BUAD 306 Business Finance Valuing Stocks In a tornado even a turkey can fly Venture Capitalist Eugene Kleiner Julia Plotts Associate Professor of Clinical Finance and Business Economics plotts marshall usc edu Stock Valuation Agenda We want to understand the major features of common and preferred stocks Voting rights dividends We want to learn how to price stocks Dividend growth model Market Multiples We want to have a basic understanding of how the stock markets work NYSE versus NASDAQ see your book Reading stock quotes 2 Main features of Common Stock Voting rights to elect board approve major decisions Unless you buy shares in the SNAP IPO Directors are elected at annual shareholders meeting General idea one share one vote of votes of shares of directors to elect Cumulative voting directors are elected all at once and shareholder may cast all votes for one director Straight voting directors are elected one at a time and shareholder may cast all votes for each director Proxy voting a shareholder grants someone the authority to vote on his her behalf Crucial in big companies with millions of shareholders 3 More features of Common Stock Classes of stock Depending on the voting rights The purpose is to keep control of the rm Other Rights Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Preemptive right rst shot at new stock issue to maintain proportional ownership if desired In jargon to prevent dilution 4 Earning Returns from Stocks The value of any asset is the present value of its expected future cash ows Stock ownership produces cash ows from Dividends Common Stock is a claim on the income generated by the rm It entitles the holder to dividends at the management s discretion Capital Gains Common Stock is also a residual claim on the assets of the rm It provides higher but riskier return than other assets It can be sold hopefully at a price higher than it was bought for capital gain 5 Dividends Dividends are payments in cash or stock made by a rm to its shareholders Dividends are not a liability of the rm until a dividend has been declared by the Board Firms cannot go bankrupt for not declaring dividends Dividends and Taxes Dividend payments are not considered a business expense so are not tax deductible Dividends received by individuals are taxed as ordinary income Corporations can exclude 70 of the received dividend from their taxable income 6 Main features of Preferred Stock Preferred stock the holder is promised by the issuer a xed dividend every quarter forever Stated dividend must be paid to preferred stockholders before dividend can be paid to common stockholders Dividends are not a liability of the rm and preferred dividends can be deferred inde nitely Most preferred dividends are cumulative Any missed preferred dividends have to be paid before common dividends can be paid Preferred stock generally does not carry voting rights 7 Estimating dividends 3 special cases Constant dividend The rm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula Constant dividend growth The rm will increase the dividend by a constant rate every period Nonconstant growth Dividend growth is not constant initially but settles down to constant growth eventually 8 Stock Valuation Formulas 9 Case 1 Zero Growth Assume that dividends will remain at the same level forever Div1 Div2 Div3 Since future cash flows are constant the value of a zero growth stock is the present value of a perpetuity Div1 P Div P0 1 r r 0 Preferred Quote 1 Div2 Div3 Since the zero growth 2 model 3 assumes that the 1 r 1 r dividend always stays the same the stock price would be equal to the annual dividends divided by the required rate of return 10 Case 1 Zero Growth Suppose a stock is expected to pay a 0 50 dividend every year and the required return is 10 What is the estimate of the stock s intrinsic value Div P0 r 5 50 10 11 Wall Street Journal Preferred Stock Quotes Div P0 r 25 1 63 The AED Preferred closed at 25 Based on the set dividend of 1 63 it is providing investors with a yield or return of 6 5 065 12 Example Alabama Power Company You can also rearrange the equation to determine the cost of capital on a Preferred Stock To illustrate consider the preferred shares issued by Alabama Power Company ALP PP which pay a 5 3 annual dividend on a 25 00 par value or 1 33 per share On November 4 2009 these preferred shares were selling for 23 60 per share Consequently investors require a 5 67 return on these shares calculated as follows Kps is the same as r 13 Case 2 Constant Growth Assume that dividends will grow at a constant rate g forever i e Div1 Div0 1 g Div 2 1 g Div 1 g 2 1 0 Div Div 1 g 1 g 3 Div Div 3 2 0 Div Dt 1 1 at a constant rate Since future cash ows grow forever the value of a constant D t t P g perpetuity growth stockPis the present value of a growing 0 r g R g 1 R g 14 Constant Growth Example Using perpetuity growth method Suppose a company just paid a dividend of 50 It is expected to increase its dividend by 2 per year this is the expected growth rate If the market requires a return of 15 on assets of this risk what is the stock s fair value today 3 92 50 1 02 51 This is called a growing perpetuity or Gordon Growth method 15 02 13 15 Estimates of Parameters The value of a rm depends upon its growth rate g and its discount rate R Where does g come from g Retention ratio ROE sustainable g Where does R come from The discount rate can be broken into two parts The dividend yield The growth rate in dividends In practice there is a great deal of estimation error involved in estimating R We will discuss various approaches for quantifying risk later in the semester 16 Using the DGM to nd the required return R Start with the DGM D0 1 g D P0 1 R g R g Then rearrange terms and solve for R R D0 1 g g D1 P0 P0 g R Dividend yield Capital gains yield Why Stock price grows at rate g R is the stock s expected annual total rate of return 17 Estimating the Cost of Equity Cost of equity R D P g What could go wrong Only for established stable rms paying dividends Some companies don t pay dividends at all Amazon Only if assumption of constant growth is reasonable Again better suited to mature companies Even for mature companies forecasting earnings dividend growth is not trivial 18 Example Applying the Dividend Discount Model A company forecasts to pay a 8 33 dividend next year which represents 100 of its