Lecture 4 (Chapter 8) Stock Valuation. Stock Valuation

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1 Lecture 4 (Chapter 8) Stock Valuation Why study stocks? Content: How to value stocks Understanding stock terminology and data Features of common stock Features of preferred stock Lecture 4: Stock Valuation 1 Stock Valuation Like any other financial asset, we value a stock based on its cash flows What cash flows do we get from stocks? Dividend payments Revenue from future sale of shares What price should we pay for a stock that we plan to sell in two years for P and that will receive dividend payments of D 1 and D? Lecture 4: Stock Valuation 1

2 Stock Valuation (cont) But how do we determine P? Price that a sensible investor would be willing to pay us Must depend on future cash flows? dividends D3 P = (1 + r) Then using this in our equation for P 0, Assumptions Investors are smart Firms last forever D4 + (1 + r) + D = 1 D D3 Di P0 = i ( 1+ r) (1 + r) (1+ r) i= 1 (1+ r) Result: the value of common stock is equal to the discounted value of its future dividend payments Lecture 4: Stock Valuation 3... Dividend Valuation Models Problem: how do we determine dividends into the infinite future, and how do we discount them back to today? Possibilities: 1. No dividends. Constant dividends 3. Constant dividend growth 4. Temporarily non-constant growth Lecture 4: Stock Valuation 4

3 Dividend Valuation (cont) Case 1: No dividends What is a firm worth that Pays no dividends? What about Growth firms? Case : Constant Dividends A firm that pays a constant dividend of D dollars per share for the infinite future should be value like a P = D/r Are these models realistic? Lecture 4: Stock Valuation 5 Gordon Growth Model Case 3: Constant dividend growth Managers often consider it to be their job to increase dividends over time to provide increasing returns to stockholders Assume dividends grow by a constant rate of g per year, so D 1 = D 0 (1+g) and D t = D 0 (1+g) t This is the same cashflow as a Value of stock: P 0 = D/(r-g) What happens if g > r? Will this hold up in the long-run? Lecture 4: Stock Valuation 6 3

4 Growth Model Examples Suppose a stock has just paid a $5 per share dividend. The dividend is projected to grow at 5% per year indefinitely. If the required return is 9%, what is the price today? What will be the price one year from now? By what percentage has it increased? Suppose a stock has just paid a $5 per share dividend. The dividend is projected to grow at 5% per year indefinitely. If the price today is $65.65, what is the required return? Lecture 4: Stock Valuation 7 Components of Required Return For a given level of risk, investors require a rate of return of r on their investment in a stock. D1 + P1 D1 P1 RoR = = + = r P P P 0 D 1 /P 0 is the dividend yield P 1 /P 0 is the rate of capital gains Higher expected dividend growth means that less of the return will be current dividends. 0 0 What dividend/capital gain mix would you expect in A hi-tech startup? A tobacco company? An oil well running dry (or a biotech with an expiring patent)? Lecture 4: Stock Valuation 8 4

5 Non-constant dividend growth Our dividend discount models will continue to work as long as dividend growth becomes constant eventually. How to find value of a temporarily non-constant dividend growth stock: 1. Find the value of the stock at the time in the future when dividend growth becomes constant and discount this back to today.. Take the present value of all cash flows between now and the start of constant growth, and add it to the value found in step 1. Example: Your internet-based cement business is expected to pay no dividends for the first three years due to startup costs. Thereafter, it will pay a dividend that will start at $1 and grow at 5% per year. The discount rate is 9%. What is the value of a share in this business? Hint: Watch the timing! Lecture 4: Stock Valuation 9 Non-constant dividend growth Example : Global warming Inc just paid a yearly dividend of $5 per share. Because of the expanding market, you predict an increase in dividends of 50% for each of the next three years, followed by constant dividends. How much should you pay for a share of stock? Lecture 4: Stock Valuation 10 5

6 Stock Market Reporting Your text shows how to interpret stock market listings from a newspaper, but most people today use the internet to get information on stocks. Some of the things we need to understand Price Volume Dividends Dividend Yield Price/Earning (P/E) ratio How do firms decide when to invest (retain) earnings and when to pay them out as dividends Lecture 4: Stock Valuation 11 Features of Common Stocks Shareholders rights: Vote proportionally for the Board of Directors Vote on issues of great importance (e.g., mergers) Share proportionally in dividends Share proportionally in liquidation value First opportunity to buy new shares (pre-emptive rights) Exact rights of shareholders depend on the corporation s charter Classes of Stock: can include non-voting shares Must receive dividends at least as high as voting shares Protected by coat-tail provision in case of takeovers Voting Systems: differ in protection of minority shareholders Cumulative system allows smaller shareholders to optimally spread votes in board elections. Proxy votes allow shareholders who cannot attend meetings to participate. Lecture 4: Stock Valuation 1 6

7 Features of Preferred Shares Preferred shares resemble bonds in many ways Have a face value and a declared dividend rate Have preference over common stockholders Must receive dividends before common (cumulative dividends) In liquidation, are paid after bonds but before common Usually have no voting rights May have other debt features Callable/convertible/sinking fund/adjustable rate/etc Preferred shares usually have lower yield than bonds, even though they come after bonds in priority Tax motive Firms like preferred shares because No bankruptcy risk Raise equity without losing control Lower payments due to tax treatment for low-tax firms Regulatory environments that encourage it Lecture 4: Stock Valuation 13 What we know now Stocks, like other assets, are valued by discounting future cashflows: dividends We use the perpetuity formula to find value of dividends Constant Growing Temporarily non-constant Returns from stocks consist of dividends and capital gains How to read stock listings on the Internet or in a newspaper Shareholders rights Classes of stock / Preferred shares Lecture 4: Stock Valuation 14 7