Fin 325 - Chapter 8 STOCKS AND THEIR VALUATION

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Fin 325 - Chapter 8 STOCKS AND THEIR VALUATION Powered By Docstoc
					                Chapter 8                     8-1

       STOCKS AND THEIR VALUATION


 Common Stock Valuation
 Some Features of Common and Preferred
  Stocks
 The Stock Markets
 Efficient Markets
 Stock Indexes – see chapter 12




                BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-2
           Key Concepts and Skills

   Understand how stock prices depend on
    future dividends and dividend growth
   Be able to compute stock prices using the
    dividend growth model
   Understand how corporate directors are
    elected
   Understand how stock markets work
   Understand how stock prices are quoted



                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                                    8-3
            Facts about Common Stock:

   Represents ownership.
   Ownership implies control.
   Stockholders elect directors.
   Directors elect management.
   Management’s goal: Maximize stock price.
   Piece of paper
   entitles owner to dividends - if company earns profit &
    decides to pay dividends - not like bond with contract -
    promise to pay interest - or DEFAULT
   can be sold at future date - hopefully for a capital gain
   hence price of common stock is the present value of those
    expected cash flows

 preemptive right - shareholders can purchase additional shares - so
  less dilution & maintain control
 Voting rights

                          BMGT440 Ch. 8. Dr. E.F.Kiss
                                            8-4
Advantages of Financing with Stock:


    No required fixed payments.
    No maturity.
    Improves debt ratio, fixed charge
     coverage.
    if prospects look bright, comm.
     stock can be sold on better terms
     than debt
    finance with common stock during
     good times to maintain reserve
     borrowing capacity
              BMGT440 Ch. 8. Dr. E.F.Kiss
                                               8-5
Disadvantages of Financing with Stock:



   Controlling shareholders may lose some
    control.
   Future earnings shared with new
    stockholders. Dilution.
   Higher flotation costs vs. debt.
   Higher component cost of capital.
   Too little debt may encourage a takeover
    bid.
   taxation - dividends doubly taxed
                 BMGT440 Ch. 8. Dr. E.F.Kiss
                                                   8-6
          Cash Flows for Stockholders

   If you buy a share of stock, you can
    receive cash in two ways
     The company pays dividends
     You sell your shares, either to another
       investor in the market or back to the
       company
   As with bonds, the price of the stock is the
    present value of these expected cash
    flows


                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                        8-7
             Dividend Characteristics
   Dividends are not a liability of the firm until a
    dividend has been declared by the Board
   Consequently, a firm cannot go bankrupt for not
    declaring dividends
   Dividends and Taxes
    Dividend payments are not considered a
      business expense, therefore, they are not
      tax deductible
    Dividends received by individuals are taxed
      as ordinary income but at a maximum of
      15% since tax changes of 2003
    Dividends received by corporations have a
      minimum 70% exclusion from taxable
      income         BMGT440 Ch. 8. Dr. E.F.Kiss
                                                              8-8
             Financial asset values:



 0               1                      2           n
        R

Value           CF1                  CF2            CFn


            CF1       CF2              CFn
     PV =                    ... +
          1 + R  1  R 
                  1        2
                                     1 + R n




                      BMGT440 Ch. 8. Dr. E.F.Kiss         9
                                                     8-9
                One Period Example

   Suppose you are thinking of purchasing the
    stock of Moore Oil, Inc. and you expect it to
    pay a $2 dividend in one year and you
    believe that you can sell the stock for $14 at
    that time. If you require a return of 20% on
    investments of this risk, what is the
    maximum you would be willing to pay?
     Compute the PV of the expected cash flows
     Price = (14 + 2) / (1.2) = $13.33
     Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

                      BMGT440 Ch. 8. Dr. E.F.Kiss
                                                   8-10
              Two Period Example

   Now what if you decide to hold the stock
    for two years? In addition to the dividend
    in one year, you expect a dividend of $2.10
    in and a stock price of $14.70 at the end of
    year 2. Now how much would you be
    willing to pay?
     PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 =
       13.33
     Or CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80;
       F02 = 1; NPV; I = 20; CPT NPV = 13.33

