CHAPTER 9 Stocks and Their Valuation

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CHAPTER 9Stocks and Their Valuation

• Features of common stock
• Stock valuations
• Constant dividend growth model
• The behavior of dividends and their PV
• The model
• Applying the model when ggtr, g0 and glt0
• Future stock price
• Dividend yield and capital gain
• Non-constant growth model
• Preferred stock

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Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Receives cash flow in the form of dividend
• Managements goal Maximize the stock price

3
Dividend growth model

• Value of a stock is the present value of the
  future dividends expected to be generated by the
  stock.

4
Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t

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Constant growth stock

• If g is constant, the dividend growth formula
  converges to

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What happens if g gt rs?

• If g gt rs, the constant growth formula leads to a
  negative stock price, which does not make sense.
• The constant growth model can only be used if
• rs gt g
• g is expected to be constant forever

7
If rRF 7, rM 12, and ß 1.2, what is the
required rate of return on the firms stock?

• Use the SML to calculate the required rate of
  return (ks)
• rs rRF (rM rRF)ß
• 7 (12 - 7)1.2
• 13
• D0 2 and g is a constant 6,

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What is the stocks market value?

• Using the constant growth model

9
What would the expected price today be, if g
-5?, if g0?

• When g-5 D11.9, P1.9/(135)10.56
• When g0, The dividend stream would be a
  perpetuity.

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Computing other variables

• Computing Ks
• Computing D
• Computing g

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What is the expected market price of the stock,
one year from now?

• D1 will have been paid out already. So, P1 is
  the present value (as of year 1) of D2, D3, D4,
  etc.

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Future stock price

• What is the expected market price of the stock
  P2, two years from now?
• What is the expected market price of the stock
  Pn, n years from now?

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The growth rate of stock price

• What is the change of stock price from P0 to
  P1 and from P1 to P2
• What is the change of stock price from Pn to
  Pn1
• What is the expected market price of the stock
  P2, two years from now?
• P2 P1 (1g) P0 (1g)2

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Dividend Yield and Capital Gain

• P0D1/(r-g)
• k(D1/P0)g
• Total returndividend yield Capital gain
• g is capital gain for constant growth stock

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What is the expected dividend yield, capital
gains yield, and total return during the first
year?

• Dividend yield
• D1 / P0 2.12 / 30.29 7.0
• Capital gains yield
• (P1 P0) / P0
• (32.10 - 30.29) / 30.29 6.0
• Total return (rs)
• Dividend Yield Capital Gains Yield
• 7.0 6.0 13.0

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Supernormal growthWhat if g 30 for 3 years
before achieving long-run growth of 6?

• Can no longer use just the constant growth model
  to find stock value.
• However, the growth does become constant after 3
  years.

17
Valuing common stock with nonconstant growth

P

18
Nonconstant growthWhat if g 0 for 3 years
before long-run growth of 6?
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Preferred stock

• Hybrid security
• Like bonds, preferred stockholders receive a
  fixed dividend that must be paid before dividends
  are paid to common stockholders.
• However, companies can omit preferred dividend
  payments without fear of pushing the firm into
  bankruptcy.

20
A preferred stock has an annual dividend of 5,
what should the preferred stock price be if
discount rate is 10?

• Vp D / rp
• 50 5 / 10