Chapter 8 Stock Valuation Bonds and Stock Valuation o Bonds and Stock Similarities Provide long term funding source of money Future funds that investor must consider Future periodic payments Purchased in marketplace at price today o Differences Stock is equity bond is long term debt firm s perspective Bond gets paid off at maturity date stock continues indefinitely firm s perspective Common stock valuation Cash flow for stockholders o Must bring expected future values into present terms price Buy stock two ways to receive cash Company pays dividends current income Sell shares either to another investor in market or back to company o Sell buy stock price capital gain loss o Sales price is not a guarantee in common stock One period example o You expect a 2 dividend in first year current income believe you can sell for 14 at that time If you are required a 20 rate on investments of the risk what is the maximum you re willing to pay 1 N 20 I Y 2 PMT FV 16 CMP PV 13 34 Value stock need to figure out dividend payments Assume in future will pay dividends no matter how far in the future How do they evolve over time Future dividends o Constant dividend zero growth o Dividends changes by growth rate constant P0 D0 1 G R G or D1 R G When G R negative number doesn t work When G R undefined doesn t work Dividend Growth model assumptions only for constant Three requirements o Future dividend growth must be constant o G R o G must not equal R Example D0 50 per share increases 2 per year 15 required rate what should sale price be 50 1 02 15 02 13 33 o Some unusual growth periods and then level off to constant growth rate changes over time Growth of 20 in one year growth of 15 in next two years then dividend will increase at 5 per year indefinitely Dividend of 1 with rate of 20 What is present value P3 D 1 G R G o 1 59 1 05 20 5 11 13 Chapter 8 Stock Valuation Stock valuation based on dividends with no maturity date o Example Firm pays annual dividend of 3 50 What is the price given with a discount of 12 D P 3 50 12 29 17 Firm pays an annual dividend of 5 What is the price given a discount rate of 10 and given a growth rate of 5 D1 R G 5 10 05 100 Firm pays a dividend of 1 in year one In year two it pays 2 in year three it pays a dividend of 3 that will grow at 3 going into the future What is the price given at discount rate of 8 Stock is equity bond is long term debt firm s perspective CFO 0 CO1 1 FO1 1 CO2 2 FO2 1 CO3 640 08 P3 3 F 3 1 NPV 8 COM PV 54 08 o P3 D4 R 3 05 Using the DGM to find rate o When given particular time and particular dividend R D0 1 g P0 D1 Po G Sells for 10 50 just paid 1 dividend expected to grow at 5 o R 1 1 05 10 50 0 05 15 Do 1 g P0 1 1 05 10 50 10 yield o Received in dividends in current year divided by Dividend yield sale price Capital gains yield G 5 o Appreciation in price of stock in amount of time o Required return dividends yield capital gains Stock Valuation Alternative o Value stock without cash flow valuation Benchmark ratios PE Benchmark PE ratio X EPS PE Benchmark price sales ratio X sales price per share o Makes prices relative to each other o Problems How many good comparables are there to get an accurate measure Never get the value just scaling How to decide dividend and rate Features of Common Stock o Voting Rights quarterly or annually Common holders Affect the firm agent problem o Executive compensation o Restructuring of business Hard to follow all companies in depth for voting Someone else votes for you at the companies so voting problem doesn t arise o Proxy voting o Classes of shares Depending on class of share affects how many votes you are given Shows amount of votes per stock A 100 votes per stock B 1 10 votes per stock Three requirements Dividends Characteristics o Future Share proportionally in declared dividend o Share proportionally in remaining assets during liquidation if any o Preemptive right first shot at new stock issue to maintain proportional ownership if desired If open to market it would decrease proportion of previous owners go from 9 ownerships 6 ownership example o Dividends are not a liability to a firm not obligation until dividend has been declared by the board Firm can not go bankrupt for not declaring dividend Dividend payments are not considered a business expenses therefore they are not tax deductable Taxation of dividend by individual depends on the holding period Dividends received by corporation have minimum of 70 exclusion from taxable income Some unusual growth periods and then level off to constant growth rate Features of preferred stock over time o Most preferred are cumulative any missed preferred dividends have to be paid before common stock dividends can be paid Firm can omit preferred stock But make up back payment o Doesn t carrying voting rights o Has stated rates Chapter 9 Net Present Value Tools to value decisions capital budget process o Uses of capital budgeting Replace Maintain or obsolescence Cost reduction in long run Expand cash flows Current product or current service make larger o New product or new service Product line in new area Firm pays a dividend of 1 in year one In year two it pays 2 in year three it pays a dividend of 3 that will grow at 3 going into the future What is the price given at discount rate of 8 Payback period how long does it take to get the initial cost back in normal sense o Estimate cash flows Subtract future cash flows from initial cost until initial investment has been covered Low pay back receive initial cost in fast amount of time o Example Year 0 Cash Flow 165 000 Year 1 Cash Flow 63 120 Year 2 Cash Flow 70 800 Year 3 Cash Flow 91 080 Rate 12 Year 1 165 000 63 120 101 880 Year 2 101 880 70 800 31 080 Year 3 31 080 91 080 60 000 received all initial costs back and more o Accept over recover our cost of project early o Payback Decisions Restaurants typically uses 5 years most companies use either 3 or 4 years Use arbitrary numbers Depend on business Disadvantages Doesn t adjust for time value of money Do not use required rate no adjustment for risk Requires an arbitrary cutoff Biased against long term projects such as research Ignores cash flows beyond the cut off date and development and new projects Discounted payback period o Include time value of money and adjust for risks …
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