Chapter8StockValuationMcGraw-Hill/IrwinCopyright?2013byTheMcGraw-HillCompanies,Inc.Allrightsreserved. Chapter8McGraw-Hill/IrwinCopKeyConceptsandSkillsUnderstandhowstockpricesdependonfuturedividendsanddividendgrowthBeabletocomputestockpricesusingthedividendgrowthmodelUnderstandhowcorporatedirectorsareelectedUnderstandhowstockmarketsworkUnderstandhowstockpricesarequoted8-2KeyConceptsandSkillsUnderstChapterOutlineCommonStockValuationSomeFeaturesofCommonandPreferredStocksTheStockMarkets8-3ChapterOutlineCommonStockVaCashFlowsforStockholdersIfyoubuyashareofstock,youcanreceivecashintwowaysThecompanypaysdividendsYousellyourshares,eithertoanotherinvestorinthemarketorbacktothecompanyAswithbonds,thepriceofthestockisthepresentvalueoftheseexpectedcashflows8-4CashFlowsforStockholdersIfOne-PeriodExampleSupposeyouarethinkingofpurchasingthestockofMooreOil,Inc.Youexpectittopaya$2dividendinoneyear,andyoubelievethatyoucansellthestockfor$14atthattime.Ifyourequireareturnof20%oninvestmentsofthisrisk,whatisthemaximumyouwouldbewillingtopay?ComputethePVoftheexpectedcashflowsPrice=(14+2)/(1.2)=$13.33OrFV=16;I/Y=20;N=1;CPTPV=-13.338-5One-PeriodExampleSupposeyouTwo-PeriodExampleNow,whatifyoudecidetoholdthestockfortwoyears?Inadditiontothedividendinoneyear,youexpectadividendof$2.10intwoyearsandastockpriceof$14.70attheendofyear2.Nowhowmuchwouldyoubewillingtopay?PV=2/(1.2)+(2.10+14.70)/(1.2)2=13.338-6Two-PeriodExampleNow,whatifThree-PeriodExampleFinally,whatifyoudecidetoholdthestockforthreeyears?Inadditiontothedividendsattheendofyears1and2,youexpecttoreceiveadividendof$2.205attheendofyear3andthestockpriceisexpectedtobe$15.435.Nowhowmuchwouldyoubewillingtopay?PV=2/1.2+2.10/(1.2)2+(2.205+15.435)/(1.2)3=13.338-7Three-PeriodExampleFinally,wDevelopingTheModelYoucouldcontinuetopushbacktheyearinwhichyouwillsellthestockYouwouldfindthatthepriceofthestockisreallyjustthepresentvalueofallexpectedfuturedividendsSo,howcanweestimateallfuturedividendpayments?8-8DevelopingTheModelYoucouldEstimatingDividends:

SpecialCasesConstantdividendThefirmwillpayaconstantdividendforeverThisislikepreferredstockThepriceiscomputedusingtheperpetuityformulaConstantdividendgrowthThefirmwillincreasethedividendbyaconstantpercenteveryperiodThepriceiscomputedusingthegrowingperpetuitymodelSupernormalgrowthDividendgrowthisnotconsistentinitially,butsettlesdowntoconstantgrowtheventuallyThepriceiscomputedusingamultistagemodel8-9EstimatingDividends:

SpecialZeroGrowthIfdividendsareexpectedatregularintervalsforever,thenthisisaperpetuityandthepresentvalueofexpectedfuturedividendscanbefoundusingtheperpetuityformulaP0=D/RSupposestockisexpectedtopaya$0.50dividendeveryquarterandtherequiredreturnis10%withquarterlycompounding.Whatistheprice?P0=.50/(.1/4)=$208-10ZeroGrowthIfdividendsareexDividendGrowthModelDividendsareexpectedtogrowataconstantpercentperperiod.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+…Withalittlealgebraandsomeserieswork,thisreducesto:8-11DividendGrowthModelDividendsDGM–Example1SupposeBigD,Inc.,justpaidadividendof$0.50pershare.Itisexpectedtoincreaseitsdividendby2%peryear.Ifthemarketrequiresareturnof15%onassetsofthisrisk,howmuchshouldthestockbesellingfor?P0=.50(1+.02)/(.15-.02)=$3.928-12DGM–Example1SupposeBigD,DGM–Example2SupposeTBPirates,Inc.,isexpectedtopaya$2dividendinoneyear.Ifthedividendisexpectedtogrowat5%peryearandtherequiredreturnis20%,whatistheprice?P0=2/(.2-.05)=$13.33Whyisn’tthe$2inthenumeratormultipliedby(1.05)inthisexample?8-13DGM–Example2SupposeTBPiraStockPriceSensitivitytoDividendGrowth,gD1=$2;R=20%8-14StockPriceSensitivitytoDivStockPriceSensitivitytoRequiredReturn,RD1=$2;g=5%8-15StockPriceSensitivitytoReqExample8.3GordonGrowth

