1. Valuation of Common Stock Common stock is a variable income security d ividend may be increased or decreased, depending on earnings. Represents equity or ownership Includes voting rights Limited liability; liability is limited to the owners’ investment Priority; lower than debt owners for proceeds of liquidity Special features to be considered - No maturity period - variable return based on the residual income 1

2. Valuation of Common Stock Cont. When you want to invest in a stock, you are very interested in whether the stock is under-priced or over-priced. To find out, you need to value the stock Two simple approaches to price a stock –Simple dividend discount model –Dividend growth model We will apply these two approaches to real stocks. 2

3. Constant Dividend Valuation Model Let’s suppose a firm is going to continue paying Rs. 3 dividend per share, forever We are planning to buy the stock and hold it forever Of course, we must be able to draw the cash flow diagram PV ??? Rs.33333 Yr1 Yr2Yr3Yr4Yr5Time=infinity 3

4. Constant Dividend Valuation Model Cont. 4

5. Single Period Valuation Model 5

6. Ex: Single Period Valuation Model You expect ABC stock to pay a Rs. 5.50 dividend at the end of the year. The stock price is expected to be Rs. 120 at that time. If you require a 15% rate of return, what would pay for (price) the stock today? 6

7. Common Stock Valuation Model (DDM) Assumptions: If we make the following assumptions, we can derive a simple model for common stock valuation: –Your holding period is infinite (i.e., you will never sell the stock, so you don’t have to worry about forecasting a future selling price). –The dividends will grow at a constant rate forever. Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend and the growth rate. 7

8. Common Stock Valuation Model (DDM) With these assumptions, we can derive a model that is variously known as the Dividend Discount Model, the Constant Growth Model, or the Gordon Model: This model gives us the present value of an infinite stream of dividends that are growing at a constant rate. 8

9. Dividend Growth Model When dividends grow at a rate of g=4%, the cash flow diagram looks like as follows: PV ??? Yr1 Yr2Yr3Yr4Yr5Time=infinity $3.0 $3*(1.04) ∞ $3.12$3.37$3.24 9

10. 10

11. Multiple Dividend Growth For many firms (especially those in new or high-tech industries), dividends are low and expected to grow rapidly. As product markets mature, dividends are then expected to slow to some “steady state” rate. How should stocks such as these be valued? 11

12. P 0 =present value of dividends in the non constant growth period(s) + present value of dividends in the “steady state” period Multiple Dividend Growth Cont. 12

13. Multiple Dividend Growth cont. You expect ABC stock to pay a Rs. 2.00 dividend at the end of the last year, but assume that the dividend will grow at a rate of 10% per year for the next three years before settling down to a constant 8% per year. Required rate of return is 12%.What’s the value of the stock now? 01234 D1D2D3D4 … g = 10%g = 8% 13

14. 14

15. 15 Example—Share valuation with variable dividend growth The ABC Company’s dividend payment for its last financial year was Rs.5.55 per share. Because of substantial investment requirements the directors are not predicting any growth in dividends for the next two years. However, they do then expect dividends to grow at 10 per cent for the subsequent two years, after which time the growth rate is expected to reduce to 5 per cent per year indefinitely. Investor’s currently require a return of 15 per cent from shares in this risk class. What would be the value of this stock?