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September 19, 2012 Stock Valuation Chapter Outline: Common Stock Valuation Some Features of Common and Preferred

ed Stocks The Stock Markets

Chapter 8: Stock Valuation

Additional Notes: Even complex cash flow analysis calculations are based on assumptions and estimates, which can cause calculations to deviate from reality; not as much of a deviation for Preferred stocks. Stocks are much more volatile than bonds. Unless instructed otherwise, required rates of return are constant forever Stocks are less structured than bonds, making pricing them difficult; assumptions make pricing easier From the Motley Fool: Ask the Fool Q: How can novices tell when a stock is overvalued (and therefore should be avoided)? J.M from AZ A: Experienced investors often crunch a lot of numbers, considering lots of factors. Novices can learn these skills, but understand that even complex discounted cash flow analysis calculations are still based on assumptions and estimates. Think about the above question. We are learning how to analyze cash flows in FINA 3000. Cash Flows for Stockholders If you buy a share of stock, you can receive cash in two ways (two ways to make money): 1. The company pays dividends. These transactions are good for investors because they get money. Bad, though, because (1) have to pay tax on income and (2) have to reinvest if want the money to grow and that can be costly. Firms do not have to declare dividends. 2. You sell your shares, either to another investor in the market or back to the company. When company buys back shares, called a buyback or a repurchase. They then reinvest the money in the company. Investors who do not sell their shares benefit because they will own a larger portion of the company, and their shares become more valuable. Investors who do sell their shares benefit by selling the shares for a higher price than they were bought at. As with bonds, the price of the stock is the present value of these expected cash flows. Just like older chapters, we will use a timeline to find this. (Our

two expected future cash flows are dividends = D and the price of the shares = P.) 0 1 2 3 4 5 |----------|----------|----------|----------|----------| P0 D1 P1 Dividend and price in one year is random and you dont know! It could be 0 or could be a huge number! Still want to think what dividend will be worth on average (expected value).

This formula gives the PV at time 0 of the dividend and price at time 1 Et[x] denotes the expected value of the term in brackets Discount rate is still an opportunity cost! Using new information, you can change your opinions of what cash flows should be on the timeline. Its always best guess with this formula. If this stock is transferred at time 1 from the original owner to a second owner, the second owner should be willing to pay the present value at time 1, which is the expected dividend and expected price at time 2, dragged back to PV at time 1 (D2 + P2)/ (1+r) -Note that the buyer does not include the dividend at time 1 in determining P1. This is called trading ex-dividend meaning that the price of the stock consists only of future cash flows. If the buyer were to include D1 when purchasing at time 1, it would be called trading cum-dividend. A stock never matures! You will just leave expected dividends on time line to get PV of expected dividends. 0 1 2 3 4 5 |----------|----------|----------|----------|----------| P0 D1 P1 D2 P2

P0

Et D1

1 r

Et D 2 Et P2

1 r

0 1 2 3 4 5 |----------|----------|----------|----------|----------| P0 D1 P1 D2

P2

D3 P3

P0

Et D1

1 r 1 r 2

Et D2

Et D3 Et P3

1 r

0 1 2 3 4 5 |----------|----------|----------|----------|----------| P0 D1 P1 D2 P2 D3 P3 D4 P4

P0

Et D1

1 r 1 r 2 1 r 3

Et D2

Et D3

Et D4 Et P4

1 r

0 1 2 3 4 5 |----------|----------|----------|----------|----------| P0 D1 P 1 D2 P2 D3 P3 D4 P4 D5 P5 You can do this substitution any number of times because the stock will never be mature. It will just keep going as long as the company does. Developing the Model You could continue to push back when you would sell the stock. You would find that the price of the stock is really just the present value of all expected future dividends. (The PV of the time at time infinity is worth nothing; you wind up with only the expected dividends on the timeline.)

This is the most complicated way to predict dividends. With bonds you know what the coupon will be and when it occurs because indenture and contract. You know it must converge on the face value (because there is a maturity date). With stocks you know nothing with certainty. Even preferred stock will not necessarily pay dividends. They dont have to converge on anything. So, how can we estimate all future dividend payments? In mathematics, you make assumptions (something that makes the model less realistic but more tractable) to estimate things in the future. Here, we will impose assumptions in a number of different ways.

