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STOCK VALUATION 2005 FUNDS DEBT EQUITY Bonds Preferred Stock etc… Common Stock Contents: A) PREFERRED STOCK Definition of Preferred Stock Features & Types of Preferred Stock Preferred Stock Valuation Preferred Stockholder’s Expected Rate of Return B) COMMON STOCK 1. Definition of Common Stock 2. Characteristics of Common Stock 3. Common Stock Valuation 4. Common Stockholder’s Expected Rate of Return A) PREFERRED STOCK 1. Definition of Preferred Stock… Preferred Stock (PS) PS is a hybrid security with characteristics of both common stock and bonds. It has no fixed maturity date (common stock) and the dividends are fixed in amount (bonds) 2. Features & Types of Preferred Stock… 1. Multiple classes : company can issue more than one class of PS, and each class can have different characteristics. 2. Claims on assets and income :PS is safer than common stock because it has a prior claim on assets and income. However PS is riskier than long-term debt (bond) so its claims on assets and income come after bonds. *(Risk : Bonds > Preferred Stock > Common Stock) 3. Cumulative feature : requires all past unpaid PS dividends be paid before any common stock dividends are declared Cont.. 4. Protective provisions : provisions for PS that are included in the terms of the issue to protect the investor’s interest. 5. Convertibility: Convertible PS allows the preferred stockholder to convert the PS into a predetermined number of shares of common stock. 6. Adjustable rate (dividend) : PS intended to provide investors with some protection against wide swings in the stock value that occur when interest rates move up and down. 7. Participation : allows the preferred stockholder to participate in earnings beyond the payment of the stated dividend Cont.. 8. Payment-In-Kind (PIK) : investors receive no dividends initially, they merely get more preferred stock, which in turn pays dividends in even more PS 9. Retirement features : Firms generally provide for some method of retirement : - Call provision : lets company buy its PS back from the investor, usually at premium price above the stock’s par value. - Sinking Fund : A fund that requires the firm periodically to set aside an amount of money for the retirement of its PS. This money is then used to purchase the PS in the open market or through the use of the call provision. 3. Valuing Preferred Stock… In general, the intrinsic value of an asset is equal to the present value of the stream of expected cash flows discounted at an appropriate required rate of return. n S Ct V = (1 + k)t t=1 Ct= cash flow to be received at time t. k = the investor’s required rate of return. V = the intrinsic value of the asset. The return from PS comes in the form of dividends and most PS are perpetuities (no maturity date) The value of PS is the present value of all future dividends. The dividends continue to infinity. Formula Annual dividend D Vps = = Required rate of return Kps Example: Preferred Stock Example : Xerox preferred pays an 8% dividend on a $50 par value. Supposed your required rate of return on Xerox preferred is 9%. Value of the preferred stock will be…. 8% x $50 Annual dividend 4.00 Vps = = = $44.44 Required rate of return 0.09 exercise.. Calculate the value of a preferred stock that pays a dividend of $6 per share and your required rate of return is 12% What is the value of a preferred stock where the dividend rate is 14% on a $100 par value? The appropriate discount rate for a stock of this risk level is 12% 4. Expected Rate of Return of Preferred Stock (kps ) The preferred stockholder’s expected rate of return ; Where D : annual dividend kps = D / P0 P0 : Market Price Info!! When the expected rate of return is greater than the required rate of return, you should buy the stock BUY when kps > kps example : If you know the preferred stock price is $40, and the preferred dividend is $4.125. a) What is your expected rate of return? b)If your require 11% return, given the current price should you buy more stock? a) kps = $4.125 / $40 = 0.103 @ 10.3% b)I shouldn’t buy the stock because the expected rate of return is lower than the required rate of return. ( 10.3% < 11% ) exercise.. 1) Calculate the expected return of preferred stocks that : a) Pay dividend $1.95 per share & currently sale for $42.16 b)Currently sell for $38.50 per share and pay dividend of $3.25 per share. 2) RBC’s preferred stock, which currently sells for $75.80 per share and pays dividends of $5.50 per share a) What is your expected rate of return? b)If you require 7% return, should you buy the stock? B) COMMON STOCK 1. Definition of Common Stock ( CS ).. Common stock is a variable-income security It represents the ownership in a corporation Dividends may be increased or decreased depending on earnings. Dividends payment must be declared by Board of Director before being issued No maturity date, which means its exists as long as the firm does Priority : lower than debt and preferred. 