Company-IGordonGrowthCompanyisexpectedtopayadividendof$4nextperiod,anddividendsareexpectedtogrowat6%peryear.Therequiredreturnis16%.Whatisthecurrentprice?P0=4/(.16-.06)=$40Rememberthatwealreadyhavethedividendexpectednextyear,sowedon’tmultiplythedividendby1+g8-16Example8.3GordonGrowth

ComExample8.3–GordonGrowth

Company-IIWhatisthepriceexpectedtobeinyear4?P4=D4(1+g)/(R–g)=D5/(R–g)P4=4(1+.06)4/(.16-.06)=50.50Whatistheimpliedreturngiventhechangeinpriceduringthefouryearperiod?50.50=40(1+return)4;return=6%PV=-40;FV=50.50;N=4;CPTI/Y=6%Thepriceisassumedtogrowatthesamerateasthedividends8-17Example8.3–GordonGrowth

CNonconstantGrowth

Example-ISupposeafirmisexpectedtoincreasedividendsby20%inoneyearandby15%intwoyears.Afterthat,dividendswillincreaseatarateof5%peryearindefinitely.Ifthelastdividendwas$1andtherequiredreturnis20%,whatisthepriceofthestock?RememberthatwehavetofindthePVofallexpectedfuturedividends.8-18NonconstantGrowth

Example-NonconstantGrowth

Example-IIComputethedividendsuntilgrowthlevelsoffD1=1(1.2)=$1.20D2=1.20(1.15)=$1.38D3=1.38(1.05)=$1.449FindtheexpectedfuturepriceP2=D3/(R–g)=1.449/(.2-.05)=9.66FindthepresentvalueoftheexpectedfuturecashflowsP0=1.20/(1.2)+(1.38+9.66)/(1.2)2=8.678-19NonconstantGrowth

Example-QuickQuiz–PartIWhatisthevalueofastockthatisexpectedtopayaconstantdividendof$2peryeariftherequiredreturnis15%?Whatifthecompanystartsincreasingdividendsby3%peryear,beginningwiththenextdividend?Therequiredreturnstaysat15%.8-20QuickQuiz–PartIWhatistheUsingtheDGMtoFindRStartwiththeDGM:8-21UsingtheDGMtoFindRStartwExample:FindingtheRequiredReturnSupposeafirm’sstockissellingfor$10.50.Itjustpaida$1dividend,anddividendsareexpectedtogrowat5%peryear.Whatistherequiredreturn?R=[1(1.05)/10.50]+.05=15%Whatisthedividendyield?1(1.05)/10.50=10%Whatisthecapitalgainsyield?g=5%8-22Example:FindingtheRequiredStockValuation

UsingMultiplesAnothercommonvaluationapproachistomultiplyabenchmarkPEratiobyearningspershare(EPS)tocomeupwithastockpricePt=BenchmarkPEratio*EPStThebenchmarkPEratioisoftenanindustryaverageorbasedonacompany’sownhistoricalvaluesTheprice-salesratiocanalsobeused8-23StockValuation