                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                  8-11
             Three Period Example

   Finally, what if you decide to hold the
    stock for three periods? In addition to the
    dividends at the end of years 1 and 2, you
    expect to receive a dividend of $2.205 at
    the end of year 3 and a stock price of
    $15.435. Now how much would you be
    willing to pay?
    PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 +
     15.435) / (1.2)3 = 13.33
    Or CF0 = 0; C01 = 2; F01 = 1; C02 =
     2.10; F02 = 1; C03 = 17.64; F03 = 1;
     NPV; I = 20; CPT NPV = 13.33
                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-12
             Developing The Model

   You could continue to push back when
    you would sell the stock
   You would find that the price of the stock
    is really just the present value of all
    expected future dividends
   So, how can we estimate all future
    dividend payments?




                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                    8-13
      Estimating Dividends: Special Cases

   Constant dividend
    The firm will pay a constant dividend forever
    This is like preferred stock
    The price is computed using the perpetuity
     formula
   Constant dividend growth
    The firm will increase the dividend by a
     constant percent every period
   Supernormal growth
    Dividend growth is not consistent initially,
      but settles down to constant growth
      eventually
                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                     8-14
                   Zero Growth

   If dividends are expected at regular
    intervals forever, then this is like preferred
    stock and is valued as a perpetuity
   P0 = D / R
   Suppose stock is expected to pay a $0.50
    dividend every quarter and the required
    return is 10% with quarterly compounding.
    What is the price?
     P0 = .50 / (.1 / 4) = .50/.025 = $20.00



                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                   8-15
     For a constant growth stock,



       D   1    D    0    1      g    1



       D   2    D     0   1      g 
                                              2



       D   t    D    0    1      g 
                                          t




If g is constant, then:

      ˆ  D0 1  g   D1
      P0
           R g        Rs  g

                     BMGT440 Ch. 8. Dr. E.F.Kiss
                                                    8-16
             Dividend Growth Model

   Dividends are expected to grow at a
    constant percent per period.
     P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
     P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
      D0(1+g)3/(1+R)3 + …
   With a little algebra, this reduces to:


                   D0 (1  g)    D1
              P0             
                    R -g        R -g
                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                                 8-17
     If Rs< g, get negative stock price, which is nonsense.
     We can’t use model unless (1) Rs> g and (2) g is expected
   $ to be constant forever.
                                 D t  D 0  1  g
                                                  t




                                   Dt
0.25                     PVDt 
                                  R
                                 1
                                      t




       ^
       P   PVDt
        0
                               If g > R, P0  !
   0                                          Years (t)
                          BMGT440 Ch. 8. Dr. E.F.Kiss
                                                    8-18
                DGM – Example 1

   Suppose Big D, Inc. just paid a dividend of
    $.50. It is expected to increase its dividend
    by 2% per year. If the market requires a
    return of 15% on assets of this risk, how
    much should the stock be selling for?
   P0 = .50(1+.02) / (.15 - .02) = $3.92




                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-19
               DGM – Example 2

   Suppose TB Pirates, Inc. is expected to
    pay a $2 dividend in one year. If the
    dividend is expected to grow at 5% per
    year and the required return is 20%, what
    is the price?
     P0 = 2 / (.2 - .05) = $13.33
     Why isn’t the $2 in the numerator
       multiplied by (1.05) in this example?




                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                                                8-20
              Stock Price Sensitivity to Dividend Growth, g

              250
                        D1 = $2; R = 20%
              200
Stock Price




              150

              100

              50

                0
                    0         0.05              0.1                0.15   0.2
                                           Growth Rate


                                     BMGT440 Ch. 8. Dr. E.F.Kiss
                                                                              8-21
              Stock Price Sensitivity to Required Return, R

              250
                        D1 = $2; g = 5%
              200
Stock Price




              150

              100

              50

                0
                    0     0.05     0.1        0.15         0.2   0.25   0.3
                                          Growth Rate


                                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-22
         Example 8.3 Gordon Growth Company - I

