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Chapter08

Chapter08 - Outline L8-1 Chapter 8 Stock Valuation n Common...

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L8-1 Outline Chapter 8. Stock Valuation n Common Stock Valuation n Some Features of Common and Preferred Stocks n The Stock Markets n Summary and Conclusions

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L8-2 Common Stock Valuation n In 1938, John Burr Williams postulated what has become the fundamental theory of valuation : The value today of any financial asset equals the present value of all of its future cash flows. n A share of stock is more difficult to value than a bond because: 1. Promised cash-flows are not known in advance. 2. The life of the investment is essentially forever. 3. The market required rate of return is not easily observed.
L8-3 Common Stock Valuation Example: Suppose that you are considering to buy a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth \$70 at that time. You predict that the stock will also pay a \$10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the \$10 dividend along with the \$70 ending value at 25 percent? If you buy the stock today and sell it at the end of the year, you will have a total of \$80 in cash. At 25 percent, Present value = (\$10 + 70) / 1.25 = \$64 Therefore, \$64 is the value you would assign to the stock today.

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L8-4 Common Stock Valuation (continued) n More generally, let P 0 be the current price of the stock, and assign P 1 to be the price in one period. If D 1 is the cash dividend paid at the end of one period, then we get: P 0 = (D 1 + P 1 ) / (1 + R) where R is the required return in the market on this investment. So, to know the current price of the stock, we should know the price of the stock in one period, which may be even harder. What is the price in one period, P1? We don’t know it in general. But, if we know the price in two periods, P2, then the stock price in one period would be P 1 = (D 2 + P 2 ) / (1 + R) with the assumption that the dividend in two periods, D2, can be predicted. If we were to substitute this expression of P1 into our expression for P0, we get: P 0 = [D 1 + (D2 + P 2 ) / (1 + R)] / (1 + R) = D 1 /(1 + R) + D 2 / (1 + R) 2 + P 2 /(1 + R) 2 Finally, if we continue these substitutions, we get: P0 = D1/ (1 + R) + D2/(1 + R)2 + D3/(1 + R)3 + . . . because if we push the sale of stocks far enough away then the present value of the future price will become zero. Hence, the price of the stock today is equal to the present value of all of the future dividends .
L8-5 Common Stock Valuation (continued) n What if the firm pays no dividends? Imagine a company that has a provision in its corporate charter that prohibits the paying of dividends now or ever. In other words, the corporation never pays out any money to stockholders in any form whatsoever. Such a corporation couldn’t really exist because the IRS wouldn’t like it; and the stockholders could always vote to amend the charter if they wanted to.

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