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© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Stock Valuation Chapter Eight

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8.1 Key Concepts and Skills Understand how stock prices depend on future dividends and dividend growth Be able to compute stock prices using the dividend growth model Understand how corporate directors are elected Understand how stock markets work Understand how stock prices are quoted

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8.2 Chapter Outline Common Stock Valuation Common Stock Features Preferred Stock Features Stock Market Reporting

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8.3 Cash Flows for Shareholders 8.1 If you buy a share of stock, you can receive cash in two ways Dividends Selling your shares As with any asset, the market price of common stock is equal to the present value of the expected future cash flows the stock will generate

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8.4 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 Calculator Approach 16FV 0PMT 1N 20I PV$13.33

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8.5 Two Period Example Now what if you decide to hold the stock for two years? In addition to the $2 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 now? Calculator Approach 0CF j 2CF j 16.80 CFj 20I 2 nd NPV$13.33

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8.6 Three Period Example Finally, what if you decide to hold the stock for three periods? 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 a stock price of $15.435. Now how much would you be willing to pay? Calculator Approach 0CF j 2CF j 2.10CFj 17.64CFj 20I 2 nd NPV$13.33

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8.7 Developing The Model We could continue this process for many time periods In fact, the price of the stock is just the present value of all expected future dividends So, how can we estimate all future dividend payments?

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8.8 Estimating Dividends: Special Cases Constant dividend The firm will pay a constant dividend forever Market instrument – preferred stock Price is computed using the level perpetuity formula Constant dividend growth The firm will increase the dividend by a constant percent every period Market instrument – common stock Price is computed using a growing perpetuity formula Supernormal growth Dividend growth is high initially, but later settles down to a long-run constant growth rate

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8.9 Zero Growth Rate The dividends on most preferred stocks are expressed as a constant percentage of the share’s face value Suppose a preferred share is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

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8.10 Constant Growth Rate To value a common stock, we usually assume the dividend stream will grow at some constant growth rate over time With a little algebra, this reduces to:

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8.11 Constant Growth: Example 1 Suppose 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?

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8.12 Constant Growth: Example 2 Suppose 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?

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8.13 Stock Price Sensitivity to Dividend Growth, g Div 1 = $2; r = 20%

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8.14 Stock Price Sensitivity to Required Return, r Div 1 = $2; g = 5%

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8.15 Gordon Growth Company – Example 1 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?

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8.16 Gordon Growth Company – Example 2 What is the price expected to be in year 4?

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8.17 Gordon Growth Company - Continued What is the holding period return due to the capital gain over the four year period? What is the annually compounded rate of return due to the capital gain? Note that the price of the stock grows at the same rate as the growth rate in the dividend stream!

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8.18 Non-constant Dividend Growth Suppose a firm is expected to increase dividends by 20% in one year and by 15% in year 2. After that, dividends will increase at a rate of 5% per year indefinitely. If the last dividend that was just paid 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. ∞ 04321 $1.00 15%20%5%

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8.19 Non-constant Dividend Growth - Continued Compute the dividends until growth levels off Find the present value of the expected future cash flows ∞ 04321 $1.00 15%20%5% $1.45$1.20$1.38

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8.20 Quick Quiz – Part I What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%? What if the company starts increasing dividends by 3% per year, beginning with the next dividend? Assume that the required return stays at 15%.

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8.21 Calculating the Required Rate of Return Start with the constant dividend growth formula: The required rate of return on a common stock can always be decomposed into: Dividend yield Capital gain or loss

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8.22 Example – Finding the Required Return Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? What is the dividend yield? What is the capital gains yield?

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8.23 Table 8.1 - Summary of Stock Valuation

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8.24 Common Stock – Features Voting Rights Other Rights Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Preemptive right – the right to purchase new stock to maintain proportional ownership, if desired Classes of stock Dual class shares Voting & not-voting Allows founders to retain control while raising new equity Coattail provision Protects non-voting shareholders in the event of a take-over bid

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8.25 Dividends Dividends are not a liability of the firm until a dividend has been declared by the Board Consequently, a firm cannot go bankrupt for not declaring dividends Dividends and Taxes Dividend payments are not considered a business expense and are not tax deductible Dividends received by individual shareholders are partially sheltered by the dividend tax credit Dividends received by corporate shareholders are not taxed, thus preventing the double taxation of dividends

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8.26 Preferred Stock - Characteristics Preferreds have priority to common stock upon liquidation Dividends Most preferreds have a stated dividend that must be paid before common dividends can be paid Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely Most preferred dividends are cumulative – any missed dividends on preferred stock have to be paid before a dividend can be paid on common stock Preferred stock generally does not carry voting rights

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8.27 Preferred Stock & Taxes Companies with a low tax rate cannot make use of the tax shield available from interest Therefore, they have an incentive to issue preferred shares, which typically pay a dividend lower than a comparable interest rate. The dividend is non-taxable in the hands of the recipient corporation. The loophole was partially closed in 1987 by forcing issuers of preferreds to pay a tax of 40% of the preferred dividend. However, it may still be cheaper to use preferreds than debt for the firm with a zero marginal tax rate

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8.28 Example: Preferreds & Taxes Assume that there are two firms, Zero Tax and Full Tax. As the name implies, Zero Tax pays no tax but needs to raise $1,000. It can issue debt at 10% or preferreds at 6.7%. Full Tax is a fully taxed firm which will either purchase the preferreds or extend a loan to Zero Tax. Issuer: Zero Tax Dividend or interest Dividend tax @ 40% Tax deduction on int. Total cost of financing After-tax cost Preferred $67.00 $26.80 0.00 $93.80 9.38% Debt $100.00 0.00 $100.00 10% Buyer: Full Tax Before tax income Tax After-tax income After-tax yield Preferred $67.00 0.00 $67.00 6.70% Debt $100.00 $45.00 $55.00 5.5%

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8.29 Stock Market Reporting 8.4 Stock market quotations are published in the newspapers and are also available on-line (usually with 15-minute delays) In Canada, large cap stocks trade on the TSX Quotes and corporate information on stocks that trade on the TSX can be found at the exchange’s website Click on the web surfer to go to the site

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8.30 Figure 8.1 – Sample Stock Market Quotation

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8.31 Work the Web Example Information on a large number of stocks in several different markets can also be found at the Globe & Mail website Click on the web surfer to go to the site Publicly traded companies usually have an investor relations section on their webpage

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8.32 Quick Quiz – Part II You observe a stock price of $18.75. You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return? What are some of the major characteristics of common stock? What are some of the major characteristics of preferred stock?

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8.33 Summary 8.5 You should know: The price of a stock is the present value of all future expected dividends There are three approaches to valuing the stock price, depending on the growth rate(s) of the dividends The rights of common and preferred shareholders How to read a stock market quotation from the newspaper

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