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BUAD 306 Business Finance Session 8 Stock Valuation Professor Kristy Jansen Why do stock prices move Roadmap At the end of this class you should be able to Explain in detail shareholder rights of different types of shares Common vs preferred stock Understand the relevant participants in stock markets Explain how to price stocks using Dividend Growth Model DGM Understand alternative valuation model Multiples Main features of Common Stock Common Stock is a claim on the income generated by the firm Holders receive dividends decided by the firm management a residual claim on the assets of the firm Assets value may appreciate So stocks may be sold a price higher than the purchase price capital gain Dividends and capital gain are two ways to make money from stock investments Main features of Common Stock Voting rights to elect the board and approve major decisions Directors are elected at annual shareholders meeting One share one vote per director 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 More features of Common Stock Proxy voting a shareholder grants someone the authority to vote on his her behalf Crucial in big companies with millions of shareholders Proxy fights The act of a group of shareholders joining forces and attempting to gather enough shareholder proxy votes to win a corporate vote More features of Common Stock Many firms issue different classes of stock Depending on the voting rights E g Alphabet Class A public share has 1 vote Class B private share has 10 votes class C public share has no voting right E g Uber All shares have 1 vote E g Snap Class A public shares have no voting rights The purpose is to keep control of the firm A crucial feature of Common Stock Dividends Dividends are payments in cash or stock made by a firm to its shareholders Dividends are not a liability of the firm Firms cannot go bankrupt for not declaring dividends Dividends and Taxes Dividends received by individuals are taxed as ordinary income Main features of Preferred Stock Preferred stock the holder is promised by the issuer a fixed dividend every quarter forever Preferred dividend must be paid to preferred stockholders before dividend can be paid to common stockholders Most preferred dividends are cumulative Any missed preferred dividends must be paid before common dividends can be paid Preferred stock generally does not carry voting rights Debt versus Equity Companies issue both stocks and bonds to raise money Unlike bonds common stocks give holder an ownership in the firm No maturity date on a stock it exists if the firm exists No upper limit on dividend payments Debt versus Equity Debt Equity Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest or principal payments are missed Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not tax deductible Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid Excess debt can lead to bankruptcy An all equity firm cannot go bankrupt Stock exchange markets New York Stock Exchange Stock exchange markets Los Angeles Stock Exchange Left 1935 Right 2021 Stock Exchange markets Intermediaries Dealers and Brokers time Think of Car dealers inventory Think of Real estate brokers Dealers Maintains inventory and stands ready to buy and sell at any Brokers Brings buyers and sellers together but does not maintain an Common stock valuation A basic principle if you buy a share of stock you can receive cash in two ways The company pays dividends You sell your shares either to another investor in the market or back to the company leading to capital gain Like bonds the price of the stock is the present value of these expected cash flows A one period example Suppose you are thinking of purchasing the stock of Moore Oil Inc and you expect it to pay a 2 dividend in one year and you believe that you can sell the stock for 14 at that time If you require a return of 20 on investments of this risk what is the maximum you would be willing to pay Compute the PV of the expected cash flows 0 1 1 1 2 14 1 0 2 13 33 Excel FV 16 rate 20 N 1 Then click PV 13 33 In practice we do not know 1 A two periods example Now what if you decide to hold the stock for two years In addition to the dividend in one year you expect a dividend of 2 10 and a stock price of 14 70 at the end of year 2 Now how much would you be willing to pay Compute the PV of the expected cash flows 0 1 1 2 1 2 2 1 2 0 2 1 0 2 2 1 1 0 2 2 14 7 1 0 2 2 13 33 Excel CF0 0 CF1 2 CF2 16 80 r 20 NPV 13 33 A three periods example Finally what if you decide to hold the stock for three periods You expect to receive a dividend of 2 205 at the end of year 3 and a stock price of 15 435 Now how much would you be willing to pay Compute the PV of the expected cash flows 2 1 2 2 1 1 2 2 2 205 15 435 1 2 3 13 33 Calculator CF0 0 CF1 2 CF2 2 10 CF3 17 64 I YR 20 Then click NPV 13 33 Developing a valuation model You could continue to push forward when you would sell the stock to 4 years 5 years You would find that the price of the stock is really just the present value of all expected future dividends 0 1 1 2 1 2 3 1 3 4 1 4 So how can we estimate all future dividend payments This is obviously a crucial point Estimating dividends three special cases Constant dividend zero growth The firm will pay a constant dividend forever This is like preferred stock How do we compute it Perpetuity formula Constant dividend growth The firm will increase the dividend by a constant rate every period How do we compute it Growing perpetuity formula Non constant growth Dividend growth is not constant initially but settles down to constant growth eventually How do we compute it Split the problem Zero growth If dividends are expected at regular intervals forever then this is like preferred stock and is valued as a perpetuity P0 D R Example Suppose stock is expected to pay a 0 50 dividend every quarter and the annual required return is 10 with quarterly compounding What is the price P0 0 50 0 1 4 20 Dividend growth model DGM Dividends are expected to grow at a constant rate g per period 0 1 1 2 1 2 1 0 0 1 1 0 1 2 …


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USC BUAD 306 - Session 8: Stock Valuation

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