Chapter 5: Stock Valuation

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Chapter 5 Stock Valuation

• Professor Thomson
• Finance 3013

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Debt vs. Equity Debt
Debt securities represent a legally enforceable
claim.
Debt securities offer fixed or floating cash
flows.
Bondholders dont have any control over how the
company is run.
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Debt vs. Equity Equity
Stockholders have voting rights on important
company decisions.
Debt and equity have substantially different
marginal benefits and marginal costs.
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Preferred Stock
Preferred stock is a hybrid having some features
similar to debt and other features similar to
equity.

• Claim on assets and cash flow senior to common
  stock
• As equity security, dividend payments are not tax
  deductible for the corporation.
• For tax reasons, straight preferred stock held
  mostly by corporations.

Promises a fixed annual dividend payment, but not
legally enforceable. Firms cannot pay common
stock dividends if preferred stock is in arrears
(i.e. preferred stock is typically cumulative)
- Preferred stockholders usually do not have
voting rights. - May be convertible to common
stock
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Valuing Preferred Stock

• Because preferred stock pay a constant dividend,
  they are easy to value because the dividends are
  a perpetuity.
• Recall the present value of a perpetuity is

Where D1 is the constant dividend whose first
payment is one period from today
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Example 5.1 Valuing preferred

• You purchase a preferred stock with a 12 per
  year dividend. For a 10 market rate, what is
  its value?

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Rights of Common Stockholders
Common stockholders voting rights can be
exercised in person or by proxy.
Most US corporations have majority voting, with
one vote attached to each common share.
Cumulative voting gives minority shareholders
greater chance of electing one or more directors.
Shareholders have no legal rights to receive
dividends. They are declared by the board of
directors, and typically paid quarterly if it is
a dividend paying stock. Dividends typically
increase over time
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Common Stock
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Common Stock
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Largest firms by market capitalization in the SP
500 (5/31/2006)
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Stock Valuation

• Like other assets in finance, the value of a
  stock is the PV of its CFs
• Stocks are typically valued as perpetual
  securities as corporations potentially have an
  infinite life, and thus can pay dividends forever.

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How to make money in the stock market

• The standard answer Buy Low, Sell High i.e.
  Earn capital gains
• From dividends Over the long run, historically
  speaking almost ½ of the total return to stock
  market investors was from dividends.

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Example 5.2. Stock valuation with a one year
holding period

• You expect that JK Corp stock will sell for 25
  one year from today. You expect to receive 1.20
  in dividends over the year you hold this stock.
  For a 15 required rate of return for this stock,
  how much should you pay for it? What is your
  projected capital gain?

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Example 5.3. Stock valuation with a two year
holding period

• You expect to sell MyCo for 28 two years from
  today. You expect to receive 1 dividend the
  first year, and a 1.10 dividend the second year.
  For a 16 discount rate, what is the maximum you
  should pay for this stock?

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Example 5.4. Stock valuation with a three year
holding period

• What you be willing to pay for a stock which pays
  a 2 dividend the first year, a 2.10 dividend
  the second year, and 2.21 in the third year if
  you will sell the stock for 40 after three
  years? Discount rate is 13

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Model assumption

• Probably the biggest weakness in the previous
  three examples was that we had to predict a
  selling price.
• The buyer of the stock, when we sell it, will
  presumably go through a similar procedure to
  value the stock in other words the buyer will
  be using future dividends to value the stock.
• The selling price of the stock should thus be the
  value of all future dividends.

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Valuation of Common StockAssume 1 year holding

• P0 Present value or price of stock today
• P1 Price of stock next period
• D1 Dividends received in first period
• i discount rate

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Stock Value next yearUse same approach
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Valuation FundamentalsCommon Stock

• How was P1 determined?
• PV of expected stock price P2, plus dividends
• P2 is the PV of P3 plus dividends, etc...
• Repeating this logic over and over, you find that
  todays price equals PV of the entire dividend
  stream the stock will pay in the future

Must be able to predict future dividends to use
this model
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Zero Growth Valuation Model

• To value common stock, you must make assumptions
  about future dividend growth.

• Plugging constant value D into the common stock
  valuation formula reduces to simple equation for
  the present value of a perpetuity

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Constant Growth Valuation Model

• Assumes dividends will grow at a constant rate
  (g) that is less than the required return (r)
• If dividends grow at a constant rate forever, you
  can value stock as a growing perpetuity, denoting
  next years dividend as D1

Note D1 D0(1g)
Commonly called the Gordon growth model Also
called a DDM Dividend Discount Model
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Dividends over time

• In the Gordon growth model

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Review Notation

• D0 Current Dividend (time period 0)
• D1 Dividend one period from now
• r appropriate discount rate or rate of return
  for the particular stock (adjusts for time value
  of money and risk)
• g constant growth rate in dividends
• P0 the present value of the infinite series of
  dividends, which is the estimate stock price

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Use the Gordon model when . . .

• A dividend is paid on a regular basis
• Growth rate in the dividends is constant
• rgtg

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Example

• Dynasty Corp. will pay a 3 dividend in one
  year.  If investors expect that dividend to
  remain constant forever, and they require a 10
  return on Dynasty stock, what is the stock worth?

What is the stock worth if investors expect
Dynastys dividends to grow at 3 per year?
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Example 5.5 Applying the DDM

• Sombria industries recently paid a 2 dividend,
  and its dividends have been growing at 5 per
  year. The appropriate discount rate for this
  stock is 12.
• What should its current price be?
• What do you projects its price to be 5 years from
  now?