   Gordon Growth Company is expected to
    pay a dividend of $4 next period and
    dividends are expected to grow at 6% per
    year. The required return is 16%.
   What is the current price?
     P0 = 4 / (.16 - .06) = $40
     Remember that we already have the
      dividend expected next year, so we
      don’t multiply the dividend by 1+g
     What is Do? Do = D1/(1.06) = 4/1.06= 3.77

                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                    8-23
        Example 8.3 – Gordon Growth Company - II
   What is the price expected to be in year 4?
     P4 = D4(1 + g) / (R – g) = D5 / (R – g)
     P4 = 3.77(1+.06)5 / (.16 - .06) = 50.50 =
     P4 = (3.77)(1.34) / (.16 - .06) = 50.50
     P4 = 5.05 / (.16 - .06) = 50.50
     P4 = 4(1+.06)4 / (.16 - .06) = 50.50
   What is the implied return given the
    change in price during the four year
    period?
     50.50 = 40(1+return)4; return = 6%
     PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
   The price grows at the same rate as the
    dividends         BMGT440 Ch. 8. Dr. E.F.Kiss
                                                    8-24
    Nonconstant Growth Problem Statement

   Suppose a firm is expected to increase
    dividends by 20% in one year and by 15%
    in two years. After that dividends will
    increase at a rate of 5% per year
    indefinitely. If the last dividend was $1 and
    the required return is 20%, what is the
    price of the stock?
   Remember that we have to find the PV of
    all expected future dividends.



                    BMGT440 Ch. 8. Dr. E.F.Kiss
                                                     8-25
    Nonconstant Growth – Example Solution

   Compute the dividends until growth levels
    off
     D1 = 1(1.2) = $1.20
     D2 = 1.20(1.15) = $1.38
     D3 = 1.38(1.05) = $1.449
   Find the expected future price
     P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
   Find the present value of the expected
    future cash flows
     P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 =
       8.67
                     BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-26
              Quick Quiz – Part I

   What is the value of a stock that is
    expected to pay a constant dividend of $2
    per year if the required return is 15%?
   What if the company starts increasing
    dividends by 3% per year, beginning with
    the next dividend? The required return
    stays at 15%.




                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-27
           Using the DGM to Find R

   Start with the DGM:


              D 0 (1  g)    D1
         P0              
                 R -g       R -g
         rearrange and solve for R
              D 0 (1  g)      D1
         R               g     g
                   P0          P0




                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-28
    Finding the Required Return - Example

   Suppose a firm’s stock is selling for
    $10.50. They just paid a $1 dividend and
    dividends are expected to grow at 5% per
    year. What is the required return?
     R = [1(1.05)/10.50] + .05 = 15%
   What is the dividend yield?
     1(1.05) / 10.50 = 10%
   What is the capital gains yield?
     g =5%



                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                            8-29
Table 8.1 - Summary of Stock Valuation




              BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-30
                 Stock Market

   Dealers vs. Brokers
   New York Stock Exchange (NYSE)
    Largest stock market in the world
    Members
       • Own seats on the exchange
       • Commission brokers
       • Specialists
       • Floor brokers
       • Floor traders
    Operations
    Floor activity
                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-31
                   NASDAQ

   Not a physical exchange – computer
    based quotation system
   Multiple market makers
   Electronic Communications Networks
   Three levels of information
     Level 1 – median quotes, registered
      representatives
     Level 2 – view quotes, brokers & dealers
     Level 3 – view and update quotes, dealers
      only
   Large portion of technology stocks
                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-32
            Work the Web Example

   Electronic Communications Networks
    provide trading in NASDAQ securities
   The Island allows the public to view the
    “order book” in real time
   Click on the web surfer and visit The
    Island!




                   BMGT440 Ch. 8. Dr. E.F.Kiss
                                                            8-33
              Reading Stock Quotes

 Sample Quote
-3.3 33.25 20.75 Harris HRS    .20 .7 87 3358 29.60 +0.50
   What information is provided in the stock
    quote?
   Click on the web surfer to go to CNBC for
    current stock quotes.




                      BMGT440 Ch. 8. Dr. E.F.Kiss
                                                 8-34
              Quick Quiz – Part II

   You observe a stock price of $18.75. You
    expect a dividend growth rate of 5% and
    the most recent dividend was $1.50. What
    is the required return?
   What are some of the major
    characteristics of common stock?
   What are some of the major
    characteristics of preferred stock?




