Chapter 3

STOCK VALUATION

Key Differences Between Debt & Equity

TYPE OF CAPITAL DEBT EQUITY Voice in Management No Yes Claims on Income & Assets Senior to Equity Subordinate to Debt Maturity Stated None

The Nature of Equity Capital: Voice in Management

Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. Common equity holders have voting rights that permit them to elect the firms board of directors and to vote on special issues. Bondholders and preferred stockholders receive no such privileges.

The Nature of Equity Capital: Claims on Income & Assets

Equity holders are have a residual claim on the firms income and assets. Their claims can not be paid until the claims of all creditors, including both interest and principle payments on debt have been satisfied. Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear.

The Nature of Equity Capital: Maturity

Unlike debt, equity capital is a permanent form of financing. Equity has no maturity date and never has to be repaid by the firm.

Common Stock
Common stockholders, who are sometimes referred to as residual owners or residual claimants, are the true owners of the firm. As residual owners, common stockholders receive what is leftthe residualafter all other claims on the firms income and assets have been satisfied. Because of this uncertain position, common stockholders expect to be compensated with adequate dividends and ultimately, capital gains.

Common Stock: Ownership

The common stock of a firm can be privately owned by an individual, closely owned by a small group of investors, or publicly owned by a broad group of investors. Typically, small corporations are privately or closely owned and if their shares are traded, this occurs infrequently and in small amounts. Large corporations are typically publicly owned and have shares that are actively traded on major securities exchanges.

Common Stock: Preemptive Rights

A preemptive right allows common stockholders to maintain their proportionate ownership in a corporation when new shares are issued. This allows existing shareholders to maintain voting control and protect against the dilution of their ownership. In a rights offering, the firm grants rights to its existing shareholders, which permits them to purchase additional shares at a price below the current price.

Common Stock: Authorized, Outstanding, and Issued Shares

Authorized shares are the number of shares of common stock that a firms corporate charter allows. Outstanding shares are the number of shares of common stock held by the public. Treasury stock is the number of outstanding shares that have been purchased by the firm. Issued shares are the number of shares that have been put into circulation and includes both outstanding shares and treasury stock.

Common Stock: Voting Rights

Each share of common stock entitles its holder to one vote in the election of directors and on special issues. Votes are generally assignable and may be cast at the annual stockholders meeting. Many firms have issued two or more classes of stock differing mainly in having unequal voting rights.

Usually, class A common stock is designated as nonvoting while class B is designated as voting.

Common Stock: Voting Rights (cont.)

Because most shareholders do not attend the annual meeting to vote, they may sign a proxy statement giving their votes to another party. Occasionally, when the firm is widely owned, outsiders may wage a proxy battle to unseat existing management and gain control.

Common Stock: Dividends

Payment of dividends is at the discretion of the board of directors. Dividends may be made in cash, additional shares of stock, and even merchandise. Because stockholders are residual claimants they receive dividend payments only after all claims have been settled with the government, creditors, and preferred stockholders.

Preferred Stock
Preferred stock is an equity instrument that usually pays a fixed dividend and has a prior claim on the firms earnings and assets in case of liquidation. The dividend is expressed as either a dollar amount or as a percentage of its par value. Therefore, unlike common stock a preferred stocks par value may have real significance. If a firm fails to pay a preferred stock dividend, the dividend is said to be in arrears.

Preferred Stock (cont.)

In general, and arrearage must be paid before common stockholders receive a dividend. Preferred stocks which possess this characteristic are called cumulative preferred stocks. Preferred stocks are also often referred to as hybrid securities because they possess the characteristics of both common stocks and bonds. Preferred stocks are like common stock because they are perpetual securities with no maturity date.

Preferred Stock (cont.)

Preferred stocks are like bonds because they are fixed income securities. Dividends never change. Because preferred stocks are perpetual, many have call features which give the issuing firm the option to retire them should the need or advantage arise. In addition, some preferred stocks have mandatory sinking funds which allow the firm to retire the issue over time. Finally, participating preferred stock allows preferred stockholders to participate with common stockholders in the receipt of dividends beyond a specified amount.