Estimating Dividends: Special Cases #1: Constant dividend The firm will pay a constant dividend forever. This is like preferred stock, which pays a constant quarterly dividend. -However, if they dont pay one year it goes into arrears to be paid later which would cause inconsistent dividends. The price is computed using the perpetuity formula. Not a great assumption because it is very likely that profits will be a different amount from year to year, especially for companies that have grown over time (their profits will likely grow, which in turn will cause dividends to be growing over time too). #2: Constant dividend growth The firm will increase the dividend by a constant percent every period. Dividends would all be different and getting bigger but doing so in a structured way. -This model is more realistic than the constant dividend model. #3: Supernormal growth Dividend growth is not consistent initially, but settles down to constant growth eventually. For some period of time the dividends will be like random lump sums (you will have to drag back to time 0 to find PV) but at some point they will become either constant forever or grow constantly forever. It is very hard to predict lump sums.

-the assumption that dividends will settle to constant growth is reasonable b/c of competition; profitability will attract competitors which will decrease profitability and stabilize dividends. Zero Growth If dividends are expected at regular intervals forever (all dividends the same amount), then this is like preferred stock and is valued as perpetuity:

P0= D1 / rP

Rate and dividends must be the same: annual, quarterly, etc. THIS IS ONE PERIOD PRIOR TO WHEN THE DIVIDENDS ARE PAID (one period is a quarter prior if distributed every quarter, one period prior is a year prior if dividends distributed every year) Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price? P0 = .50/ (.1/4) = $20 Here you have made two huge assumptions: the dividend is the same forever and the opportunity cost is the same forever. Remember that we assume the trade is ex-dividend and therefore do not include the dividend at time 0 in the price. Present Value of Each Dividend

September 24, 2012 Dividend Growth Model Dividends are expected to grow at a constant percent per period.

Correction: D1 should be D3 for the top equation in the last part. This model includes estimation of what future cash flows (by looking at past dividends +expected growth over time) will be. Assumptions: -g is constant forever - r is fixed forever - r >g forever (not necessarily every period but in the long-run r must be greater than g **In this equation, g is in the numerator. In Ch 6 we learned that discount factors (AKA r) in the denominator make the PV smaller. So, the g offsets the effect of the discounting and makes the PV bigger. When the r and the g get close to one another (when r = g) the PV of D1 = D0. D2 will also = D0 The PV of all dividends will all equal D0. With a little algebra, this reduces to:

D0 (1+g) = estimation of D It is very hard to estimate what stocks will pay in the future. One mistake will make the whole thing wrong. With information, you can predict much more accurately. R must be greater than G for this to work!!! Stock Price Sensitivity to Dividend Growth

250 200

Stock Price

150 100 50 0 0 0.05 0.1 Growth Rate 0.15 0.2

P0
-

$2 .20 g
As g gets closer to r it offsets discounting more and more, increasing the stock price. As estimated g increases so does the error in price. 20%= cost of equity Line will approach infinity if continues because $2/ .2-.2 = $2/ 0 = infinity

Stock Price Sensitivity to Required Return


250 200 Stock Price 150 100 50 0 0 0.05 0.1 Discount Rate 0.15 0.2

The axes tell you that as the discount rate (AKA r) increases, the stock price decreases. As r and g approach each other, the price is more sensitive to estimation mistakes. If r and g are far apart the stock price is less sensitive to error. There is an additional formula: A hat (^) above r or g indicates that they are expected values. DGM Example 1 Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock sell for?

P0

$2 r .05

P0

D0 (1 g) r-g

or P0

D1 r-g

G=2%, r= 15% P0 = .50(1+.02)/(.15-.02) = $3.92307692 Just paid = red flag for D0, this gives you info to estimate D1 DGM Example 2 Krispy Kreme is expected to pay a dividend of $2 (D1!) next period and dividends are expected to grow at 4% per year. The required return is 14%.

What is the current price? Price Today = 2/ (.14-.04) = $20 Dont forget we are calculating the price one period prior to the first cash flow in the stream occurring. Remember that we already have the dividend expected next year, so we dont multiply the dividend by 1+g. What is the price expected to be in year 4? P4 = D4 (1 + g) / (rE g) = D5 / (rE g) P4 = 2(1.04)4/ (.14-.04) = $23.39717120 You need a timeline for this. Its important to ID which dividend will be the first you will receive because you will use the perpetuity formula to discount back to the lump sum value. In order to get D5, you have to grow up the dividend received at time 1 by four period. You are making money by prices increasing and dividends (capital gain). What is the implied return given the change in price during the four-year period? 20 PV, 23.39717120 FV, 4 N, CPT I/Y => 4% The price grows at the same rate as the dividends. This is because the stock price represents your claim on the future dividends from that stock. Price growth rate = dividend growth rate. An increase in price means there is a positive capital gains yield. Since we know that price increases at the same rate as dividends, we know that the capital gains yield is 4%. You can also double check this with $20(1.04)4. Nonconstant Growth Problem Statement Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock? Remember that we have to find the PV of all expected future dividends. Use a timeline! I--------------I--------------I---------------I---------I----------------0 20% g 1 15% 2 5% 3 5% 4 Infinity $1 $1.20 $1.38 $1.449 D4.. Example Solution Compute the dividends until growth levels off D1 = 1(1.2) = $1.20 D2 = 1.20(1.15) = 1.38 D3 = 1.38(1.05) = 1.449 After you find the first cash flow in the stream of the perpetuity (all growth stops at 5%), you can just find the value of the perpetuity by discounting it back to PV Find the expected future price

