Lecture7 - LECTURE 7 VALUATION OF STOCK Reading: Chapter 9,...

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L ECTURE 7 V ALUATION OF S TOCK Reading: Chapter 9, Sections 9.1-9.3, 9.5 Online, plus my supplemental problems at the end of the notes. Objectives: Explain what common and preferred stock are Value preferred stock Identify the factors that determine the value of common stock Use forecasts of dividend growth to value common stock Estimate the organic growth rate Compute realized common stock returns
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W HAT IS S TOCK ? A share of common stock, or equity, represents an ownership claim on a firm that has no maturity and no promised payments. Payments are in the form of dividends that are declared at the discretion of the board of directors. Payments can also come if a company is bought out by another, or if the firm buys back its own shares Shares of common stock are a lower priority claim than bonds, and are sometimes called residual claims. Common stock typically carries voting rights to elect directors and approve certain actions, such a mergers A share of preferred stock has no maturity, but receives a pre- specified regular dividend. Preferred stock is a hybrid security: Like a perpetual (consol) bond in some ways, like stock in others ¾ Like a consol bond: fixed promised cashflow (dividend) in perpetuity, no voting rights ¾ Like a stock: company can choose not pay the dividend; will not have to declare bankruptcy if it fails to pay
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V ALUATION OF PREFERRED STOCK Typically, preferred stock pays a fixed dividend in perpetuity (like a perpetual bond). What is the price (or present value) of a share of preferred stock which pays a constant dividend (DIV) in perpetuity? Time 0 1 2 3 Payment $0 DIV DIV DIV DIV The present value of preferred stock. $ Price(preferred stock) pe DIV r = r pe is the investors’ required rate of return on preferred stock. This formula is valid if there is a single r pe to discount all cash flows and the next dividend arrives one year from today. Quotes on issues of preferred stock:. Firm Dividend Div/Price Closing Price TCI Comm pf $2.18 8.6% $25.44 ConEd pf $5.00 7.0% $71.50
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V ALUATION OF COMMON STOCK U SING THE D IVIDEND D ISCOUNT M ODEL The value of any financial instrument is the present value of its expected cash flows For most stocks, the only expected cash flows are their dividends. Thus for a stock that is expected to pay dividends, its price will be: 3 12 4 0 234 EE E E DIV DIV DIV DIV P (1 r ) (1+ r ) (1+ r ) (1+ r ) = + + + +⋅⋅⋅ + To value common stock we need to estimate Future dividends (DIVs) (need to estimate growth) The required expected rate of return on equity (r E ), also called the “equity cost of capital” Since there is no maturity and dividends are discretionary and dependent upon future cash flow, the valuation of common stock requires much more judgment than does the valuation of preferred stock and bonds.
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Lecture7 - LECTURE 7 VALUATION OF STOCK Reading: Chapter 9,...

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