Chapter08StockValuation

# Chapter08StockValuation - OEM 2009 Program Common Stock...

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OEM 2009 Program Stocks and Their Valuation Page 1 CHAPTER 8 Stocks and Their Valuation Common Stock: Terminology ± Voting rights ± Preemptive rights ± Classified stock ± Initial public offering (IPO) ± Par value ± Dividends ± Stock splits Control ± Stock represents ownership ± Ownership implies control ± Stockholders elect directors ± Directors hire management ± Management’s goal: Maximize the stock price Common Stock Symbols D t = Expected dividend at period t P 0 = Current price P = Expected price at period t ^ t g = Expected growth rate BR = Sustainable growth rate B = Retention rate = (1 - DPR) R = Return on equity Common Stock Symbols r S = Required rate of return r S = Expected rate of return = Actual 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 Stock Valuation ² 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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OEM 2009 Program Stocks and Their Valuation Page 2 Stock Valuation P 0 = [D 1 + P 1 ] But what is the value of P 1 1+r S 1 ^ ^ ________ But, what is the value of P 1 P 1 = [D 2 + P 2 ] 1 1+r S 1 ^ ^ ________ Stock Valuation P 0 = [D 1 ] + [D 2 + P 2 ] 1 1+r S 1 1 1+r S 2 ^ ________ ________ P 0 = [D 1 ] + [D 2 ] + . .. + [D + P ] 1 1+r S 1 1 1+r S 2 1 1+r S ^ ________ ________ ________ Stock Valuation 0 1 2 P 0 =D 1 D 2 D r S Assume present value of P will be zero: P 0 = + + … + D 1 D 2 D (1+r S ) 1 (1+r S ) 2 (1+r S ) 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. 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% 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: z Zero (or no) growth z Constant growth z Non-constant growth (followed by constant growth)
OEM 2009 Program Stocks and Their Valuation Page 3 Zero Growth P 0 = Σ [D t ] t =1 1 (1+r S ) t __________ Assume D t = D for all t, since g = 0 P 0 = [D] Σ = D r S 1 (1+r S ) t t =1 ___________ Zero Growth At a zero growth rate, the dividend

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Chapter08StockValuation - OEM 2009 Program Common Stock...

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