P2 = 1.449/ (.20-.05) = $9.66 at time 2 Find the expected future price: 1.38+9.66=11.04 at time 2 Discount 1.20 back one period and 11.04 back two periods to find the PV0. P0 = 1.20/ (1.2) + (1.38+9.66)/ (1.2)2 = $8.67 TWEAK TO MAKE PROBLEM FASTER: Make a timeline. We already know T0 dividend = $1, T1 dividend = 1.20 (with growth of 20% included), T2 dividend = 1.38 (with growth of 15% included), and after that, the growth rate is constant forever (5%). At any time you can use D/(r-g) to convert the PV into a lump sum. EX: Using numbers at time 2: 1.38/ (.20-.05) = 9.20 (price at T1) Add 9.20 to the dividend at T1 (1.20) = 10.40. Now you can discount that amount back to PV by just dividing it 10.40/ (1.20) = 8.67 (price at T0) **The point when the perpetuity starts, you can use D/(r-g) General Approach: 1. Put dividends on timeline until point where g becomes constant; between now and then, the dividends could look like anything, including a growing annuity! Dont be confused if there are constant growths for x years and then changes to a different rate forever. Look at the two stage growth model section in the bookwe are responsible for knowing it! Treat the first stage as a growing annuity and the second stage as a growing perpetuity. 2. Note when constant growth occurs (maybe zero) 3. Convert constant growth dividends into lump sum 1 period prior to first dividend in constant growth stream 4. Take all lump sums back to time zero one at a time 5. Add them up to get price Competition makes g > r at some point. A cash cow is a grown firm with limited opportunities to grow (AKA g<r). (Ex: Kellogg. All the people who will eat cereal probably already are. The only thing that will make Kellogg grow is the population growing.) Special Case: Two-Stage Growth I-------------I----------------------------I--------I------------------- infinity 0 1 13 14 .25 $92.037 g1= 5%/ qtr g2= 2.5%/qtr D14= .25 x (1.05)12 x (1.025) = .46018818/ r-g (.03-.025) = $92.03763671 (move to time 0) -occurring one per prior to first stream of cash flow so $92.037 is at time 13 - Find PV perpetuity at time 0= $62.67315205

PV0, Annuity= $.25 (1-(1+.05/1+.03)13/ (.03-.05)]= 3.55044138 Price = 3.55044138+$62.67315205= $66.22359343 Using the DGM to Find rE: Start with the DGM:

D1/P0= Dividend yield g= capital gains yield (1+g)= checks There are two components in this formula. Component 1 (the D1/P0 part) is called dividend yield. Component 2 (the g) is called capital gains yield. Capital gains are changes in price, technically. (You buy a house for 100k, sell it for 200k, you make a capital gain of 100k or 100 %.) Remember, in this formula, the price is growing at the same rate as the dividends are growing, and that there are two ways to make money off of stocks: selling and dividends. Essentially: r = dividend yield + capital gains yield Finding the Required Return - Example Suppose a firms stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? r = [$1(1.05)/10.50] + .05 = 15% What is the dividend yield? 10% What is the capital gains yield? 5% September 26, 2012 Feature of Common Stock Voting Rights (typically one share = one vote, not all shareholders vote though) o Voting of Board of Directors, selling off firms, extraordinary dividends, changing bylaws Proxy voting (as a shareholder you can assign someone to vote for you; you should be careful who you assign them to because managers can offer to vote on your behalf, and that is an agency problem; o Staggered elections are a technique used by mgmt to prevent takeovers. In staggered elections, only a few seats on the board are up for election at a time, this prevents a group from taking over the board in one election.

