Stock Valuation ch 8

Stock Valuation Notes

Learning Objectives

• Explain how stock prices depend on future dividends and their growth.
• Value stocks using multiples.
• Understand the election of corporate directors.
• Define how stock markets operate.

Common Stock Valuation

• Challenges in Valuing Common Stock
  • Promise of Cash Flows: Unlike bonds, common stock cash flows are uncertain.
  • Investment Duration: Common stock generally has no maturity, leading to indefinite cash flows.
  • Market Required Return: Market required return is not easily observable.

Cash Flows from Stocks

• Example: To determine the present value of future cash flows:

  • Assume stock price in one year, P1 = 70 and dividend D1 = 10.
  • Required return R = 25 ext{%}.
  • Present Value Calculation:
    P0 = \frac{D1 + P_1}{1 + R} = \frac{10 + 70}{1.25} = 64

• General formula for present value:

  • If Dt is the dividend at time t, the stock price today is: P0 = \sum{t=1}^{n} \frac{Dt}{(1+R)^t}

Growth Stocks

• Constant Dividend: Similar to preferred stock, but growth potential.

• Zero-growth Stock: For constant dividends:

  • Value: P = \frac{D}{R} (where D is constant)

• Constant Growth Model: If dividends grow at a constant rate g:

  • Next dividend: D1 = D0 imes (1 + g)
  • Price using the dividend growth model:
    P0 = \frac{D1}{R - g}

Example of Constant Growth

• For D_0 = 2.30, R = 0.13, and g = 0.05:

  • Price per share:
    P_0 = \frac{2.30 \times 1.05}{0.13 - 0.05} = \frac{2.415}{0.08} = 30.19

• Price in future years relies on estimated future dividends while taking into account the growth rate.

Nonconstant Growth

• Modeling Future Dividends: Based on forecasts, dividends might grow at a constant rate after a certain period.
  • Example calculations for dividends leading up to and after the transition can use present value concepts to add future dividends.

Required Return Components

• Total return R from a stock has two components:
  • Dividend Yield: \frac{D1}{P0}
  • Capital Gains Yield: g
• Return formula:
  R = \text{Dividend Yield} + \text{Capital Gains Yield}

Example Calculation

• Given a stock price of 20 and future dividend of 1:
  • If dividend grows by 10 ext{%}:
  • R = \frac{1}{20} + 0.10 = 0.15 ext{ or } 15 ext{%}

Stock Valuation using Multiples

• Many companies do not pay dividends.
• Use the Price to Earnings (PE) ratio:
  • PE = \frac{\text{Price per Share}}{\text{Earnings per Share (EPS)}}
• Non-profitable companies can use Price to Sales (PS) or Price to EBITDA (EV/EBITDA) ratios.

Common Stock Features: Shareholder Rights

• Dividend Priority: Common stock dividends are not guaranteed; shareholders can only receive dividends declared by the board.
• Voting Rights: Shareholders elect directors at annual meeting; can use cumulative or straight voting.
  • Cumulative Voting: Allows all votes to be cast for a single director.
  • Straight Voting: Votes cast individually for each director.
• Proxy Voting: Shareholders can assign their voting rights to another party.

Common Stock Features: Dividends

• Dividends: Payments made to shareholders, subject to discretion of board.
  • Not considered a corporate liability until declared.
  • Tax implications exist for shareholders; dividends taxed at a rate of 15-20% (2020).

Preferred Stock Features

• Dividend Priority: Preferred stock has fixed dividends and ranks higher than common stock in liquidation.
  • May be cumulative or noncumulative.
• Features: Convertible into common stock, callable, and may have sinking funds.

Stock Market Structure

• Primary and Secondary Markets: Transactions generally facilitated by brokers and dealers.
• Market Makers: Handle orders and maintain liquidity.
• Trading Platforms: Difference between NYSE (physical and electronic) and Nasdaq (entirely electronic with multiple market makers).

Conclusion

• Understanding stock valuation, the role of dividends, the importance of growth rates, and market structure is essential for effective investment strategies. Now, review and consolidate specific formulas and examples for in-depth preparation for the exam.