                   BMGT440 Ch. 8. Dr. E.F.Kiss
      Holders of Corporate Equity Securities                      8-35

                  (June 30, 1995)


HOLDER                     AMOUNT                    PERCENTAGE
                        ($IN BILLIONS)                OF TOTAL
Households             $3,714                           50.2
Pension Funds            1,817                          24.6
Mutual Funds               965                          13.1
Foreign Investors          339                           4.6
Insurance                  278                           3.8
Companies
Bank Personal Trusts      197                           2.7
Other                      83                           1.1
  Total                 7,393                         100.0


                       BMGT440 Ch. 8. Dr. E.F.Kiss
Holders of Corporate Equity Securities                     8-36

        (September 30, 1998)

HOLDER                     AMOUNT             PERCENTAGE
                              ($IN             OF TOTAL
                           BILLIONS)
Households                  $5,349               41.9
Pension Funds                 3,059              24.0

Mutual Funds                  2,029              15.9
Foreign Investors               934               7.3
Insurance Companies             765               6.0
Bank Personal Trusts            433               3.4
Other                           189               1.5
  Total                     $12,758             100.0



                BMGT440 Ch. 8. Dr. E.F.Kiss
                                               8-37
Different Approaches for Valuing Common
                  Stock



   Dividend growth model
   Free cash flow method
   Using the multiples of comparable firms




                 BMGT440 Ch. 8. Dr. E.F.Kiss
some stock market index values 3/24/03 & 10/26/99 8-38
      DJIA 3/24/03                              8214.68                  - 307.29                            -3.61%
      S& P 500                                  864.23                      - 31.56                          -3.52%
      NASDAQ comp                               1369.78                   - 52.02                            -3.66%
      Russell 2000                               367.25                    - 2.39                            -2.39%
      NYSE comp.                                4801.58                    -129.36                           -3.41%
      Wilshire 5000                              8180.45                    -282.87                          -3.34%
      ------------------------------------------------------------------------------------------------------------

      DJIA 10/26/99 10349.93 - 120.32 - 1.15%
      S& P 500       1293.63 -                6.69 - 8.02%
      NASDAQ comp 2815.95 -                   0.57 - 0.02%
      Russell 2000    417.76 - 0.93 - 0.22%
      NYSE comp.      597.31 - 3.85 - 0.64%
      Wilshire 5000  11825.20 - 50.00 - 0.42%
                     BMGT440 Ch. 8. Dr. E.F.Kiss
                                                         8-39
                  Stocks in DJIA as of 11/1/99
   Company              market value in billions
   Microsoft            $486.19
   General Electric      416.79
   Intel Corp.           253.50
   Wal-Mart Stores, Inc. 237.17
   Merck & Co., Inc.     183.98
   Exxon Corp.           175.42
   IBM Corp.             172.88
   Citigroup             169.50
   Johnson & Johnson 141.84
   AT&T Corp             141.81
   Coca Cola             138.74
   Proctor & Gamble      131.32
   Home Depot            109.19
   SBC Communication 90.25
   Hewlett Packard        78.58
                           BMGT440 Ch. 8. Dr. E.F.Kiss
                  Stocks in DJIA as of 11/1/99                            8-40
   Company             market value in billions
   DuPont              $       66.89
   American Express            65.40
   Philip Morris Co.           61.55
   Walt Disney Co.             53.88
   McDonald’s Corp.            53.60
   Boeing Co.                  43.16
   General Motors Corp.        42.72
   Minnesota Mining & Mfg.     38.02
   Allied Signal Inc.          28.82
   United Technologies Corp. 26.87
   ALCOA Inc.                  23.01
   Eastman Kodak               21.62
   JP Morgan & Co.             21.60
   International Paper         20.16
   Caterpillar Inc.            19.58
    in 1999 - 27% mfg., 33% consumer, 27% technology, 10% financial, 3%
                               BMGT440 Ch. 8. Dr. E.F.Kiss
    energy; in 1979 57% mfg., 23% consumer, 10% technology/, 10% energy

				
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