The most you can get is 4 per year, 12 managers o Say on pay Issue in WSJ, the Board is typically the organization that oversees the mangers compensation, special committee to decide this, shareholders think managers are getting paid too much, agency problem o Proxy solicitation- managers want votes Classes of stock o The majority of firms have 1 class of stock. Those with two classes are referred to as dual class shares. Dual class shares are common for firms founded by families or a small number of owners (ex: Ford). One class is traded publically, while the others are not. Usually private shares have more votes than public ones, meaning their holders control voting. Common shareholders must vote with their feet, making their opinion heard by buying or selling shares. o Google- owners have so many voting rights compared to public, public cant change Board of Directors Other Rights (set forth in corporate bylaws or state laws) Share proportionally in declared dividends (all owners receive dividend) Share proportionally in remaining assets during liquidation (if firm liquidated, then all owners receive a portion of proceeds; however this is uncommon because when firms go under there is usually little left), shareholders are residual claimants Preemptive right first shot at new stock issue to maintain proportional ownership if desired (when a firm issues new shares, existing shareholders have the option of buying the stock before other people; this can prevent the firm from diluting the power of a shareholder)

106 cars/1000 people Slovak Republic produces most cars per capita 15% on corporations and income, 0% on dividends everyone is going there because of tax incentives. Dividend Characteristics Dividends are not a liability of the firm until a dividend has been declared by the Board. If you are an all equity firm you can not go bankrupt. Consequently, a firm cannot go bankrupt for not declaring dividends. This might be an advantage now, when the economy is bad, and firms need all the money they can get. When you are an all equity firm, you cannot go bankrupt. Dividends and Taxes Dividend payments are not considered a business expense, therefore, they are not tax deductible *in the US (in many other places, there is not double taxation when dividend paid from firm to shareholder). Dividends received by individuals are taxed as ordinary income.* S-Corps are an exception; because they are small corporations, they can choose to be taxed as an individual (once) or as a corporation (twice). LLCs are also taxed only once. Only large companies are double taxed in the US. (THIS OBVIOUSLY DEPENDS ON THE TAX CODE)

Dividends received by corporations have a minimum 70% exclusion from taxable income. -If dividend declared and paid, a large part is an internal capital flow because from firm to firm that is taxed at preferential rates. -Greater ownership translates to greater tax exemption Features of Preferred Stock Dividends- preferred stock has priority on dividends -Stated dividend that must be paid before dividends can be paid to common stockholders. If a firm misses a div. pmt the amount goes into arrears (to be paid in the future). Payments in arrears must be made before payments to common stockholders can begin. Firms in arrears are generally not profitable. -Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely. -Most preferred dividends are cumulative any missed preferred dividends have to be paid before common dividends can be paid. Firms are legally allowed to let dividends accumulate for later periods instead of paying them now. Preferred stock generally does not carry voting rights. There are exceptions but in general the trade off is that, as a preferred stockholder, you get better cash flow rights (you know they are supposed to pay you a dividend, how much it will be, and when you will get paid), in exchange for no voting rights. Alternately, common stockholders may not ever get dividends but they have a say in how the firm should be run (aka voting rights). US Govt took preferred stock when they bailed out firms so they would not have voting rights. Banks have to keep a certain amount of equity on hand. Preferred stock is a way to satisfy this rule. It looks like debt, but it is equity. Stock Markets Dealers vs. Brokers New York Stock Exchange (NYSE) Largest stock market in the world --most valuable stock market in the world in that it has the largest capitalization, aka largest dollar value --not the largest in volumenumber of shares traded is highest in London Stock Exchange. Why? Sarbanes-Oxley has caused a lot of problems because it requires expensive control implementation to meet compliance (particularly disproportionate for small firms) Stocks trade through Specialists (basically brokers who match up buyers and sellers) this will go away soon and be replaced by computers NASDAQ Not a physical exchange computer based quotation system (Quote Levels) Multiple market makers- multiple dealers in any one stock --Dealer market (buy low at bid, sell high at ask how they make profits)

--If you are selling low and buying high, the bid-ask spread will not allow you to become profitable --NASDAQ aggregates and simplifies all bids and asks to find price Not free to list on these exchanges and there are several rules you have to meet to be traded on these exchanges. NYSE is more stringent than is NASDAQ. Moving to the NYSE is a signal that you are a firm that is LESS RISKY. You meet all their criteria and pay more to be listed, meaning they are a higher quality firm. Thus, their cost of capital is less. However the number of stocks being traded in the US is going down due to the regulatory nature in the US. 2-3 firms do most of the trading on these two exchanges. Up to 100,000 trades per day (e.g. Renaissance)

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