Chapter 7 Stock Valuation  Common Stock Basics  Stock Valuation – Future Cash Flows  Dividend Pricing Models  Dividend Growth Models  Changing Dividend Patterns  Preferred Stock  CAPM  Beta  Common Stock Features

Common Stock Basics  Common Stock – Ownership of Company  Equity financing  Major financing source for companies  Voting Rights  Pick the management team of the company  Determine charter and changes to charter  Receive Dividends  Payment of “profits”  Principal not repaid until shareholder sells stock

Stock Valuation  Just like a bond…the value is all future cash flows received  Final payment (when stock is sold) is the same as principal repayment  Dividends are the same as coupons

Dividend Pricing Models  Four Models  Two assumptions  Growth, constant or no-growth dividend or dividend growing at a constant rate  Horizon, finite or infinite  Constant Dividend and Infinite Horizon  Priced as a perpetuity  Price = Dividend / r  r is the desired rate of return on investment

Dividend Pricing Models  Constant Dividend with Finite Horizon  Assumption on final payment  Dividends Only – Only annuity stream formula  Dividends and Final Sale at end of horizon – Annuity Stream and Lump Sum formula  TVM equations  Finding Bond Selling Price  New owner buys remaining dividend stream  Perpetuity for new owner?

Dividend Growth Models  Common practice to raise dividends each year  Example, Coca-Cola  Dividend changes range  $0.04 to $0.08  5.88% to 14.71%  Not constant…but…  Smooth out pattern for constant percentage change each year  Constant percentage change allows for a simplified pricing model

Dividend Growth Models  First Constant Growth Model – Infinite Horizon  Need g, the dividend growth rate  Need r, the require rate of return  Both stated on annual basis

Dividend Growth Models  Finding g,  Averaging annual dividend changes  g = (Last Dividend / First Dividend) 1/n  n is the number of dividend changes  Example of Johnson and Johnson, g = 13.8%  Select r, example J&J, r = 15%

Dividend Growth Models  Adjusted for Finite Horizon  Dividend stream for a fixed period of time but still has constant growth, g>0  Shareholder only gets a portion of infinite dividend stream  Add portion adjustment to model

Changing Dividend Patterns  What happens when g is not constant or the dividends are not constant?  Look for patterns inside the overall dividend stream  Series of dividends with constant dividends  Series of dividends with constant growth  Apply models within the series finding PV of the series  Add up all present value pieces for price

Preferred Stock  Preferred stock has stated annual dividend  Constant dividend each period  Dividend = dividend rate x par value  Preferred stock has no maturity date  Infinite horizon  No payment of par value  Fits constant dividend model with infinite horizon

CAPM  Capital Asset Pricing Model – CAPM  Future cash flows (dividends)  Difficult to predict  May not follow nice patterns  More encompassing model  CAPM – Expected return is directly related to risk (Chapter 5, Risk and Return)  Model works with returns

CAPM  Assumptions  #1 – There is a reward for waiting  #2 – The greater the risk the greater the expected reward  #3 – There is a constant tradeoff between risk and reward  E(return) = risk-free rate + slope (level of risk)  Trick is to find the level of risk for an investment

Beta  Beta – A measure of risk  The systematic risk of an individual asset in a well- diversified portfolio  Correlation between an asset’s returns and the market in general  Estimated with OLS regression  Beta’s  Less than 1, 1 or greater than 1  Less risk than market, same risk as market, greater risk than the market

Beta  Using Beta  Security Market Line  All firms plot on SML (ex-ante)  Firms above the line are under priced  Firms below the line are over priced  Security Market Line estimates expected returns

Common Stock Features  Claim on Assets and Cash Flows (Residual)  No Maturity Date  Vote (Voice in Management)  Tax Issues – Dividends Taxable  Other Issues  Authorized, Outstanding, Treasury Shares  Pre-emptive Rights

Problems  Problem 1 – Constant Dividend, Infinite Horizon  Problem 2 – Constant Dividend, Infinite Horizon  Problem 3 – Constant Dividend, Infinite Horizon  Problem 5 – Constant Growth, Infinite Horizon  Problem 7 – Constant Growth, Finite Horizon  Problem 11 – Preferred Stock  Problem 15 – Security Market Line  Problem 17 – Expected Returns