UsingMultiplExample:StockValuationUsingMultiplesSupposeacompanyhadearningspershareof$3overthepastyear.TheindustryaveragePEratiois12.Usethisinformationtovaluethiscompany’sstockprice.Pt=12x$3=$36pershare8-24Example:StockValuationUsingTable8.1-StockValuationSummary8-25Table8.1-StockValuationSuFeaturesofCommonStockVotingRightsProxyvotingClassesofstockOtherRightsShareproportionallyindeclareddividendsShareproportionallyinremainingassetsduringliquidationPreemptiveright–firstshotatnewstockissuetomaintainproportionalownershipifdesired8-26FeaturesofCommonStockVotingDividendCharacteristicsDividendsarenotaliabilityofthefirmuntiladividendhasbeendeclaredbytheBoardConsequently,afirmcannotgobankruptfornotdeclaringdividendsDividendsandTaxesDividendpaymentsarenotconsideredabusinessexpense;therefore,theyarenottaxdeductibleThetaxationofdividendsreceivedbyindividualsdependsontheholdingperiodDividendsreceivedbycorporationshaveaminimum70%exclusionfromtaxableincome8-27DividendCharacteristicsDivideFeaturesofPreferredStockDividendsStateddividendthatmustbepaidbeforedividendscanbepaidtocommonstockholdersDividendsarenotaliabilityofthefirm,andpreferreddividendscanbedeferredindefinitelyMostpreferreddividendsarecumulative–anymissedpreferreddividendshavetobepaidbeforecommondividendscanbepaidPreferredstockgenerallydoesnotcarryvotingrights8-28FeaturesofPreferredStockDivStockMarketDealersvs.BrokersNewYorkStockExchange(NYSE)LargeststockmarketintheworldLicenseholders(1,366)CommissionbrokersSpecialistsFloorbrokersFloortradersOperationsFlooractivity8-29StockMarketDealersvs.BrokerNASDAQNotaphysicalexchange–computer-basedquotationsystemMultiplemarketmakersElectronicCommunicationsNetworksThreelevelsofinformationLevel1–medianquotes,registeredrepresentativesLevel2–viewquotes,brokers&dealersLevel3–viewandupdatequotes,dealersonlyLargeportionoftechnologystocks8-30NASDAQNotaphysicalexchangeWorktheWebExampleElectronicCommunicationsNetworksprovidetradinginNASDAQsecuritiesClickonthewebsurferandvisitInstinet8-31WorktheWebExampleElectronic

Whatinformationisprovidedinthestockquote?ClickonthewebsurfertogotoBloombergforcurrentstockquotes.ReadingStockQuotes8-32ReadingStockQuotes8-32QuickQuiz–PartIIYouobserveastockpriceof$18.75.Youexpectadividendgrowthrateof5%,andthemostrecentdividendwas$1.50.Whatistherequiredreturn?Whataresomeofthemajorcharacteristicsofcommonstock?Whataresomeofthemajorcharacteristicsofpreferredstock?8-33QuickQuiz–PartIIYouobservEthicsIssuesThestatusofpensionfunding(i.e.,over-vs.under-funded)dependsheavilyonthechoiceofadiscountrate.Whenactuariesarechoosingtheappropriaterate,shouldtheygivegreaterprioritytofuturepensionrecipients,management,orshareholders?Howhastheincreasingavailabilityanduseoftheinternetimpactedtheabilityofstocktraderstoactunethically?8-34EthicsIssuesThestatusofpenComprehensiveProblemXYZstockcurrentlysellsfor$50pershare.Thenextexpectedannualdividendis$2,andthegrowthrateis6%.Whatistheexpectedrateofreturnonthisstock?Iftherequiredrateofreturnonthisstockwere12%,whatwouldthestockpricebe,andwhatwouldthedividendyieldbe?8-35ComprehensiveProblemXYZstockEndofChapter8-36EndofChapter8-36

