1. Stock Valuation (ch 8) 1 Common Stock Valuation Features of Common and Preferred Stocks The Stock Market Stock Valuation

2. Stock Valuation (ch 8) 2 1. Common Stock Valuation In 1938, John Burr Williams postulated what has become the fundamental theory of valuation: The value today of any financial asset equals the present value of all of its future cash flows. For common stocks, this implies the following (the general case): D 1 P 1 D 2 P 2 P 0 = +and P 1 = + (1 + R) 1 (1 + R) 1 (1 + R) 1 (1 + R) 1 substituting for P 1 gives D 1 D 2 P 2 P 0 = + +. Continuing to substitute, we obtain (1 + R) 1 (1 + R) 2 (1 + R) 2 D 1 D 2 D 3 D 4 P 0 = + + + + … (1 + R) 1 (1 + R) 2 (1 + R) 3 (1 + R) 4

3. Stock Valuation (ch 8) 3 Common Stock Valuation: The Zero Growth Case According to the fundamental theory of value, the value of a financial asset at any point in time equals the present value of all future dividends. If all future dividends are the same, the present value of the dividend stream constitutes a perpetuity. The present value of a perpetuity is equal to C/r or, in this case, D 1 /R. Question:Cooper, Inc. common stock currently pays a $1.00 dividend, which is expected to remain constant forever. If the required return on Cooper stock is 10%, what should the stock sell for today? Answer:P 0 =

4. Stock Valuation (ch 8) 4 Common Stock Valuation: The Constant Growth Case In reality, investors generally expect the firm (and the dividends it pays) to grow over time. How do we value a stock when each dividend differs from the one preceding it? As long as the rate of change from one period to the next, g, is constant, we can apply the growing perpetuity model: D 1 D 2 D 3 D 0 (1+g) 1 D 0 (1+g) 2 D 0 (1+g) 3 P 0 = + + + … = + + +... (1 + R) 1 (1 + R) 2 (1 + R) 3 (1 + R) 1 (1 + R) 2 (1 + R) 3 D 0 (1 + g) D 1 P 0 = =. R - g R- g Now assume that D 1 = $1.00, r = 10%, but dividends are expected to increase by 5% annually. What should the stock sell for today?

5. Stock Valuation (ch 8) 5 Common Stock Valuation: The Constant Growth Case Answer:The equilibrium value of this constant-growth stock is D 1 = = $ R - g Question:What would the value of the stock be if the growth rate were only 3%? Answer: D 1 = = $ R - g Why does a lower growth rate result in a lower value?

6. Stock Valuation (ch 8) 6 Stock Price Sensitivity to Dividend Growth, g 0 2% 4% 6% 8% 10% 50 45 40 35 30 25 20 Stock price ($) Dividend growth rate, g D 1 = $1 Required return, R, = 12% 15 10 5

7. Stock Valuation (ch 8) 7 Common Stock Valuation - The Nonconstant Growth Case For many firms (especially those in new or high-tech industries), dividends are low but are expected to grow rapidly. As product markets mature, the dividend growth rate is then expected to slow to a “steady state” rate. How should stocks such as these be valued? Answer: We return to the fundamental theory of value - the value today equals the present value of all future cash flows. Put another way, the nonconstant growth model suggests that P 0 =present value of dividends in the nonconstant growth period(s) + present value of dividends in the “steady state” period.

8. Stock Valuation (ch 8) 8 See Examples in page 223 If a firm is not paying dividend currently and it expects to pay $0.50/share dividend in year 5. Dividend will grow by 10% since then. The required rate of return is 20%. What is the price of the stock today? the starting point is year 0 while first dividend is in year 5. Let’s ignore the period from year 0 to year 5. Assuming year 5 is a new year 0. What would be the stock price of the new stock in the setup: P(5) = D(5)+D(5)*(1+g)/(R-g) = 0.5+0.5*1.1/(.2-.1)=6.0 P(0) = P(5)/(1+R)^5 = 6.0/1.2^5=2.41 Go through the next example (figure 8.1, p223) Go through Table 8.1

9. Stock Valuation (ch 8) 9 Example 2: A company has been growing at a rate of 30% for 3 years and then drops to 10% per year. Its total dividend just paid were $5 million and required rate of return is 20%. If the growth rate remains constant indefinitely, what is the total value of the stock?

10. Stock Valuation (ch 8) 10 The Required Return The required return, r, can be written as the sum of two things: R = D 1 /P 0 + g where D 1 /P 0 is the dividend yield and g is the capital gains yield (which is the same thing as the growth rate in dividends for the steady growth case).

11. Stock Valuation (ch 8) 11 2. Features of Common and Preferred Stock Features of Common Stock The right to vote The right to share proportionally in dividends paid The right to share proportionally in assets remaining after liabilities have been paid, in event of a liquidation The preemptive right Features of Preferred Stock Preferences over common stock - dividends, liquidation Dividend arrearages Stated/liquidating value

12. Stock Valuation (ch 8) 12 3. The Stock Markets Primary vs. secondary markets New York Stock Exchange (NYSE) Operations Exchange members Commission brokers Specialists Floor brokers Floor traders Stated/liquidating value Nasdaq Operations Dealers vs. brokers Multiple market makers