Common Stock Valuation

Stockholders expect to be compensated for their investment in a firms shares through periodic dividends and capital gains. Investors purchase shares when they feel they are undervalued and sell them when they believe they are overvalued. This section describes specific stock valuation techniques after first discussing the concept of market efficiency.

Common Stock Valuation: Market Efficiency

Investors base their investment decisions on their perceptions of an assets risk. In competitive markets, the interaction of many buyers and sellers results in an equilibrium pricethe market valuefor each security. This price is reflective of all information available to market participants in making buy or sell investment decisions.

Common Stock Valuation: Market Adjustment to New Information

The process of market adjustment to new information can be viewed in terms of rates of return. Whenever investors find that the expected return is not equal to the required return, price adjustment will occur. If expected return is greater than required return, investors will buy and bid up price until new equilibrium price is reached.

The opposite would occur if required return is greater than expected return.

COMMON STOCK VALUATION

Stock Valuation Models: The Basic Stock Valuation Equation Single-Period

P0= D1 + (1 + rs) P1 (1 + rs)

Where: P0= value of common stock P1= market price D1= year 1 dividend rs= required return on common stock

How to calculate D1
D1= D0(1+g)
Where: D0 = dividend received in year 0 G = growth rate

Example
Suppose an investor is contemplating the purchase of CPQ common stock at the beginning of this year. The dividend at year end is expected to be RM0.60, and the market price by the end of the year is projected to be RM3.00. If the investors required rate of return is 6%, the value of the security would be

 P0 = RM0.60 + RM3.00 (1 + 0.06) (1 + 0.06) = RM3.40

Stock Valuation Models: The Basic Stock Valuation Equation Multiple Holding Period

Stock Valuation Models: The Zero Growth Model

The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

P0 = D1 / rs

Stock Valuation Models: The Zero Growth Model (cont.)

The dividend of Denham Company, an established textile manufacturer, is expected to remain constant at $3 per share indefinitely. What is the value of Denhams stock if the required return demanded by investors is 15%?

P0 = $3/0.15 = $20
Note that the zero growth model is also the appropriate valuation technique for valuing preferred stock.

Stock Valuation Models: Constant Growth Model

The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year year after year forever.

Stock Valuation Models: Constant Growth Model (cont.)

Lamar Company, a small cosmetics company, paid the following per share dividends:

Stock Valuation Models: Constant Growth Model (cont.)

Growth? Using Table A-1 & A-2 and time value techniques, we can determine that the growth in dividends is 7%. $1.40 /$1.00 = 1.400; refer to Table A-1 (n=5; factor 1.400). Growth is 7% $1.00 /$1.40 = 0.7142; refer to Table A-2 (n=5; factor 0.7142). Growth is 7%

Stock Valuation Models: Constant Growth Model (cont.) P0 = $1.50/(0.15 0.07) = $18.75
Assuming the values of D1, rs, and g are accurately estimated, Lamar Companys stock value is $18.75 per share.

Growth based on ROE & retention rate

If XYZ Bhd's ROE is 16% and the management plans to retain 60% of earnings for investment purposes, what will be the firm's growth rate?

g = return on equity X retention rate

= 16% x 60%
= 9.6%

Expected Rate of Return on a Constant Growth Stock

Stock Returns are derived from both dividends and capital gains, where the capital gain results from the appreciation of the stocks market price due to the growth in the firms earnings. Mathematically, the expected return may be expressed as follows:

Expected rate of return = (D1/P0) + g

 Channel Inc. currently pays $2.00 per share in common stock dividends. The firms dividends are expected to grow at a constant rate of 5% per year to infinity. The current market price of the stock is $2.10. Calculate the expected rate of return for this stock.
Expected rate of return = ($2.00/$2.10) + 0.05 = 10%

Stock Valuation Models: Variable-Growth Model

The non-constant dividend growth or variable-growth or supernormalgrowth model assumes that the stock will pay dividends that grow at one rate during one period, and at another rate in another year or thereafter.

