Title: Stocks (Equity) Characteristics and Valuation
1Stocks (Equity)Characteristics and Valuation
- What is equity?
- What factors affect stock prices?
- How are stock prices determined?
- How are stock returns determined?
- What techniques do investors use to value stocks?
2Basic Types of Stock
- Preferred stock hybrid
- Common stock
3Preferred Stock Features
- Par value
- The nominal or face value of a stock or bond
- Dividends
- Generally fixed, like debt based on the par
value - Cumulative dividends
- Preferred dividends not paid in previous periods
must be paid before common dividends can be paid - Maturity
- No specific maturity date
- Priority to assets and earnings
- Preferred stockholders are paid before common
stockholders
4Preferred Stock Features
- Control of the Firm (Voting Rights)
- Most preferred stock is nonvoting, unless
dividends are not paid for a particular number of
periods - Convertibility
- Can be converted to common stock
- Call provision
- Firm has the right to call in preferred stock for
redemption - Sinking fund
- A fund used to retire a given amount of the stock
each year - Participating
- Shares earnings with common stockholders
5Common Stock Features
- Par value
- Stockholders minimum financial obligation
- Dividends
- No legal obligation to pay dividends
- Maturity
- No specific maturity date
- Priority to assets and earnings
- Receive distributions last
- Preemptive right
- Right to buy new issues
- Control of the firm
- Vote on board of directors, stockholder
proposals, etc.
6Types of Common Stock
- Classified Stock
- Special designations, such as Class A, Class B,
etc., used to meet special needs of the company - Founders Shares
- Classified stock
- A class of stock owned by the firms founders who
have sole voting rights for a particular time
period
7Equity Instruments in International Markets
- American Depository Receipts
- Certificates that represent ownership in stocks
of foreign companies - Foreign Equity
- Yankee stockissued by foreign firm and traded in
the United States - Euro stocktraded outside of home country,
excluding the United States
8Stock Valuation
- Stock value Present value of the dividends that
the company is expected to pay during its life. - If the stock never pays a dividendwhether a
regular dividend or a liquidating dividendthen
its value is 0.
9Stock ValuationTerms
D0 the most recently paid dividend
P0 current market price
g growth rate
rs the rate of return investors require to
purchase the firms common stock
(hat) an expected valuethat is, a value that
is forecasted to occur in the future.
10Stock Valuation
Stock ownership entitles the investor to the
future cash flows, called dividends, that are
paid by the firm
11Stock Valuation
rs required return on stock
12Stock ValuationConstant Growth, g
If growth is constant such that g g1 g2
g8
Value of a constant-growth stock
Required g constant rs gt g
13Stock ValuationConstant Growth, g
- The most recent dividend paid (D0) by a firm was
2 the firm is expected to grow at a constant
rate (g) equal to 4 percent and the required
rate of return (rs) on similar risk investments
is 12 percent.
14Stock ValuationConstant Growth, g
1 2.0800 2.00(1.04)1 1.8571
2 2.1632 2.00(1.04)2 1.7245
3 2.2497 2.00(1.04)3 1.6013
5 2.4333 2.00(1.04)5 1.3807
10 2.9605 2.00(1.04)10 0.9532
50 14.2134 2.00(1.04)50 0.0492
100 101.0099 2.00(1.04)100 0.0012
15Stock ValuationConstant Growth, g0
g 0
16Stock ValuationConstant Growth, g0
The preferred stock of a company pays a constant
dollar dividend equal to 4 per share. The
required rate of return on similar risk
investments is 8 percent.
Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0
8.0
12.0
Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0 80.00
Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0 80.00
8.0 50.00
Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0 80.00
8.0 50.00
12.0 33.33
17Stock ValuationNonconstant Growth
gnorm constant, or normal, growth
18Stock Valuation with Nonconstant GrowthExample
D0 1.25 g1 25 g2 20 g3 10 g4
-4 g5 5 g6 g8 rs 14
19Stock Valuation with Nonconstant GrowthExample
25
1.3706
1.2500(1.25)
1.5625
1
20Stock Valuation with Nonconstant GrowthExample
- Because the dividends grow at a constant rate
after Year 4, we can apply the constant growth
model such that
21ValuationCash Flow Time Line
14
1.5625
1.8750
2.0625
1.9800
5.3778
23.10
13.6771
22Stock ValuationNonconstant Growth
- The key to computing the value of a stock that
exhibits nonconstant growth is to assume constant
growth occurs at some point in the futureit
might start in five years, 50 years, or 100
years - Apply the constant growth model to compute the
value of the expected dividends from that point
forward. - Compute the present value of the stocks value at
the point where you assume constant growth
begins. - Prior to the point where constant growth begins
- Compute the dividend for each year
- Find the present value of each dividend
- Sum the PV results.
23Stock Return
Expected dividend yield
Expected growth rate (capital gains yield)
Expected rate of return
24Stock Return
25Stock Return
- In one year, the price of the stock is expected
to be
26Stock Return
- Because the value of the stock is expected to
increase from 30.00 to 31.80 during the year,
27Valuation Using P/E Ratios
- P/E ratio Price EPS price multiple
- Normal P/E
- Example A firms P/E is normally 8.0x. If its
EPS 7, then the value of its stock should be
56 7 x 8
28Valuation Using EVA
- Economic Value Added EVA
- Earnings must be sufficient to pay those who
provide funds to the firm otherwise the value of
the firm should decrease.
29Stocks (Equity)Characteristics and Valuation
- What is equity?
- Stock/ownership.
- What factors affect stock prices?
- Investors change their expectations about the
returns the firm will generate in the future. - How are stock prices determined?
- The price is equal to the present value of the
dividends stockholders expect to receive during
the companys life.
30Stocks (Equity)Characteristics and Valuation
- How are stock returns determined?
- Returns are based on the dividend the company
pays and the change in the market value of the
stock during the year - What techniques do investors use to value stocks?
- P/E Ratio
- Economic Value Added (EVA)