Common Stock Valuation by liaoqinmei

VIEWS: 17 PAGES: 40

									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)?

								
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