Stocks Equity Characteristics and Valuation What is equity

Stocks (Equity) Characteristics and Valuation What is equity? What factors affect stock prices? How are stock prices determined? How are stock returns determined? What techniques do investors use to value stocks? 1

Basic Types of Stock Preferred stock: hybrid Common stock 2

Preferred Stock Features Par value The nominal or face value of a stock or bond Dividends Generally fixed, like debt; based on the par value Cumulative dividends Preferred dividends not paid in previous periods must be paid before common dividends can be paid Maturity No specific maturity date Priority to assets and earnings Preferred stockholders are paid before common stockholders 3

Preferred Stock Features Control of the Firm (Voting Rights) Most preferred stock is nonvoting, unless dividends are not paid for a particular number of periods Convertibility Can be converted to common stock Call provision Firm has the right to call in preferred stock for redemption Sinking fund A fund used to retire a given amount of the stock each year Participating Shares earnings with common stockholders 4

Common Stock Features Par value Stockholders’ minimum financial obligation Dividends No legal obligation to pay dividends Maturity No specific maturity date Priority to assets and earnings Receive distributions last Preemptive right Right to buy new issues Control of the firm Vote on board of directors, stockholder proposals, etc. 5

Types of Common Stock Classified Stock Special designations, such as Class A, Class B, etc. , used to meet special needs of the company Founder’s Shares Classified stock A class of stock owned by the firm’s founders who have sole voting rights for a particular time period 6

Equity Instruments in International Markets American Depository Receipts Certificates that represent ownership in stocks of foreign companies Foreign Equity Yankee stock—issued by foreign firm and traded in the United States Euro stock—traded outside of “home” country, excluding the United States 7

Stock Valuation Stock value = Present value of the dividends that the company is expected to pay during its life. If the stock never pays a dividend—whether a regular dividend or a liquidating dividend— then its value is $0. 8

Stock Valuation—Terms = dividend expected in Period t, such that = the dividend expected in Period 1 D 0 = the most recently paid dividend = stock price expected in Period t, such that = the price expected in Period 1 P 0 = current market price g = growth rate rs = the rate of return investors require to purchase the firm’s common stock ^ (hat) = an expected value—that is, a value that is forecasted to occur in the future. 9

Stock Valuation Stock ownership entitles the investor to the future cash flows, called dividends, that are paid by the firm 0 1 2 3 … ∞ . . . 10

Stock Valuation rs = required return on stock 11

Stock Valuation Constant Growth, g If growth is constant such that g = g 1 = g 2 = … = g∞ … Value of a constantgrowth stock Required: g = constant rs > g 12

Stock Valuation—Constant Growth, g The most recent dividend paid (D 0) by a firm was $2; the firm is expected to grow at a constant rate (g) equal to 4 percent; and the required rate of return (rs) on similar risk investments is 12 percent. 13

Stock Valuation—Constant Growth, g D 0 = $2; g = 4%; rs = 12% Year Dividend, = $2. 00(1. 04)t PV of @ 12% 1 $2. 0800 = $2. 00(1. 04)1 $1. 8571 2 2. 1632 = 2. 00(1. 04)2 1. 7245 3 2. 2497 = 2. 00(1. 04)3 1. 6013 5 2. 4333 = 2. 00(1. 04)5 1. 3807 10 2. 9605 = 2. 00(1. 04)10 0. 9532 50 14. 2134 = 2. 00(1. 04)50 0. 0492 100 101. 0099 = 2. 00(1. 04)100 0. 0012 14

Stock Valuation—Constant Growth, g=0 Pˆ 0 = D D + +L + ¥ = 1 2 (1 + r s ) rs 15

Stock Valuation—Constant Growth, g=0 The preferred stock of a company pays a constant dollar dividend equal to $4 per share. The required rate of return on similar risk investments is 8 percent. Relationship between value and rs Required Return, rs Stock Value 5. 0% $80. 00 8. 0 50. 00 12. 0 33. 33 16

Stock Valuation—Nonconstant Growth gnorm = constant, or normal, growth 17

Stock Valuation with Nonconstant Growth —Example D 0 g 1 g 2 g 3 g 4 g 5 rs = = = = $1. 25 25% 20% 10% -4% 5% = g 6 = … = g∞ 14% 18

Stock Valuation with Nonconstant Growth—Example D 0 = $1. 25; rs = 14% Growth Year rate, g Dividend, 1 25% 2 PV of @ 14% $1. 5625 = $1. 2500(1. 25) $1. 3706 20 1. 8750 = 1. 5625(1. 20) 1. 4428 3 10 2. 0625 = 1. 8750(1. 10) 1. 3921 4 -4 1. 9800 = 2. 0625(0. 96) 1. 1723 S = 5. 3778 19

Stock Valuation with Nonconstant Growth—Example Because the dividends grow at a constant rate after Year 4, we can apply the constant growth model such that: 20

Valuation—Cash Flow Time Line 0 1 2 3 4 1. 5625 1. 8750 2. 0625 1. 9800 14% 5. 3778 13. 6771 19. 0549 23. 10 21

Stock Valuation—Nonconstant Growth The key to computing the value of a stock that exhibits nonconstant growth is to assume constant growth occurs at some point in the future—it might start in five years, 50 years, or 100 years: Apply the constant growth model to compute the value of the expected dividends from that point forward. Compute the present value of the stock’s value at the point where you assume constant growth begins. Prior to the point where constant growth begins: Compute the dividend for each year Find the present value of each dividend Sum the PV results. 22

Stock Return r s = Expected rate = of return D 1 P 0 Expected dividend yield + g + Expected growth rate (capital gains yield) 23

Stock Return P 0 = $30. 00; D 0 = $1. 50; g = 6. 0% 24

Stock Return In one year, the price of the stock is expected to be: 25

Stock Return Because the value of the stock is expected to increase from $30. 00 to $31. 80 during the year, ^ rs = 11. 3% 26

Valuation Using P/E Ratios P/E ratio = Price ÷ EPS = price multiple “Normal” P/E Example: A firm’s P/E is normally 8. 0 x. If its EPS = $7, then the value of its stock should be $56 = $7 x 8 27

Valuation Using EVA Economic Value Added = EVA Earnings must be sufficient to pay those who provide funds to the firm; otherwise the value of the firm should decrease. 28

Stocks (Equity) Characteristics and Valuation What is equity? Stock/ownership. What factors affect stock prices? Investors change their expectations about the returns the firm will generate in the future. How are stock prices determined? The price is equal to the present value of the dividends stockholders expect to receive during the company’s life. 29

Stocks (Equity) Characteristics and Valuation How are stock returns determined? Returns are based on the dividend the company pays and the change in the market value of the stock during the year What techniques do investors use to value stocks? P/E Ratio Economic Value Added (EVA) 30