2. Features & Characteristics of Common Stock.. i. Claim on Income : as the owners of the corporation the common stockholders have the right to the residual income after bondholders and preferred stockholders have been paid. ii. Claim on Assets : also has a residual claim on assets in the case of liquidation. Only after the claims of debt holders and preferred stockholders have been satisfied do the the claims of common shareholders receive attention. iii. Voting Rights : common shareholders have the right to elect the board of directors at corporation’s annual meeting iii. Preemptive Rights : it entitles the common shareholders to maintain a proportionate share of ownership in the firm. When new shares are issued, common shareholders have the first right of refusal. iv. Limited Liability: common shareholders liability in the case of bankruptcy is limited to the amount of their investment. 3. Common Stock Valuation… common stock’s value is equal to the present value of the expected cash flows to be received by the stockholder. the expected cash flows consist of 2 elements - the dividends expected in each year - the price investors expect to receive when they sell the stock common stock’s dividend is based on: a)the profitability of the firm b)management’s decision to pay dividends or to retain the profits to grow the firm. The Growth Factor in Valuing Common Stock through infusion of new capital: borrowing money to invest in new stocks acquire another company to merge (increase firm’s assets) realize through the injection of new capital through internal growth NO financing was acquired from new external sources. from retained earning for investment, results in future earnings the current stockholders participate in the growth of the company. Growth factor (internal growth) : g = ROE x r g : growth rate of future earnings and the growth in the common stockholders investment in the firm. ROE: Return on Equity; Net Income Common book value. r : the company’s % of profit retained example : given that firm’s return on equity is 24 percent and management plans to retain 60 percent of earning for investment purposes. What will be the firm’s growth rate? g : 0.24 x 0.60 : 0.144 / 14.4% 2 types of Common Stock Valuation : a) Single Holding Period b) Multiple Holding Periods i. Constant Growth ii. Non-constant Growth (Supernormal Growth) Common Stock Valuation : a) Single Holding Period Single Holding Period : for an investor that holding common stock for only 1 year. The value of stock should equal the PV of both the expected dividend in year 1 (D1) and the anticipated market price of the share at year end (P1) D1 P1 Vcs = (1 + Kcs) + (1 + Kcs) Present value Present value of of dividend received in market price received in one year (D1) one year (P1) example : XYZ common stock is expected to pay $5.50 in dividends next year and the market price is projected to be $120 by year end.If the investor’s required rate of return is 15%, what is the current value of the stock? $120 : P1 $5.50 : D1 0 1 Vcs = (5.50/1.15) + (120/1.15) = 4.783 + 104.348 = $ 109.13 exercise 1)Honey common stock is expected to pay RM1.85 in dividend next year, and the market price is projected to be RM42.50 by year end. If the investor’s required rate of return is 11 percent, what is the current value of the stock? 2)You intend to purchase Marigos common stock at RM50 per share. Hold it 1 year and sell after a dividend of RM6 is paid. How much will the stock price have to appreciate for you to satisfy your required rate of return of 15 percent. Common Stock Valuation : b) Multiple Holding Period Multiple Holding Period : for common stock that has no maturity date & is frequently held for many years (perpetuities) 2 types of Multiple Holding Period ; 1. Constant Growth Model : where CS dividends grow at a constant rate every year. 2. Non-Constant Model (Supernormal Growth) : where CS dividends grow at non constant rate. : Multiple Holding Period 1) Constant Growth Stock Constant Growth Model : where CS dividends grow at a constant rate every year Formula : D1 = the dividend at D1 the end of period 1 Vcs = kcs - g Kcs = the required return on the common stock g = the constant, annual dividend growth rate Example : XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year. What would we be willing to pay if our required return on XYZ stock is 15%? $ 5.00 10% 10% 10% 0 1 2 n… D1 = 5 (1.10) = $5.50 D1 5.50 Vcs = = = $110 kcs - g 0.15 - 0.10 exercise 1)Header Bhd. paid a RM3.50 dividend last year. At a constant growth rate 5 percent, what is the value of the common stock if the investors require a 20 percent rate of return? 