Presentation on theme: "Cash Flows for Stockholders"— Presentation transcript:
0 Chapter 8: Outline Common Stock Valuation Some Features of Common and Preferred StocksThe Stock Markets
1 Cash Flows for Stockholders If you buy a share of stock, you can receive cash in two waysThe company pays dividendsYou sell your shares, either to another investor in the market or back to the companyAs with bonds, the price of the stock is the present value of these expected cash flows
2 One Period ExampleSuppose 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 flowsPrice = (14 + 2) / (1.2) = $13.33Or FV = 16; I/Y = 20; N = 1; CPT PV =
3 Two Period ExampleNow 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 in two years and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay?PV = 2 / (1.2) + ( ) / (1.2)2 = 13.33
4 Three Period ExampleFinally, what if you decide to hold the stock for three years? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and the stock price is expected to be $ Now how much would you be willing to pay?PV = 2 / / (1.2)2 + ( ) / (1.2)3 = 13.33
5 Infinite Periods: Special Cases Constant dividendThe firm will pay a constant dividend foreverThis is like preferred stockThe price is computed using the perpetuity formulaConstant dividend growthThe firm will increase the dividend by a constant percent every periodSupernormal growthDividend growth is not consistent initially, but settles down to constant growth eventually
6 Zero GrowthIf dividends are expected at regular intervals forever, then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formulaP0 = D / RSuppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?P0 = .50 / (.1 / 4) = $20
7 Dividend Growth ModelDividends are expected to grow at a constant percent per period.P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + …g is the growth rate in dividendsWith a little algebra and some series work, this reduces to:
8 DGM – Example 1Suppose Big D, Inc. just paid a dividend of $.50. 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?P0 = .50(1+.02) / ( ) = $3.92
9 DGM – Example 2Suppose TB Pirates, Inc. is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?P0 = 2 / ( ) = $13.33Why isn’t the $2 in the numerator multiplied by (1.05) in this example?
10 Stock Price Sensitivity to Dividend Growth, g D1 = $2; R = 20%As the growth rate approaches the required return, the stock price increases dramatically.
11 Stock Price Sensitivity to Required Return, R D1 = $2; g = 5%As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.
12 Example 8.3 Gordon Growth Company Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.What is the current price?P0 = 4 / ( ) = $40Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g
13 Nonconstant Growth Problem Statement Suppose a firm is expected to increase dividends by 20% in one year and by 15% in 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 20%, what is the price of the stock?Remember that we have to find the PV of all expected future dividends.
14 Nonconstant Growth – Example Solution Compute the dividends until growth levels offD1 = 1(1.2) = $1.20D2 = 1.20(1.15) = $1.38D3 = 1.38(1.05) = $1.449Find the expected future priceP2 = D3 / (R – g) = / ( ) = 9.66Find the present value of the expected future cash flowsP0 = 1.20 / (1.2) + ( ) / (1.2)2 = 8.67
16 Features of Common Stock Voting RightsProxy votingClasses of stockOther RightsShare proportionally in declared dividendsShare proportionally in remaining assets during liquidationPreemptive right – first shot at new stock issue to maintain proportional ownership if desiredProxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote.Different classes of stock can have different rights. Owners may want to issue a nonvoting class of stock if they want to make sure that they maintain control of the firm.
17 Dividend Characteristics Dividends are not a liability of the firm until a dividend has been declared by the BoardConsequently, a firm cannot go bankrupt for not declaring dividendsDividends and TaxesDividend payments are not considered a business expense; therefore, they are not tax deductible
18 Features of Preferred Stock DividendsStated dividend that must be paid before dividends can be paid to common stockholdersDividends are not a liability of the firm and preferred dividends can be deferred indefinitelyMost preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paidPreferred stock generally does not carry voting rights
19 Stock Market, I Dealers vs. Brokers Dealer: maintains an inventory and stands ready to trade at quoted bid (price at which they will buy) and ask (price at which they will sell) prices. Make their profit from the difference between the bid and ask prices, called the bid-ask spread. The smaller the spread the more competition and the more liquid the stock. The move to decimalization allows for a smaller bid-ask spread. There will be more discussion of this later.Broker: a broker matches buyers and sellers. They perform the search function for a fee (commission). They do not hold an inventory of securities.
20 Stock Market, II New York Stock Exchange (NYSE) Largest stock market in the worldMembersOwn seats on the exchangeCommission brokersSpecialists. Specialists manage the order flow by keeping the limit order book. The limit order book lists the trades that investors have given to their brokers that include desired trading prices. The specialist is also a dealer that holds an inventory in their assigned stock, they post bid and ask prices and they are supposed to maintain an orderly market.Floor brokersFloor traders
21 NASDAQ Not a physical exchange – computer-based quotation system Multiple market makersElectronic Communications NetworksThree levels of informationLevel 1 – median quotes, registered representativesLevel 2 – view quotes, brokers & dealersLevel 3 – view and update quotes, dealers onlyLarge portion of technology stocks
22 Figure 8.2: Stock Quotes Sample Quote YTD % Change = 4.5% HarrahEntn HETYTD % Change = 4.5%52 week high = 57.50; 52 week low = 38.60Company is Harrahs EntertainmentTicker is HETAnnual dividend = $1.20 per shareDividend yield = 2.3%P/E ratio = 20Volume = 10943*100 = 10,943,000 sharesClosing price = 52.03Change from previous day is This means the closing price the day before was = 51.68