Chapter8StockValuationMcGraw-Hill/IrwinCopyright?2013byTheMcGraw-HillCompanies,Inc.Allrightsreserved. Chapter8McGraw-Hill/IrwinCopKeyConceptsandSkillsUnderstandhowstockpricesdependonfuturedividendsanddividendgrowthBeabletocomputestockpricesusingthedividendgrowthmodelUnderstandhowcorporatedirectorsareelectedUnderstandhowstockmarketsworkUnderstandhowstockpricesarequoted8-38KeyConceptsandSkillsUnderstChapterOutlineCommonStockValuationSomeFeaturesofCommonandPreferredStocksTheStockMarkets8-39ChapterOutlineCommonStockVaCashFlowsforStockholdersIfyoubuyashareofstock,youcanreceivecashintwowaysThecompanypaysdividendsYousellyourshares,eithertoanotherinvestorinthemarketorbacktothecompanyAswithbonds,thepriceofthestockisthepresentvalueoftheseexpectedcashflows8-40CashFlowsforStockholdersIfOne-PeriodExampleSupposeyouarethinkingofpurchasingthestockofMooreOil,Inc.Youexpectittopaya$2dividendinoneyear,andyoubelievethatyoucansellthestockfor$14atthattime.Ifyourequireareturnof20%oninvestmentsofthisrisk,whatisthemaximumyouwouldbewillingtopay?ComputethePVoftheexpectedcashflowsPrice=(14+2)/(1.2)=$13.33OrFV=16;I/Y=20;N=1;CPTPV=-13.338-41One-PeriodExampleSupposeyouTwo-PeriodExampleNow,whatifyoudecidetoholdthestockfortwoyears?Inadditiontothedividendinoneyear,youexpectadividendof$2.10intwoyearsandastockpriceof$14.70attheendofyear2.Nowhowmuchwouldyoubewillingtopay?PV=2/(1.2)+(2.10+14.70)/(1.2)2=13.338-42Two-PeriodExampleNow,whatifThree-PeriodExampleFinally,whatifyoudecidetoholdthestockforthreeyears?Inadditiontothedividendsattheendofyears1and2,youexpecttoreceiveadividendof$2.205attheendofyear3andthestockpriceisexpectedtobe$15.435.Nowhowmuchwouldyoubewillingtopay?PV=2/1.2+2.10/(1.2)2+(2.205+15.435)/(1.2)3=13.338-43Three-PeriodExampleFinally,wDevelopingTheModelYoucouldcontinuetopushbacktheyearinwhichyouwillsellthestockYouwouldfindthatthepriceofthestockisreallyjustthepresentvalueofallexpectedfuturedividendsSo,howcanweestimateallfuturedividendpayments?8-44DevelopingTheModelYoucouldEstimatingDividends:

SpecialCasesConstantdividendThefirmwillpayaconstantdividendforeverThisislikepreferredstockThepriceiscomputedusingtheperpetuityformulaConstantdividendgrowthThefirmwillincreasethedividendbyaconstantpercenteveryperiodThepriceiscomputedusingthegrowingperpetuitymodelSupernormalgrowthDividendgrowthisnotconsistentinitially,butsettlesdowntoconstantgrowtheventuallyThepriceiscomputedusingamultistagemodel8-45EstimatingDividends:

SpecialZeroGrowthIfdividendsareexpectedatregularintervalsforever,thenthisisaperpetuityandthepresentvalueofexpectedfuturedividendscanbefoundusingtheperpetuityformulaP0=D/RSupposestockisexpectedtopaya$0.50dividendeveryquarterandtherequiredreturnis10%withquarterlycompounding.Whatistheprice?P0=.50/(.1/4)=$208-46ZeroGrowthIfdividendsareexDividendGrowthModelDividendsareexpectedtogrowataconstantpercentperperiod.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+…Withalittlealgebraandsomeserieswork,thisreducesto:8-47DividendGrowthModelDividendsDGM–Example1SupposeBigD,Inc.,justpaidadividendof$0.50pershare.Itisexpectedtoincreaseitsdividendby2%peryear.Ifthemarketrequiresareturnof15%onassetsofthisrisk,howmuchshouldthestockbesellingfor?P0=.50(1+.02)/(.15-.02)=$3.928-48DGM–Example1SupposeBigD,DGM–Example2SupposeTBPirates,Inc.,isexpectedtopaya$2dividendinoneyear.Ifthedividendisexpectedtogrowat5%peryearandtherequiredreturnis20%,whatistheprice?P0=2/(.2-.05)=$13.33Whyisn’tthe$2inthenumeratormultipliedby(1.05)inthisexample?8-49DGM–Example2SupposeTBPiraStockPriceSensitivitytoDividendGrowth,gD1=$2;R=20%8-50StockPriceSensitivitytoDivStockPriceSensitivitytoRequiredReturn,RD1=$2;g=5%8-51StockPriceSensitivitytoReqExample8.3GordonGrowth

Company-IGordonGrowthCompanyisexpectedtopayadividendof$4nextperiod,anddividendsareexpectedtogrowat6%peryear.Therequiredreturnis16%.Whatisthecurrentprice?P0=4/(.16-.06)=$40Rememberthatwealreadyhavethedividendexpectednextyear,sowedon’tmultiplythedividendby1+g8-52Example8.3GordonGrowth

