Equity Markets and Stock Valuation

1
Chapter
7
Equity Markets and Stock Valuation
2
Key Concepts and Skills

• Understand how stock prices depend on future
  dividends and dividend growth
• Be able to compute stock prices using the
  dividend growth model
• Understand how corporate directors are elected
• Understand how stock markets work
• Understand how stock prices are quoted

3
Feature of Common Stock

• Voting Rights
• Proxy voting
• Other Rights
• Share proportionally in declared dividends
• Share proportionally in remaining assets during
  liquidation
• Preemptive right first shot at new stock issue
  to maintain proportional ownership if desired

4
Dividend Characteristics

• 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
• Dividends received by corporations have a minimum
  70 exclusion from taxable income

5
Features of Preferred Stock

• Dividends
• Stated dividend that must be paid before
  dividends can be paid to common stockholders
• Dividends are not a liability of the firm and
  preferred dividends can be deferred indefinitely
• Most preferred dividends are cumulative any
  missed preferred dividends have to be paid before
  common dividends can be paid
• Preferred stock generally does not carry voting
  rights

6
Stock Markets

• New York Stock Exchange (NYSE)
• Huge room with electronic trading posts
• Each stock assigned to single specialist
• Specialists Employed by exchange to be market
  makers
• Hold inventory of stocks, advertise prices to buy
  (bid) and sell (ask) at
• Stock Bid Ask
• YWEE 28.65 28.75

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Specialists

• Bid Ask
• YWEE 28.65 28.75
• Specialist buys low, sells high
• Specialists buys at 28.65, so you sell at
  28.65.
• Specialist sells at 28.75, so you buy at 28.75
• 28.75 - 28.65 0.10 spread

8
Stock Markets

• NASDAQ
• Not a physical exchange computer based
  quotation system
• National Association of Securities Dealers
  Automated Quotation
• Multiple dealers acting as market makers Hold
  inventory of stock, post bid ask prices
• Large portion of technology stocks

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NASDAQ

• DULL Computers three dealers
• Joe Bob Englebert
• Bid Ask Bid Ask Bid Ask
• 8.00 8.50 7.75 8.25 7.50 8.50
• NASDAQ reports Bid Ask 8.00 8.25

10
Cash Flows to 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
• Value PV of expected future CFs

11
Estimating Dividends Special Cases

• Constant dividend
• The firm will pay a constant dividend forever,
  like preferred stock
• Perpetuity formula
• Constant dividend growth
• The firm will increase the dividend by a constant
  percent every period
• Nonconstant growth
• Dividend growth is not consistent initially, but
  settles down to constant growth eventually

12
Zero Growth

• If dividends are expected at regular intervals
  forever, then this is like preferred stock and is
  valued as a perpetuity
• P0 D / R
• Suppose stock is expected to pay a 2 dividend
  every year and the required return is 10. What
  is the price?
• P0 2 / .1 20

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Dividend Growth Model

• Dividends grow at a constant rate g
• D1 D0 (1 g)
• D2 D1 (1 g)
• ?
• D2 D0 (1 g) (1 g) D0 (1 g)2
• Dt D0 (1 g)t
• D43 D0 (1 g)43

14
Dividend Growth Model (DGM)

• Dividends are expected to grow at a constant
  percent per period.
• P0 D1 /(1R) D2 /(1R)2 D3 /(1R)3
• P0 D0(1g)/(1R) D0(1g)2/(1R)2
  D0(1g)3/(1R)3
• With a little algebra, this reduces to

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DGM Example 1

• Suppose Big D, Inc. just paid a dividend of .50.
  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?
• What variable is .50?
• P0 .50(1.02) / (.15 - .02) 3.92

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DGM Example 2

• Suppose TB Pirates, 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?
• P0 2 / (.2 - .05) 13.33
• Why isnt the 2 in the numerator multiplied by
  (1.05) in this example?

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Example

• Gordon Growth Company is expected to pay a
  dividend of 2 next year and dividends are
  expected to grow at 6 per year. The required
  return is 15.
• What is the current price?

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Using the DGM to Find R

• Start with the DGM

19
Components of R

• You can get your R in two forms
• Dividend yield D1/P0
• Capital gains yield g
• R D1/P0 g

20
Example

• Suppose a firms stock is selling for 10.50.
  They just paid a 1 dividend and dividends are
  expected to grow at 5 per year. What is the
  required return?
• R 1(1.05)/10.50 .05 15
• What is the dividend yield?
• 1(1.05)/10.50 10
• What is the capital gains yield?
• g 5

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Criticisms of P0 D1 ? (R g)

• Constant g
• g R ? P
• D1 0 ? P 0
• Sensitive to R g
• 1,2,3 can be fixed (young firms)

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Stock Price Sensitivity to Dividend Growth
D1 2 R 20
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Stock Price Sensitivity to Required Return
D1 2 g 5
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Firms with D1 0

• Firm expects to pay no divds until year 5
• That divd expected 1
• g 12, R 15 P?
• Solution Throw D, R , g into equation

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Firms with D1 0

• P 1 ? (.15 - .12) 33.33?
• Formula ? D1 ? (R g) P0
• What we did ? D5 ? (R g) ????
• D always one period ahead of P
• (D5 ? P4)
• Stock Value PV (expected divd payments)

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Firms with D1 0

• P4 33.33 ? P0 ???
• P4 FV ? P0 PV
• P0 PV(P4) _at_ R
• 4 N, 15 I/YR, 33.33 FV, PV???
• P0 19.06

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Nonconstant Growth

• 1. Compute PV(dividends that experience
  nonconstant growth)
• 2. Find the P stock the end of the nonconstant
  growth period, and discount P back to the present
• 3. Add these two components to find the value of
  the stock.

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Nonconstant Growth

• TannerHater.com recently paid a dividend of
  1.00. Analysts expect that dividend to grow at
  20 annually for 3 years, then grow at 10
  indefinitely. If R 15, what is the stocks
  intrinsic value?

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Nonconstant Growth

• 1. Compute PV(dividends that experience
  nonconstant growth)
• D1 D0 (1 g) 1.001.2 1.20
• D2 D1 (1 g) 1.201.2 1.44
• D3 D2 (1 g) 1.441.2 1.73
• Need PV of D1 ? D3?

30
Nonconstant Growth

• Use CFj button on calculator
• 0 CFj (CF in year 0)
• 1.2 CFj (CF in year 1)
• 1.44 CFj (CF in year 2)
• 1.73 CFj (CF in year 3)
• 15 I/YR
• NPV
• 3.27 PV (D1 ? D3)

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Nonconstant Growth

• 2. Find the P stock the end of the nonconstant
  growth period, and discount P back to the
  present.
• D4 D3 (1 g) 1.73 1.10 1.90
• 1.90 ?(R g) 1.90 ? (.15 - .10) 38.06
  P????

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Nonconstant Growth

• 38.06 D4 ? (r g) P3 FV3
• 3 N
• 15 I/YR
• 38.06 FV
• PV ?
• PV 25.03 PV(D4 ? D?)

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Nonconstant Growth

• P0 PV(D1 ? D?)
• PV(D1 ? D3) 3.27
• PV(D4 ? D?) 25.03
• PV(D1 ? D?) 28.30 P0

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Nonconstant Growth Problem

• Suppose a firm is expected to increase dividends
  by 20 in one year and by 15 in two years. After
  that dividends will increase at a rate of 5 per
  year indefinitely. If the last dividend was 1
  and the required return is 20, what is the price
  of the stock?
• Remember that we have to find the PV of all
  expected future dividends.