1 Stock Valuation Corporate Finance Dr. A. DeMaskey

2 Learning Objectives Questions to be answered: What are the rights and privileges of stock ownership? What types of common stock exist? How can stock market transactions be classified? How are stocks valued? What is the total return on stocks? What does stock market equilibrium mean and how is it established? What is preferred stock and how is it valued?

3 Facts About Common Stock Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. price. Management’s goal: Maximize stock price.

4 Basics of Common Stock Preemptive Right Right to purchase new shares in proportion to current holdings. Classified Stock Founders’ shares, with voting rights but dividend restrictions. New shares might be called “Class A” shares, with voting restrictions but full dividend rights.

5 The Market for Common Stock Secondary Market Primary Market Initial Public Offering (IPO) Market

6 The Dividend Valuation Model Stock Value = PV of Expected Dividends

7 Return on Stocks Total return = Dividend yield + Capital gains yield Dividend yield = D 1 /P 0 Capital gains yield = (P 1 – P 0 )/P 0 If dividends are paid quarterly, the annual return is (1 + quarterly return) 4 – 1.0

8 Zero Growth Model Dividends are not expected to grow over time. Value of a zero growth stock: The expected rate of return:

9 Constant Growth Model Dividends are expected to grow at some normal, or constant rate forever. For a constant growth stock, D t = D 0 (1 + g) t If g is constant, then

$ 0.25 Years (t) 0

11 If k s < g, get negative stock price, which is nonsense. We cannot use the model unless (1) g  k s and (2) g is expected to be constant forever. Because g must be a long- term growth rate, it cannot be  k s. What happens if g > k s ?

12 Growth Rate of Dividends The growth rate, g, can be stated in terms of the dividend payout ratio: The greater k s, the higher the expected growth rate of dividends. The greater the dividend payout ratio, the lower the expected growth rate of dividends.

13 Total Expected Return on a Constant Growth Stock Rearrange the constant growth model to rate of return form:

14 Nonconstant Growth Model Find the present value of the dividends during the period of non-constant growth. Find the price of the stock at the end of the non- constant growth period, at which point it has become a constant growth stock, and discount this price back to the present. Add these two components to find the stock’s present value. P 0 = PV of DIV during constant growth period + PV of DIV after the constant growth period to infinity

15 Summary of Dividend Valuation Model The greater the current dividend, the grater the value of a share of stock. The greater the expected growth in dividends, the greater the value of a share of stock. The greater the uncertainty of dividends, the greater the discount rate and the lower the value of a share of stock.

16 Stock Market Equilibrium In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. ^

17 Stock Market Equilibrium If the expected rate of return is less than the required rate of return, investors will desire to sell the stock. If the expected rate of return is greater than the required rate of return, investors will try to purchase the stock. expected returnsrequired returns Only at the equilibrium price, where the expected returns and the required returns are equal, will the stock be stable. If the expected rate of return is less than the required rate of return, investors will desire to sell the stock. If the expected rate of return is greater than the required rate of return, investors will try to purchase the stock. expected returnsrequired returns Only at the equilibrium price, where the expected returns and the required returns are equal, will the stock be stable. k s = D 1 /P 0 + g = k s = k RF + (k M - k RF )b. ^

18 How is stock market equilibrium established? If k s = (D 1 /P 0 ) + g > k s, then P 0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the price will be bid up, and D 1 /P 0 falls until D 1 /P 0 + g = k s = k s. ^^ ^

19 Why do stock prices change? k i = k RF + (k M - k RF )b i could change Inflation expectations Risk aversion Company risk g could change ^

20 Preferred Stock Hybrid security. Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.

21 Valuation of Preferred Stock The value of preferred stock is found as: The greater the preferred dividend, the greater the value of a share of preferred stock. The greater the required rate of return, the lower the value of preferred stock.