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Unformatted text preview: Chapter 7 Equity Markets and Stock Valuation As in Chapter 6, we again apply the “time value of money” tools from chapters 4 and 5 to the topic of stock valuation. We will spend most of our time talking about the valuation of common stock. We will also discuss the valuation of preferred stock. What is common stock? The right hand side of a typical corporation’s balance sheet is composed of liabilities (e.g., accounts payable, bank debt, bonds) and equity. Common stock is main “equity” security. All corporations have at least some common stock. Owners of common stock have voting rights in the corporation and receive dividend payments. (We will discuss more of the details in Section 7.2.) Valuation of common stock  As with bonds, the price of common stock is the present value of its cash flows. The cash flows associated with a bond are the coupon interest payments (typically paid every six months) and the face amount paid on the maturity date. Common stock pays dividends (typically every three months). Unlike bonds, common stock never matures, and therefore does not have a “face amount” that is paid at some future date. Common Stock Valuation To value a common stock (or “stock” from now on), calculate the present value of its dividends. Formula : PV = D 1 / (1+r) + D 2 / (1+ r) 2 + D 3 / (1+ r) 3 + D 4 / (1+ r) 4 + … Since stocks never mature, it could (in theory) pay dividends forever, making the calculation of its present value quite difficult. However, remember that the present value of any cash flow in the distant future is small, so you can approximate the present value with a finite set of dividends (e.g., take a PV of the stock’s dividends over the first 50100 years – more on this later). As an alternative, if you think the dividends will grow at a constant rate forever, then you can use the formula for a perpetuity: 1 ) 1 ( + ÷  = t t r g r C PV Example : A stock expects to pay a $1 dividend at time one. Its dividends are expected to grow at a rate of 2% forever. What is the present value of the stock using a 12% discount rate? 2 Stock Valuation continued With a bond, we calculate the value at any point in time by calculating the PV of the bond’s remaining payments (coupon and face amount). Example : Issue date = December 31, 2008 Maturity date = December 31, 2028 Coupon rate = 6% with annual payments (on December 31) Face amount = $1,000 per bond Time line 1 2 3 4 5 6 … 19 20 Using an 8% discount rate, what is the PV of this bond at time 0, 1, 2, 3, and 20? N I/Y PV PMT FV PV PV 1 PV 2 PV 3 PV 20 3 Stock Valuation continued How about a stock? Example : A stock expects to pay a $1 dividend at time one. Its dividends are expected to grow at a rate of 2% forever. Using a 12% discount rate, what is the PV of this stock at time 0, 1, 2, 3, … ?...
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 Spring '08
 Wigmans,F
 Dividends, Time Value Of Money, Stock Valuation, Valuation

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