Stocks Valuation Models PDF

CHAPTER 7 STOCKS (EQUITY)— CHARACTERISTICS...

CHAPTER 7 STOCKS (EQUITY)— CHARACTERISTICS AND VALUATION © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 1 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Learning Outcomes LO.1 Explain what equity is, and identify some of the features and characteristics of (a) preferred stock and (b) common stock. LO.2 Describe how stock prices (values) are determined when (a) dividends grow at a constant rate and (b) dividend growth is nonconstant. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 2 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Learning Outcomes (cont.) LO.3 Describe some approaches (techniques) other than strict application of time value of money models that investors use to value stocks. LO.4 Identify factors that affect stock prices. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 3 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Types of Equity (Stock) ○ Preferred Stock: hybrid security  Similar to bonds with fixed dividend payments.  Similar to common stock because dividends are not required to be paid and there is no specified maturity date. ○ Common Stock © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 4 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Preferred Stock Features ○ Par Value  The nominal or face value of a stock or bond. ○ Cumulative Dividends  Any preferred dividends not paid in previous periods must be paid before common dividends can be distributed. ○ Maturity  Has no specific maturity date. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 5 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Preferred Stock Features (cont.) ○ Priority to Assets and Earnings  Preferred dividends are paid after interest on debt is paid.  Preferred dividends must be paid before common stock dividends are paid. ○ Control of the Firm (Voting Rights)  Almost all preferred stock is nonvoting stock. ○ Convertibility  Preferred stock that can be converted to common stock at the option of the investor. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 6 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Preferred Stock Features (cont.) ○ Other Provisions  Call provision—gives the issuing corporation the right to call in the preferred stock for redemption.  Sinking fund—calls for the repurchase and retirement of a given percentage of the preferred stock at particular times  Participating—shares (participates) with common stockholders in the distribution of the firm’s earnings. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 7 distributed with a certain product or service or otherwise on a password-protected website for classroom use. Preferred vs Common Stock Preferred Stock vs Common Stock & Bonds  Common Stock Features ○ Par Value  Legally, represents a stockholder’s minimum financial obligation in the event the corporation is liquidated. ○ Dividends  The firm has no legal obligation to pay common stock dividends. ○ Maturity  Generally has no specific maturity date. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 10 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Common Stock Features (cont.) ○ Priority to Assets and Earnings  Dividends can be paid only after interest on debt and preferred dividends are paid. ○ Control of the Firm (Voting Rights)  Common stockholders have the right to elect the firm’s directors and to vote on various proposals ○ Preemptive Right  Gives stockholders the right to purchase additional shares of stock sold by the firm on a pro rata basis before the shares can be offered to new investors. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 11 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Types of Common Stock ○ Classified Stock  Common stock that is given a special designation, such as Class A, Class B, etc., to meet special needs of the company. ○ Founder’s Shares  A class of stock owned by the firm’s founders who have sole voting rights in the early years after going public. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 12 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Dual-class IPO Shares © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 13 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Equity Instruments in International Markets ○ American Depository Receipts  Certificates created by banks that represent ownership in stocks of foreign countries. ○ Foreign Equity  Yankee stock—stock of a foreign company traded in the United States.  Euro stock—stock traded in a country other than the company’s home country, except in the United States. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 14 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Stock Valuation Models—Terms © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 15 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Stock Valuation Models—Terms © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 16 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Stock Valuation Models—Terms © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 17 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Expected Dividends as the Basis for Stock Values—Cash Flow Timeline © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 18 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Expected Dividends as the Basis for Stock Values © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 19 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Constant, or Normal, Growth ○ Growth that is expected to continue into the foreseeable future at about the same rate as that of the economy as a whole. ○ g = constant growth stated as a decimal © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 20 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Constant, or Normal, Growth (g) © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 21 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Present Value of Dividends of a Constant Growth Stock: D0 = $1.60, g = 5%, rs = 20% © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 22 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Special Case of Constant Growth: g = 0 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 23 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Expected Rate of Return on a Constant Growth Stock © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 24 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth ○ Nonconstant Growth: The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 25 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Step 1 ○ Start computing the dividends that are expected to be paid during the nonconstant growth period. ○ Continue computing dividends until you compute the last dividend that is affected by nonconstant growth. ○ Using the investors’ required rate of return, rs, compute the present values of all the nonconstant growth dividends, and then sum the present values. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 26 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Step 2 ○ Compute the first dividend that is affected by the constant growth rate. ○ Use the first “constant growth dividend” to compute the value of the stock at the end of the nonconstant growth period; all future dividends will grow at a constant rate, gnorm. ○ A modified version of the constant growth equation is used to compute the value of the stock at the end of the nonconstant growth period, P̂t. ○ Find the PV of P̂t. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 27 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Step 3 ○ Sum the results of Step 1 and Step 2 to find the intrinsic value of the stock, P̂0. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 28 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Example ○ Dividends will grow at a 20 percent rate for the next three (3) years; i.e., g1 = g2 = g3 = 20%. ○ Beginning in Year 4, dividends will grow at a 5 percent rate, which will continue for the rest of the firm’s life; i.e., g4 = … = g∞ = 5% = gnorm. ○ Last dividend paid was $1; i.e., D0 = $1.00. ○ rs = 15% © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 29 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Example: Step 1 o Compute nonconstant growth dividends: ○ Compute PV of nonconstant growth dividends: © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 30 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Example: Step 2 o Compute the first constant growth dividend: o Compute the PV of P̂3 : © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 31 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Valuing Stocks with Nonconstant Growth—Example: Step 3 o Sum the results of Step 1 and Step 2 to find the intrinsic value of the stock: © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 32 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Other Stock Valuation Models ○ P/E Ratios  The higher the P/E ratio the more investors are willing to pay for each dollar earned by the firm.  P/E ratio gives an indication of a stock’s “payback period.” © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 33 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Other Stock Valuation Models ○ Economic Value Added Approach © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 34 distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Changes in Stock Prices ○ Prices move opposite to changes in rates of return. ○ Prices move in the same direction as changes in cash flows expected from the stock in the future. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license 35 distributed with a certain product or service or otherwise on a password-protected website for classroom use.