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ch9 - CHAPTER 9 Stocks and Their Valuation Common Stock...

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Stocks and Their Valuation CHAPTER 9
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Common Stock: Terminology Voting rights Preemptive rights Classified stock Initial public offering (IPO) Par value Dividends Stock splits
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Control Stock represents ownership Ownership implies control Stockholders elect directors Directors hire management Management’s goal: Maximize the stock price
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Common Stock Symbols D t = Expected dividend at period t P 0 = Current price P t = Expected price at period t g = Expected growth rate BR = Sustainable growth rate B = Retention rate = (1 - DPR) R = Return on equity ^
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Common Stock Symbols r S = Required rate of return r S = Expected rate of return r S = Actual rate of return = Expected dividend yield = Expected capital gains yield ^ D 1 P 0 P 1 -P 0 P 0 ^ __
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Stock Valuation Assume that you plan to buy a share of stock today. You expect to hold this stock for 1 year, receive a dividend payment at the end of the year, then immediately sell the stock in the market. How much should you pay for the stock today?
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Stock Valuation P 0 = [D 1 + P 1 ] But, what is the value of P 1 P 1 = [D 2 + P 2 ] 1 1+r S 1 ^ 1 1+r S 1 ^ ^ ^ ________ ________
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Stock Valuation P 0 = [D 1 ] + [D 2 + P 2 ] P 0 = [D 1 ] + [D 2 ] + ... + [D + P ] 1 1+r S 1 1 1+r S 2 ^ 1 1+r S 1 1 1+r S 2 1 1+r S ^ ________ ________ ________ ________ ________
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Stock Valuation 0 1 2 P 0 = D 1 D 2 D Assume present value of P will be zero: r S P 0 = + + … + D 1 D 2 D (1+r S ) 1 (1+r S ) 2 (1+r S )
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Stock Valuation Our only problem now is to determine the dividend in each period and the correct discount rate (investor’s required rate of return) to use.
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Discount Rate Assume that this stock has a beta of 1.25, the risk-free rate is 5%, and the expected return on the market is 13%. We can use the CAPM to then determine r S as follows: r S = .05 + [.13 -.05][1.25] = 15%
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Dividends Assume that the firm just paid a dividend of $1.50 (you won’t get this). Future dividends will depend on growth rate assumptions: Zero (or no) growth Constant growth Non-constant growth (followed
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Zero Growth P 0 = Σ [D t ] Assume D t = D for all t, since g = 0 P 0 = [D] Σ = t =1 1 (1+r S ) t D r S 1 (1+r S ) t t =1 __________ ___________
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Zero Growth At a zero growth rate, the dividend will be the same in each period (this is a valid assumption for preferred stock, which pays a constant dividend forever). The price will be: P 0 = [$1.50] / [.15] = $10.00
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