with common stock.

9
Valuing Common Stock

• The value of common stock is the sum of the
  present values of its future expected cash flows.
  We will cover 4 basic models for valuing common
  stock
• General valuation model
• Zero-growth model
• Constant-growth model
• Multiple growth rates ending in constant growth
  model

10
Valuing Common Stock

• First we will introduce the concept of growth of
  a companys earnings.
• Earnings belong to the common stockholders
• They are paid back to the stockholders as
  dividends or
• Invested back into the company and called
  additions to retained earnings.

11
Valuing Common Stock

• When earnings are retained and invested into
  profitable projects, the companys earnings grow.
  The pace of growth depends upon
• The amount of earnings retained
• The returns earned on the projects

12
Valuing Common Stock

• A firms earnings growth rate can be computed as
  follows
• Growth retention ratio x ROE
• Growth earnings growth rate
• Retention ratio 1 dividend payout ratio
• ROE Return on Stockholders Equity

13
Valuing Common Stock

• For example, what is a firms earnings growth
  rate if it pays 40 of earnings as dividends and
  earns a 20 return on stockholders equity?
• Growth retention ratio x ROE
• Growth (1 40) x 20 60 x 20 12

14
General Dividend Valuation Model

• The value of common stock is the PV of the
  expected dividends to be received plus the PV of
  the expected price the stock is sold for in the
  future
• For simplicity we will assume a firm pays out
  dividends just once a year.

15
General Dividend Valuation Model

• Suppose an investor expects a common stocks
  dividends to be 1.00, 1.05, and 1.10 at the
  end of each of the next 3 years and expects to
  sell the stock for 15 in 3 years. If the
  investor requires a 15 rate of return, what is
  the stocks value today?

16
Zero-Growth Dividend Valuation Model

• If a companys dividends are not growing, but the
  company is paying out a constant dividend every
  year, this is similar to investing in preferred
  stock. The value of the common stock would be
  the PV of a perpetuity.

17
Zero-Growth Dividend Valuation Model

• Suppose a company expects earnings of 5 per
  share and because they do not expect to grow, all
  earnings are paid out as dividends. Thus all
  future dividends are expected to be 5.00 per
  share. If investors require a 10 rate of
  return, the stocks value today is

18
Zero-Growth Dividend Valuation Model

• Treating zero-growth common stock as a perpetuity
  seems to imply an investor will hold the stock
  forever! What if the investor just plans to hold
  the stock for 2 years and then sell it?
• What would the stocks selling price be in 2
  years?

19
Zero-Growth Dividend Valuation Model

• This investor expects to receive a 5 dividend
  for each of 2 years and then sell the stock for
  50 in 2 years. The value of the stock today is
• The investors holding period does not affect the
  stocks value! (up to here, Tad)

20
Constant-Growth Dividend Valuation Model

• A company with a constant dividend payout ratio
  and constant return on equity will have a
  constant growth rate.
• For example, what is the growth rate for a
  company earning 12 on equity and a 40 dividend
  payout ratio?
• Growth (1 40) x 12 60 x 12 7.2

21
Constant-Growth Dividend Valuation Model

• If we expect this company to have earnings of 5
  per share in the coming year and the 7.2 growth
  rate is constant, we can compute the common stock
  value to an investor requiring a 10 return with
  the following constant growth model

22
Constant-Growth Dividend Valuation Model

• The companys dividend in the coming year must be
  2.00 per share
• d1 5.00 x 40 2.00
• And thus the value of the stock is

23
Constant-Growth Dividend Valuation Model

• Why is the value in this example higher than for
  the zero-growth example? Both examples assume
  earnings of 5 per share and a 10 rate of
  return.
• The 7.2 growth rate makes the stock in the
  constant-growth example worth more!

24
Constant-Growth Dividend Valuation Model

• Notice in the constant-growth example we made no
  assumptions about the investors holding period.
• As we illustrated in the zero-growth valuation
  model, how long the investor plans to hold the
  stock should not affect the stocks value today!

25
Constant-Growth Dividend Valuation Model

• The constant-growth model provides good estimates
  of common stock value when a companys future
  growth is expected to be stable.
• The constant-growth model provides less accurate
  estimates when growth is difficult to estimate or
  large systematic differences year to year are
  expected in growth.

26
Valuing Stock with Multiple Growth Rates

• Now we will consider how to estimate the value of
  common stock when several different growth rates
  are expected and the growth rates can be forecast
  with some degree of accuracy.
• What if a company expects to pay a 2.15 dividend
  in a year and expects growth of 15 through the
  end of year 2? After year 2 growth is expected
  to decrease to 7.2 and stabilize at 7.2.