 We will use a four-step procedure to estimate the value of a share of stock assuming that a single shift in growth rates occurs at the end of year N. We will use g1 to represent the initial growth rate and g2 to represent the growth rate after the shift.

Stock Valuation Models: Variable-Growth Model (cont.)

Step 1. Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 though N.

Stock Valuation Models: Variable-Growth Model (cont.)

Step 2. Find the present value of the dividends expected during the initial growth period.

Stock Valuation Models: Variable-Growth Model (cont.) Step 3. Find the value of the stock at the end of the initial growth period, PN = (DN+1)/(rs-g2), which is the present value of all dividends expected from year N+1 to infinity, assuming a

constant dividend growth rate, g2.

Stock Valuation Models: Variable-Growth Model (cont.)

Step 4. Add the present value components

found in Steps 2 and 3 to find the value of

the stock, P0, given in Equation 7.6.

Stock Valuation Models: Variable-Growth Model (cont.) The most recent annual (2009) dividend payment of Warren Industries, a rapidly growing boat manufacturer, was $1.50 per share. The firms financial manager expects that these dividends will

increase at a 10% annual rate, g1, over the next

three years. At the end of three years (the end of 2012), the firms mature is expected to result in a slowing of the dividend growth rate to 5% per year, g2, for the foreseeable future. The firms required return, rs, is 15%.

Steps 1 and 2. See table below. Calculation of Present Value of Warren Industries Dividends (20102012)

Step 3. The value of the stock at the end of the initial growth period (N = 2012) can be found by first calculating DN+1 = D2013.
D2013 = D2012 X (1 + 0.05) = $2.00 X (1.05) = $2.10

By using D2013 = $2.10, a 15% required return, and a 5% dividend growth rate, we can calculate the value of the stock, P2012, at the end of 2012 as follows:
P2012 = D2013 / (rs-g2) = $2.10 / (.15 - .05) = $21.00

Step 3 (continued). Finally, in Step 3, the share value of $21 at the end of 2012 must be converted into a present (end of 2009) value.

= PVIF15%,3 X P2012 = 0.658 X $21.00 = $13.82

Step 4. Adding the PV of the initial dividend stream (found in Step 2) to the PV of the stock at the end of the initial growth period (found in Step 3), we get:

P2009 = $4.14 + $13.82 = $17.96 per share

This example can be summarized using the time line below:

Features of preferred stock

1.Owners of preferred stock receive dividends instead of interest. 2.Most preferred stocks are perpetuities (non-maturing). 3.Multiple classes, each having different characteristics, can be issued. 4.Preferred stock has priority over common stock with regard to claims on assets in the case of bankruptcy.

5. Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock dividends to be paid before any common stock dividends are declared.

6.Preferred stock may contain other protective provisions. 7.Preferred stock contains provisions to convert to a predetermined number of shares of common stock.

8. Retirement features for preferred stock are frequently included. a.Callable preferred refers to a feature which allows preferred stock to be called or retired, like a bond.
b. A sinking fund provision requires the firm periodically to set aside an amount of money for the retirement of its preferred stock.

Preferred Stock Valuation

The value of a preferred stock equals the present value of all future dividends. If the stock is nonmaturing, where dividends are expected in equal amount each year in perpetuity, the value may be calculated as follows:

Vps = Annual dividend / required rate of return = D / Kps

 Example
United Electric & Power Co. has an issue of preferred stock outstanding that pays a yearly dividend of $5.40. Investors require a 12% return on this preferred stock. What is the intrinsic value for this preferred stock? Vps = D / Kps

= $5.40/ 0.12 = $45.00

Expected Rate of Return on a Preferred Stock

If the present market price of preferred stock is $5.00 and it pays $0.30 dividend, the expected rate of return implicit in the present market price is; = D/Vps = $0.30/$5.00 = 6%