Chapter 7
description
Transcript of Chapter 7
Chapter
7Equity Markets and Stock Valuation
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 electedUnderstand how stock markets workUnderstand how stock prices are quoted
Feature of Common Stock
Voting RightsProxy votingOther Rights
Share proportionally in declared dividendsShare proportionally in remaining assets during
liquidationPreemptive right – first shot at new stock issue to
maintain proportional ownership if desired
Dividend Characteristics
Firm cannot go bankrupt for not declaring dividendsDividends 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
Dividends received by corporations have a minimum 70% exclusion from taxable income
Features of Preferred Stock
DividendsStated dividend that must be paid before dividends
can be paid to common stockholdersDividends are not a liability of the firm and preferred
dividends can be deferred indefinitelyMost preferred dividends are cumulative – any
missed preferred dividends have to be paid before common dividends can be paid
Preferred stock generally does not carry voting rights
Stock Markets
New York Stock Exchange (NYSE)Huge room with electronic “trading posts”Each stock assigned to single “specialist”Specialists = Employed by exchange to be “market
makers”Hold inventory of stocks, advertise prices to buy
(bid) and sell (ask) at:
Stock Bid Ask
YWEE $28.65 $28.75
Specialists
Bid Ask
YWEE $28.65 $28.75 Specialist buys low, sells high Specialists buys at $28.65, so you sell at
$28.65. Specialist sells at $28.75, so you buy at $28.75 $28.75 - $28.65 = $0.10 = “spread”
Stock Markets
NASDAQNot a physical exchange – computer based
quotation systemNational Association of Securities Dealers
Automated QuotationMultiple dealers acting as “market makers” – Hold
inventory of stock, post bid & ask pricesLarge portion of technology stocks
NASDAQ
DULL Computers: three dealers
Joe Bob Englebert
Bid Ask Bid Ask Bid Ask
8.00 8.50 7.75 8.25 7.50 8.50
NASDAQ reports:Bid Ask8.00 8.25
Cash Flows to Stockholders
If you buy a share of stock, you can receive cash in two waysThe company pays dividendsYou sell your shares, either to another investor in
the market or back to the companyValue = PV of expected future CF’s
Estimating Dividends: Special Cases
Constant dividend The firm will pay a constant dividend forever, like
preferred stock Perpetuity formula
Constant dividend growth The firm will increase the dividend by a constant percent
every periodNonconstant growth
Dividend growth is not consistent initially, but settles down to constant growth eventually
Zero Growth
If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity
P0 = D / RSuppose stock is expected to pay a $2 dividend
every year and the required return is 10%. What is the price?P0 = 2 / .1 = $20
Dividend Growth Model
Dividends grow at a constant rate g…
D1 = D0 * (1 + g)
D2 = D1 * (1 + g)
D2 = D0 * (1 + g) * (1 + g) = D0 * (1 + g)2
Dt = D0 * (1 + g)t
D43 = D0 * (1 + g)43
Dividend Growth Model (DGM)
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:
g-R
D
g-R
g)1(DP 10
0
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?
What variable is $.50?P0 = .50*(1+.02) / (.15 - .02) = $3.92
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) = $13.33Why isn’t the $2 in the numerator multiplied by
(1.05) in this example?
Example
Gordon Growth Company is expected to pay a dividend of $2 next year and dividends are expected to grow at 6% per year. The required return is 15%.
What is the current price?
Using the DGM to Find R
Start with the DGM:
gP
D g
P
g)1(D R
Rfor solve and rearrange
g-R
D
g - R
g)1(DP
0
1
0
0
100
Components of R
You can get your R in two forms:Dividend yield = D1/P0
Capital gains yield = g
R = D1/P0 + g
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%
Criticisms of P0 = D1 (R – g)
1. Constant g2. g > R P < 0 3. D1 = 0 P = 04. Sensitive to R & g:
1,2,&3 can be fixed (young firms)
Stock Price Sensitivity to Dividend Growth
0
50
100
150
200
250
0 0.05 0.1 0.15 0.2
Growth Rate
Stoc
k P
rice
D1 = $2; R = 20%
Stock Price Sensitivity to Required Return
0
50
100
150
200
250
0 0.05 0.1 0.15 0.2 0.25 0.3
Growth Rate
Stoc
k P
rice
D1 = $2; g = 5%
Firms with D1 = $0
Firm expects to pay no divds until year 5
That divd expected = $1
g = 12%, R = 15% P=?
Solution: Throw D, R , & g into equation
Firms with D1 = $0
P = $1 (.15 - .12) = $33.33?
Formula D1 (R – g) = P0
What we did D5 (R – g) = ????
D = always one period ahead of P
(D5 P4)Stock Value = PV (expected divd payments)
Firms with D1 = $0
P4 = $33.33 P0 = ???
P4 = FV P0 = PV
P0 = PV(P4) @ R%
4 N, 15 I/YR, 33.33 FV, PV=???P0 = $19.06
Nonconstant Growth
1. Compute PV(dividends that experience nonconstant growth)
2. Find the P stock the end of the nonconstant growth period, and discount P back to the present
3. Add these two components to find the value of the stock.
Nonconstant Growth
TannerHater.com recently paid a dividend of $1.00. Analysts expect that dividend to grow at 20% annually for 3 years, then grow at 10% indefinitely. If R = 15%, what is the stock’s intrinsic value?
Nonconstant Growth
1. Compute PV(dividends that experience nonconstant growth)
D1 = D0 * (1 + g) = $1.00*1.2 = $1.20
D2 = D1 * (1 + g) = $1.20*1.2 = $1.44
D3 = D2 * (1 + g) = $1.44*1.2 = $1.73
Need PV of D1 D3?
Nonconstant Growth
Use CFj button on calculator:0 CFj (CF in year 0)
1.2 CFj (CF in year 1)1.44 CFj (CF in year 2)1.73 CFj (CF in year 3)
15 I/YR<color> NPV
$3.27 = PV (D1 D3)
Nonconstant Growth
2. Find the P stock the end of the nonconstant growth period, and discount P back to the present.
D4 = D3 * (1 + g) = $1.73 * 1.10 = $1.90
$1.90 (R – g) = $1.90 (.15 - .10) = $38 = P????
Nonconstant Growth
$38.06 = D4 (r– g) = P3 = FV3
3 N15 I/YR38 FVPV = ?
PV = $24.99 = PV(D4 D)
Nonconstant Growth
P0 = PV(D1 D)
PV(D1 D3) = $3.27
+ PV(D4 D) = $24.99
PV(D1 D) = $28.26 = P0
Nonconstant Growth Problem
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.