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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

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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

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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

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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

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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?

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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

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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

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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%

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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

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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

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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

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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

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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

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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

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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

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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

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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

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