ComExample8.3–GordonGrowth

Company-IIWhatisthepriceexpectedtobeinyear4?P4=D4(1+g)/(R–g)=D5/(R–g)P4=4(1+.06)4/(.16-.06)=50.50Whatistheimpliedreturngiventhechangeinpriceduringthefouryearperiod?50.50=40(1+return)4;return=6%PV=-40;FV=50.50;N=4;CPTI/Y=6%Thepriceisassumedtogrowatthesamerateasthedividends8-53Example8.3–GordonGrowth

CNonconstantGrowth

Example-ISupposeafirmisexpectedtoincreasedividendsby20%inoneyearandby15%intwoyears.Afterthat,dividendswillincreaseatarateof5%peryearindefinitely.Ifthelastdividendwas$1andtherequiredreturnis20%,whatisthepriceofthestock?RememberthatwehavetofindthePVofallexpectedfuturedividends.8-54NonconstantGrowth

Example-NonconstantGrowth

Example-IIComputethedividendsuntilgrowthlevelsoffD1=1(1.2)=$1.20D2=1.20(1.15)=$1.38D3=1.38(1.05)=$1.449FindtheexpectedfuturepriceP2=D3/(R–g)=1.449/(.2-.05)=9.66FindthepresentvalueoftheexpectedfuturecashflowsP0=1.20/(1.2)+(1.38+9.66)/(1.2)2=8.678-55NonconstantGrowth

Example-QuickQuiz–PartIWhatisthevalueofastockthatisexpectedtopayaconstantdividendof$2peryeariftherequiredreturnis15%?Whatifthecompanystartsincreasingdividendsby3%peryear,beginningwiththenextdividend?Therequiredreturnstaysat15%.8-56QuickQuiz–PartIWhatistheUsingtheDGMtoFindRStartwiththeDGM:8-57UsingtheDGMtoFindRStartwExample:FindingtheRequiredReturnSupposeafirm’sstockissellingfor$10.50.Itjustpaida$1dividend,anddividendsareexpectedtogrowat5%peryear.Whatistherequiredreturn?R=[1(1.05)/10.50]+.05=15%Whatisthedividendyield?1(1.05)/10.50=10%Whatisthecapitalgainsyield?g=5%8-58Example:FindingtheRequiredStockValuation

UsingMultiplesAnothercommonvaluationapproachistomultiplyabenchmarkPEratiobyearningspershare(EPS)tocomeupwithastockpricePt=BenchmarkPEratio*EPStThebenchmarkPEratioisoftenanindustryaverageorbasedonacompany’sownhistoricalvaluesTheprice-salesratiocanalsobeused8-59StockValuation

UsingMultiplExample:StockValuationUsingMultiplesSupposeacompanyhadearningspershareof$3overthepastyear.TheindustryaveragePEratiois12.Usethisinformationtovaluethiscompany’sstockprice.Pt=12x$3=$36pershare8-60Example:StockValuationUsingTable8.1-StockValuationSummary8-61Table8.1-StockValuationSuFeaturesofCommonStockVotingRightsProxyvotingClassesofstockOtherRightsShareproportionallyindeclareddividendsShareproportionallyinremainingassetsduringliquidationPreemptiveright–firstshotatnewstockissuetomaintainproportionalownershipifdesired8-62FeaturesofCommonStockVotingDividendCharacteristicsDividendsarenotaliabilityofthefirmuntiladividendhasbeendeclaredbytheBoardConsequently,afirmcannotgobankruptfornotdeclaringdividendsDividendsandTaxesDividendpaymentsarenotconsideredabusinessexpense;therefore,theyarenottaxdeductibleThetaxationofdividendsreceivedbyindividualsdependsontheholdingperiodDividendsreceivedbycorporationshaveaminimum70%exclusionfromtaxableincome8-63DividendCharacteristicsDivideFeaturesofPreferredStockDividendsStateddividendthatmustbepaidbeforedividendscanbepaidtocommonstockholdersDividendsarenotaliabilityofthefirm,andpreferreddividendscanbedeferredindefinitelyMostpreferreddividendsarecumulative–anymissedpreferreddividendshavetobepaidbeforecommondividendscanbep