Chapter 9 - Stocks and their Valuation PDF

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Professor: Weiwei Zhang
Textbook: Fundamentals of Financial Management, Concise 10e, by Eugene F. Brigham and JoelF.Houston,CengageLearning,(ISBN:9781337902571)...

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Equity Securities - Equity Security → stock - An ownership share → shareholder - Ownership is perpetual - No ownership expiration (bond securities do have expiration → ex: 10 yr bond) - Cash dividends - Characteristics: - Dividends are not a liability of the form until a dividend has been declared by the Board - A firm cannot go bankrupt for not declaring dividends - Dividends and taxes - Dividend payments are not considered a business expense → not tax deductible - Taxation of dividends received by the individuals depend on the holding period - Dividends received by corporations have a minimum of 70% exclusion from taxable income - Dividend payments are not guaranteed - Common Stock - Features: - Voting rights → proportionate ownership - Cumulative voting - Straight voting - Proxy voting - Giving you “proxy” to someone else - Classes of stock - Different rights, different characteristics - ie: BRK - Class A and BRK - class B - Preferred Stock - Generally does not carry voting rights - Stated dividend paid before dividends paid to common stockholders - Dividend are not a liability of the the firm, and preferred dividends can be deferred indefinitely - Most are cumulative → any misses preferred dividends must be paid before common dividends are paid - Bond and Stock - Similarities:

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Provide long-term funding from the organization (ex: corporations, gov’t organization) - Are future funds that an investor must consider - Have future periodic payments - Can be purchased in a marketplace at a price “today” Differences: - From the firm’s perspective:  BOND

STOCK

Is considered long-term debt Is considered equity Gets paid off at the maturity date

Continues indefinitely

Has coupon payments and a Has dividend payments lump-sum payment forever Coupon payments are fixed

Dividends change or “grow” over time

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The mix of bonds (debt) and stock (equity) defines the firm’s Capital Structure Comparison Variations

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Intrinsic Values and their Stock Prices

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The Basics of Valuing Equity - Estimating Future Dividends - Preferred Stock - Dividends fixed in terms of the payment frequency and the amount - Straight preferred stock - A fixed dividend, no maturity, and no embedded option - Adjustable rate preferred stock - Dividends that vary from period to period - Convertible preferred - Option to convert into common stock - Also referred to as “Callable” - Preferred Stock → Discounted cash flow methods - The present value of the perpetual stream of cash dividends - Common stock - The Discounted Cash Flow Approach (DCF) - Corporate Valuation Approach - The Method of Multiples Required Rate of Return - the Key to all Discount Models - A major “benchmark” for valuation - The rate investors/businesses need to justify investment - If returns are greater than Required Return → value RISES - If returns are less than Required Return → value FALLS

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Discount rate for equities (return on equity rs) The compensation for this time value of money (rf) plus a premium for breaking risk of the asset (Risk Premium, RP) rs = rf + Risk Premium Risk Premium: - The higher the risk, the higher the risk premium because investors require a higher return as compensation for bearing more risk

        Discounted Cash Flow (DCF) Approaches to Valuing Equity  We estimate the expected future cash flows associated with the security and then determine the discounted present value for those future cash flows, based on an appropriate discount rate (rs)  - Valuing Preferred Stock - Traditional Straight Preferred Stock - No maturity date, dividends of a fixed amount, regular intervals, indefinitely (represent the periodic dividend payments as Dp ) 

 The Cash Flow Pattern for a Straight Preferred Stock 

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 Ex: Suppose a preferred stock has a par value of $50 per share and dividend rate of 8%. If the required rate of return for this preferred stock is 6%, what is the value of a share of this stock? - Solution: The dividend is $50 × 0.08 = $4 per share, which we discount at the rate of 6%:

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 The stock trades at a premium at its par value What if the required rate of return on the given stock is 10% instead of 6%?

 The stock trades at a discount to its face What if the required rate of return on the given stock is 8% instead of 6%?

 The stock is valued at its par value  Valuing Common Stock - Concerns: - Which cash flow should be discounted? Dividends? Free cash flow? - Dividend Discount Model (DDM) - Most Popular - BUT No guarantee of dividends - Dividend payments are discretionary - Common Stock Value = Present Value of Expected Future Cash Flows - Specifically, dividends. Based on this premise, we estimate today’s value, based on an n-year holding period:

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P0 = value of a share of common stock today Dt = expected dividend a the end of the year t Pn = expected share value after n y ears rs = required return on the common shares  Ex: Consider a stock that is expected to pay $2 dividend at the end of the first year and a $3 dividend at the end of the second year. If the stock is expected to have a value of $20 at the end of 2 years, what is the value of the stock today if the required rate of return is 8%?