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Example 5.6 Rate of Return

• Ootsa Corp. is trading for 50 per share. Next
  year you expect it to pay a 2 dividend, and
  dividends have been growing at a 6 rate. What
  rate of return do investors require from this
  stock? What is the dividend yield? What is the
  capital gain yield?

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Example 5.7 Delayed Dividends

• Joogle is high tech start up that is not expected
  to pay a dividend for 10 years. At that time you
  expect it will pay an 8 dividend, with a growth
  rate of 7. For a 12 required return, what
  should you be willing to pay for Joogle today?
  What will its stock price be 5 years from today?

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Example 5.8 Variable Growth Model Example

• Estimate the current value of Morris Industries'
  common stock, P0
• Assume
• The most recent annual dividend payment of Morris
  Industries was 4 per share.
• Investors expect that these dividends will
  increase at an 8 annual rate over the next 3
  years.
• After three years, dividend growth will level out
  at 5.
• The firm's required return, r , is 12.

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Review Smart Animation

• Chapter 5. See a demonstration of the
  variable growth model.

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Other valuation models

• Free cash flow analysis
• Similar to the DDM model, but rather than
  discounting the dividend, one discounts the free
  cash flows (see Chapter 2)
• The discount rate used is the WACC (Weighted
  Average Cost of Capital) which is the weighted
  average of the discount rates for the firms
  bonds, stocks and preferred stocks.

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Common Stock ValuationOther Options
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View Chapter 5 Videos
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Trading Stock

• Why does any security trade?
• Primary Market a market for newly minted stock
  funds go to the company whose name is on the
  stock
• Initial Public Offering the first time a
  primary market offering is made for a company
  it represents the transition from a private firm
  to a public firm whose stock is freely traded

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Secondary Stock Market

• Biggest stock market for existing stocks is the
  NYSE New York Stock Exchange
• Trading is at Wall and Broad Street
• Second biggest market is the Nasdaq
• Nasdaq was formerly, National Association of
  Securities Dealers Automatic Quotations
• Trading is in cyberspace

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How to choose stocks

• If you are not a stock analyst, and do not have a
  lot of money to invest, I suggest choosing broad
  based mutual funds, especially index funds
• In general, dont choose stocks based on hot tips
• I invest with the Vanguard family of mutual funds
• www.vanguard.com

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Variable Growth ModelValuation Steps 1 and 2

• Compute the value of dividends in year 1, 2, and
  3 as (1g1)1.08 times the previous years
  dividend
• Div1 Div0 x (1g1) 4 x 1.08 4.32
• Div2 Div1 x (1g1) 4.32 x 1.08 4.67
• Div3 Div2 x (1g1) 4.67 x 1.08 5.04
• Find the PV of these three dividend payments
• PV of Div1 Div1 ? (1r)1 4.32 ? (1.12)
  3.86
• PV of Div2 Div2 ? (1r)2 4.67 ? (1.12)2
  3.72
• PV of Div3 Div3 ? (1r)3 5.04 ? (1.12)3
  3.59
• Sum of discounted dividends 3.86 3.72
  3.59 11.17

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Variable Growth ModelValuation Step 3

• Find the value of the stock at the end of the
  initial growth period using the constant growth
  model.
• Calculate next period dividend by multiplying D3
  by 1g2, the lower constant growth rate
• D4 D3 x (1 g2) 5.04 x (1.05) 5.292
• Then use D45.292, g 0.05, r 0.12 in Gordon
  model

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Variable Growth ModelValuation Step 3

• Find the present value of this stock price by
  discounting P3 by (1r)3

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Variable Growth ModelValuation Step 4

• Add the PV of the initial dividend stream (Step
  2) to the PV of stock price at the end of the
  initial growth period (P3)
• P0 11.17 53.81 64.98

Current stock price
Remember Because future growth rates might
change, the variable growth model allows for a
changes in the dividend growth rate.
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Valuing the Enterprise Free Cash Flow Valuation
Discount estimates of free cash flow that the
firm will generate in the future.
WACC after-tax weighted average required return
on all types of securities that firm issues.
We have an estimate of total value of the firm.
How can we use this to value the firms shares?
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Value of firms shares
VS VF VD - VP

• VS value of firms common shares
• VF total enterprise value
• VD value of firms debt
• VP value of firms preferred stock

We can use the free cash flow approach to
estimate the value of MRG shares.
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An Example Mortons Restaurant Group
Assume that Mortons will experience 14 FCF
growth from 2000 to 2004 and 7 annual growth
thereafter.
Mortons WACC is approximately 11.
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An Example Mortons Restaurant Group
Use variable growth equation to estimate Mortons
enterprise value.
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An Example Mortons Restaurant Group
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An Example Mortons Restaurant Group
Divide total share value by 4,148,002 shares
outstanding to obtain per-share value
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Stock Valuation

• Preferred stock has both debt and equity-like
  features.
• Common stock represents residual claims on
  firms cash flows
• Investment bankers play an important role in
  helping firms issue new securities
• The same principles apply to valuation of both
  preferred and common stock

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Valuation FundamentalsPreferred Stock

• Preferred stock is an equity security that is
  expected to pay a fixed annual dividend
  indefinitely.

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Investment Banks Role in Equity Offerings
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Investment Banks Role in Equity Offerings
Public security issues can be
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Investment Bank Services and Costs
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Services Provided during and after a Security
Offering
Almost all IPOs and SEOs have a green shoe
option over-allotment option to cover excess
demand.
Lead underwriter responsible for price
stabilization after offering.
After offering, lead underwriter serves as
principal market maker.
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Secondary Market
On the secondary market, investors deal among
themselves.