2)KPD Bhd. paid RM1 dividend last year. Dividends are expected to grow at an 8 percent annual rate for an indefinite number of years. If your required rate of return is 11 percent, what is the value of the stock? Multiple Holding Period : 2) Non-Constant (Supernormal Growth) where g (growths) are different each year or at least there are 2 different growths in cash flow. Steps of calculation: a) Find the expected future cash dividends (D1, D2, D3…..Dn) b) Find the price of the stock at the end of non- constant growth period. (Pn) c) Compute the PV of a & b to find the intrinsic value of the stock, (P0) example : Let say a company is experiencing a supernormal growth rate in cash dividends of 25% for each of the next 4 years. After that, the dividend growth rate is expected to be 5% per year forever. The latest annual dividend, is $0.75. The required return is 22%. How much does the company’s stock worth? a) Find the expected future cash dividends (D1, D2, D3…..Dn) FORMULA Dt : D0 (1 + g )t D1 = 0.75 (1.25) D3 = 1.172 (1.25) Dividend 0.75 0.938 1.172 1.465 1.831 1.923 D0 D1 D2 D3 D4 D5 Growth 25% 25% 25% 25% 5% Years 0 1 2 3 4 5…. b) Find the price of the stock at the end of non- constant growth period. (Pn) P4 = D5 / kcs – g = 1.923 / 0.22 - 0.05 = $ 11.312 c) Compute the PV of a & b to find the intrinsic value of the stock (P0) P0 = D1/(1+ kcs) + D2 /(1+ kcs)2 + D3/(1+ kcs)3 + D4/(1+ kcs)4 + P4/(1+ kcs)4 P0 = 0.938/(1.22) + 1.172/(1.22)2 + 1.465/(1.22)3 + 1.831/(1.22)4 + 11.312/(1.22)4 = $ 8.30 exercise 1) A company currently pays a dividend of RM2 per share. It is estimated that the company’s dividend will grow at a rate of 20 percent per year for the next 2 years, then the dividend will grow at a constant rate of 7 percent thereafter. Stockholders require a return of 10 percent on WME’s stock. Calculate the value of the stock today? 2) WME Bhd.is expected to experience a 15 percent annual growth rate for the next 5 years. By the end of 5 years this growth rate will reduce to 5 percent per year indefinitely. Stockholders require a return of 12 percent on WME’s stock. The most recent annual dividend which was paid yesterday, was RM1.75 per share. Calculate the value of the stock today? 4. Expected Rate of Return of Common Stock (kcs ) The common stockholder’s expected rate of return where D : dividend in year 1 D1 kcs = ( Po )+ g P0 : Market price G : growth rate Hint !! When the expected rate of return is greater than the required rate of return, you should buy the stock BUY when kcs > kcs example : we know a stock will pay a $3.00 dividend at time 1, has a price of $27 and growth rate of 5%. Find the expected rate of return of this stock? $3 kcs = ( $ 27 ) + 0.05 = 16.11% exercise 1) The market price for Hobart common stock is RM43. The price at the end of 1 year is expected to be RM48 and dividends for next year should be RM2.84. What is the expected rate of return? 2) The market price for Simpson’s common stock is RM44. The price at the end of 1 year is expected to be RM47 and dividends for next year should be RM2. What is the expected rate of return? 3) The common stock of Zaidi Co. is selling for RM32.84. The stock recently paid dividends of RM2.94 per share and has a projected constant growth rate of 9.5 percent. If you purchase the stock at the market price, what is your expected rate of return? 3.Mike’s common stock currently sells for RM22.50 per share. The companies anticipate a constant growth rate of 10 percent and an end-of-year dividend of RM2 • what is your expected rate of return? • if you require a 17 percent return, should you purchase the stock? 4. Black’s common stock currently sells for RM35 per share. The company anticipate a constant growth rate of 15 percent and an end-of-year dividend of RM4.50 • what is your expected rate of return • if you require a 20 percent return, what is the value of the stock for you? should you purchase the stock? 5. The last dividend paid by Duff Bhd. was RM1.00. Duff ’s growth rate expected to be a constant 5% for 2 years, after which dividends are expected to grow at a rate of 10% forever. Duff required rate of return on equity is 12%. What is the price of Duff ’s common stock? 6. Shikaz Bhd is experiencing rapid growth. Dividends are expected to grow at 12% per year during the next 3 years, and then 8% per year indefinitely. The required rate of return is 16% and the stock currently sells for RM33.60 per share. What is the expected dividend for the coming year (D1)?