Chapter 9 Stocks and Their Valuation 9 1

Chapter 9 Stocks and Their Valuation 9 -1 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Types of stock • Common stock – provides the permanent long-term financing of a firm – represents the true residual ownership of a firm – carries the right to vote on corporate policy and the composition of the board of directors Some facts about common stocks: • Represents ownership • Stockholders elect directors • Directors elect management • Management’s goal: Maximize the stock price • Preferred stock – carries no voting rights – has preference over common stock in the payment of dividends and claims on assets – usually has a fixed dividend. 9 -2 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Types of stock market transactions • - Secondary market: facilitate the trading of existing securities e. g. the sale of existing stock • - Primary market: facilitate the issuance of new securities e. g. , the sale of new corporate stock or new Treasury securities • Initial public offering (IPO) market (“going public”) 9 -3 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Intrinsic Value and Stock Price • Stock Price ->Current Market Price • Intrinsic Value -> “True” value based on it’s ability to generate cash now and in the future. • “Stock Price = Intrinsic Value” when market is at equilibrium – Stocks with a price below (above) its intrinsic value are undervalued (overvalued). 9 -4 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash flows to stockholders If you buy a share of stock, you can receive cash in two ways (i) Price appreciation/depreciation: You sell your shares either to another investor in the market. This constitutes the Capital gain/yield. (ii) Dividend payments: The price of the stock is the present value of these expected cash flows i. e. dividends. This constitutes the Dividend gain/yield. 9 -5 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Different Approaches for Estimating the Intrinsic Value of a Common Stock • • Discounted dividend model/Dividend growth Corporate valuation model 9 -6 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Discounted Dividend Model/Dividend Growth • Value of a stock is the present value of the future dividends expected to be generated by the stock. 9 -7 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Constant Growth Stock • A stock whose dividends are expected to grow forever at a constant rate, g. D 1 = D 0(1 + g)1 D 2 = D 0(1 + g)2 Dt = D 0(1 + g)t • If g is constant, the discounted dividend formula converges to Gordon Model: 9 -8 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Find the Expected Dividend Stream for the Next 3 Years and Their PVs D 0 = $2 and g is a constant 6%. 0 g = 6% 1. 8761 1. 7599 1 2 2. 12 2. 247 3 2. 382 rs = 13% 1. 6509 Using the constant growth model the stock’s intrinsic value is: 9 -9 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

What is the stock’s expected value, one year from now? • D 1 will have been paid out already. So, expected P 1 is the present value (as of Year 1) of D 2, D 3, D 4, etc. • Could also find expected P 1 as: 9 -10 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Find Expected Dividend Yield, Capital Gains Yield, and Total Return During First Year • • Dividend yield = D 1/P 0 = $2. 12/$30. 29 = 7. 0% Capital gains yield = (P 1 – P 0)/P 0 = ($32. 10 – $30. 29)/$30. 29 = 6. 0% • Total return (rs) = Dividend yield + Capital gains yield = 7. 0% + 6. 0% = 13. 0% 9 -11 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

What would the expected price today be, if g = 0? The dividend stream would be a perpetuity. 0 rs = 13% 1 2 3 2. 00 9 -12 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporate Valuation Model • Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. • This model is used as an alternative to the discounted dividend model to determine a firm’s value, especially one with no history of dividends. • This model first calculates the firm’s expected free cash flows, then finds their present values to determine the firm’s value. 9 -13 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Preferred Stock • Hybrid security. • Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. • However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy. • If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? 9 -14 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.