 = $21.5707  Valuation with Constant Growth - Dividend Growth Model aka Gordon Modell: - Assumes dividends will grow at a set rate forever “g”

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Dividend Growth Model (DGM) Assumptions (to use this model, you must meet all three requirements): - The growth of all future dividends must be constant - The growth rate must be smaller than the discount rate ( g < R ) - The growth rate must not be equal to the discount rate (g ≠ R) ** this is typically used in Mature Dividend Paying Companies 

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Limitations of the Dividend Discount Model - Best suited for companies that: - Pay dividends based on a stable dividend payout history that they want to maintain in the future - Are growing at a steady and sustainable rate

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Large corporations in mature industries - Stable profits - Established dividend policy This model does not work well for many  resource based companies, which are cyclical in nature and often display erratic growth in earnings and dividends

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Ex1: Supposed Big D, Inc., just paid a dividend (D0 ) of $0.50 per share. 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?  P0 (current stock price) = ?  D0 (recent dividend) = .50  g (expected dividend increase) = .02 Rs (discount rate)  =  .15 

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  Ex2: Suppose Moore Oil Inc., is expected to pay a $2 dividend in one year. If the dividend is expected to grow 5% per year and the required return is 20%, what is the price?  P0 =  ? dividend) = 2.00 D1 (next  g (expected dividend increase) = .05 Rs (discount rate)  =   .20 

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   Estimating the Required Rate of Return (another use for the DGM formula)

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Solve for required rate of return  Ex: Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend, and dividends are expected to grow at 5% per year. - What is the required rate of return? - R = [1(1.05/10.50] + .05 = 15% - What is the dividend yield? (D1 / P0 )  - 1(1.05) / 10.50 = 10% - What is the capital gains yield? (g) - g = 5%

 Supernormal Growth Model - Early in the firm’s life cycle of growth is either much faster or slower than that of the industry/economy - To determine the value of a non-constant growth stock, we generally assume the non-constant growth ends at some point in the future - At the point where non-constant growth ends, we assume c  onstant growth begins

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Determine Dividend Streams and Terminal Value (expected future price of stock) then discount back to present  - Ex: Suppose a firm is expected to increase dividends by 2  0% in one year and by 1  5% for 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 2  0%, what is the price of the stock?  R(discount rate)  =  .20 

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 D1 (dividend at year 1) = (D0 ) (1 + g) = ($1.00) (1 + 20%) = $1.00 x 1.20 = $  1.20 D2 (dividend at year 2) = (D1 ) (1 + g) = ($1.20) (1 + 15%) = $1.20 x 1.15 = $  1.38 D3 (dividend at year 3) = (D2 ) (1 + g) = ($1.38) (1 + 15%) = $1.38 x 1.15 = $  1.59 ** apply DGM after year 3 P3 = D4 / R – g  P3 = D3 (1 + g) / R - g P3 (stock price at year 3) = 1.59 (1.05)/ .20 - .05 = $  11.13 

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Corporate Valuation Model -

Free Cash Flow (FCF) Model - PV of firm’s Free Cash Flows - FCF is the firm’s after-tax operating income less the net capital investment

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Market Value of Company - Valuecompany = PV of expected future free cash flows

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Using the corporate valuation model to find the firm’s intrinsic value - Given: long run gFCF = WACC= 7%  5%

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What is the firm’s intrinsic value per share? - The firm has $40 million total in debt and preferred stock and has 10 million shares of common stock.

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Process: - Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs - Subtract MV of firm’s debt and preferred stock to get MV of common stock - Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value) Some issues: - Benefits: - Can be used on Public Firms that pay No dividends - Easier to compare differing firms - Frequently shares constant growth similar to DDM - Detriments: - Many variables, subject to error - Estimates Intrinsic Value

   Using Multiples to Value Equity -

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Relative Valuation - Comparing the market values of similar companies - Such as earnings, cash flow, book value, or sales Method of Multiples - Find Similar Firm - Financial Analysis & Market Values - Infer Value However, finding comparable companies is difficult - i.e., what company is similar to Microsoft? What would be an appropriate multiple? Firms Differ. Difficult & very subjective

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Price-Earnings (P/E) Ratio - How much investors are willing to pay for a company’s earnings - Share price divided by the earnings per share (P0 / EPS) - Limitations: - Practical concerns regarding the use of P/E ratios: - The P/E ratio is uninformative when companies have negative or very small earnings - The P/E ratio may be highly variable across an industry - The volatile nature of earnings implies a great deal of volatility in P/E multiples - Net income, and hence earnings per share, are susceptible to the influence of accounting choices and earnings management - P/E ratios are often based on smoothed or normalized estimates of earnings for the forecast year

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SUMMARY You should be able to: - Describe the basic characteristics of equity securities, and identify the primary factors that affect stock values. - Discuss the legal rights of stockholders. - Explain the distinction between a stock’s price and its intrinsic value. - Identify the two models that can be used to estimate a stock’s intrinsic value: the discounted dividend model and the corporate valuation model. - List the key characteristics of preferred stock, and describe how to estimate the value of preferred stock.

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