27
Valuing Stock with Multiple Growth Rates

• We can picture the growth rates and cash flows as
  follows
• 0 g 15 1 g 15 2 g 7.2
  ______________________________________
  __
  
  2.15 2.47
• What is the value of this stock to an investor
  requiring a 10 rate of return?

28
Valuing Stock with Multiple Growth Rates

• Remember, an investors holding period does not
  affect the value of common stock value.
• Thus, in our example, we can use any holding
  period and it should not change the value of the
  stock!
• To make the computation as easy as possible we
  will assume a 2-year holding period. The
  investor expects to receive 2 dividends (d1 and
  d2) and the selling price of the common stock in
  2 years (P2).

29
Valuing Stock with Multiple Growth Rates

• If we can estimate the common stock selling price
  in 2 years, then we can use the general dividend
  valuation model to compute the stock value as
  follows

30
Valuing Stock with Multiple Growth Rates

• Notice the growth rate in this example is
  constant at 7.2 annually after 2 years. This
  allows us to adapt the constant-growth model to
  estimate the price in 2 years.
• The original constant-growth model is

31
Valuing Stock with Multiple Growth Rates

• The constant-growth model can be viewed more
  generally as
• Adapting this to our example, we can estimate the
  stocks price at the end of 2 years

32
Valuing Stock with Multiple Growth Rates

• Estimate d3 by growing d2 at the 7.2 growth
  rate.
• d3 2.47 x (1 7.2) 2.65
• Use this along with the 7.2 growth rate after
  year 2 to estimate the price in 2 years

33
Valuing Stock with Multiple Growth Rates

• Now use the selling price in year 2 (94.64)
  along with the expected dividends in the first 2
  years (2.15 and 2.47) to estimate the value of
  the stock today

34
Valuing Stock with Multiple Growth Rates

• Holding Period Assumption
• We assumed a 2-year holding period in our
  computations. Assuming any other holding period
  would not have changed the answer. It would just
  change the computations and made the estimation
  of the stocks value an even more difficult
  process!

35
Valuing Stock with Multiple Growth Rates

• Simplest Computation and Holding Period
• When a stock is expected to have multiple growth
  rates, the easiest computation of the stocks
  value is obtained by assuming a holding period
  exactly long enough to reach the point at which
  the growth rate becomes constant.

36
Value, Rate of Return, and Growth

• What happens to a common stocks value if the
  investors required rate of return increases but
  the future expected cash flows remain constant?
• With the same expected future cash flows, the
  only way an investor can receive a higher rate of
  return is to pay less for the stock! Thus,
  higher rates of return cause stock values to
  decline!

(Its a SONY!)
37
Value, Rate of Return, and Growth

• Lets use the constant-growth example to
  illustrate this inverse relation between rates of
  return and common stock value. Previously we
  assumed a 2 dividend in 1 year, a 7.2 growth
  rate, and a 10 rate of return, and obtained a
  value of 71.43 as follows

38
Value, Rate of Return, and Growth

• What if the general level of interest rates rises
  and as a result investors now require a 12
  return on this common stock?
• The stock value declines to 41.67. This same
  relationship would hold for any of the common
  stock valuation models we have presented in this
  chapter.

39
Value, Rate of Return, and Growth

• What happens to a common stocks value if the
  earnings and dividends growth rate increases but
  the rate of return remains the same?
• With a higher growth rate dividends are now
  expected to be greater. Of course with the same
  rate of return, the value of the common stock
  will increase to investors!

40
Value, Rate of Return, and Growth

• Lets use the constant-growth example to
  illustrate this direct relation between dividends
  and earnings growth and common stock value.
  Using the same beginning assumptions as before

41
Value, Rate of Return, and Growth

• What if the earnings and dividends growth rate
  rises from 7.2 to 8.0 and, as a result, future
  dividends are expected to be higher than before?
• The stock value increases to 100.00. This same
  relationship would hold for any of the common
  stock valuation models we have presented in this
  chapter.

42
Summary of Chapter 7 Topics

• Common stock as a residual ownership claim
• Features of common stock
• Pros and cons of common stock financing

43
Summary of Chapter 7 Topics

• Valuing common stock 4 models introduced
• General valuation model
• Zero-growth model
• Constant-growth model
• Multiple growth rates ending in constant growth
  model
• Relationship between common stock value, rates of
  return, and earnings and dividend growth rates