Ch. 7

Chapter 7: Equity Markets and Stock Valuation

Key Concepts and Skills

• Stock Prices and Dividends: Understand how stock prices depend on future dividends and their growth.

• Corporate Directors' Elections: Identify different methods of electing corporate directors.

• Stock Market Functionality: Explain the workings of stock markets.

Chapter Outline

7.1: Common Stock Valuation

7.2: Some Features of Common and Preferred Stock

7.3: The Stock Markets

Cash Flows for Stockholders

• Shareholders receive cash in two primary ways:
    - Dividends: Payments made by the company to its shareholders.
    - Selling Shares: Proceeds from selling shares either to another investor or back to the company.

• The price of the stock is determined as the present value of the expected cash flows:
    - Dividends represent cash income.
    - When shares are sold, any profit made is considered a capital gain.

One-Period Example

Moore Oil, Incorporated

• Dividend Expectation: $2 in one year.

• Selling Price Expectation: $14 at that time.

• Required Rate of Return: 20% on this risk level.

• Calculation: Maximum price willing to pay determined via present value calculation of expected cash flows.

One-Period Calculations

• Expected Cash Flows:
    - Dividend (D) = $2
    - Selling Price (P) = $14
    - Required Return (R) = 20%

• Present Value (PV) calculation approach processes expected cash flows to derive stock price.

Two-Period Example

• Holding the stock for two years will add another layer of cash flow assessment. Calculations will adjust for the time value of money for dividends received in year two and expected price at sale.

Three-Period Example

• Extends previous calculations for three years, incorporating projected dividends and sales price.

Cash Flow Worksheet Example (Using TI BA 2+)

1. Cash Flows Setup:
      - CF0 = 0
      - CF1 = 2.00
      - CF2 = 2.10
      - CF3 = 17.64

2. NPV Calculation Process:
      - Enter cash flows into the calculator:
        - CF C00 0 (Enter)
        - CF C01 2 (Enter)
        - etc.
      - After NPV calculation with I = 20, resulting NPV = $13.33.

Basic Stock Valuation Model

• The fundamental stock value is derived from the present value of all expected future dividends expressed mathematically as:
  $ext{Stock Value} = rac{D_1}{(1 + R)} + rac{D_2}{(1 + R)^2} + rac{D_3}{(1 + R)^3} + ext{…}$

• General Formula:
  $P_0 = rac{D_0(1 + g)}{(1 + R)} + rac{D_0(1 + g)^2}{(1 + R)^2} + rac{D_0(1 + g)^3}{(1 + R)^3} + ext{…}$

Estimating Dividends

Special Cases Include:

1. Constant Dividend/Zero Growth:
      - Firm pays a constant dividend indefinitely, similar to preferred stock.
      - Valuation uses the perpetuity formula.

2. Constant Dividend Growth:
      - Firm increases dividend by a constant percent each period.

3. Supernormal Growth:
      - Inconsistent growth followed by stabilization at a constant growth rate.

Zero Growth Example

• Example: A stock paying a dividend of $0.50 quarterly with required return = 10%.

• Calculation: Using perpetuity formula for valuation.

Constant Growth Stock

• Defined as one where dividends are expected to grow indefinitely at a constant rate, denoted as g.

• Formulaic representation and practical usage illustrated.

Dividend Growth Model (DGM)

• Establishes valuation through the projection of dividends:
  $P_0 = rac{D_1}{(1 + R)} + rac{D_2}{(1 + R)^2} + ext{…}$

• Mathematical reduction shows:
  $P_0 = rac{D_0(1 + g)}{(R - g)}$

DGM Example: Big D, Incorporated

• Just paid a dividend of $0.50 and expects a growth of 2%.

• Market required return is 15%.

Nonconstant Growth Example

• Illustrates a stock with variable growth rates for dividends:
    - Year 1: 20% increase,
    - Year 2: 15% increase,
    - Following years: 5% growth indefinitely.

• Valuation requires present value calculations of expected dividends and final price during the constant growth phase.

Valuation Using Multiples

• Applied to stocks without dividends or irregular dividends:
    - Price-Earnings (PE) Ratio
    - Price-Sales Ratio: Especially useful for negative earnings scenarios.

• Example of Inactivision Valuation:
     - PE of 20 with earnings of $2.50 leads to a forecast stock price of:
     $ext{Target Price} = 20 imes 2.50 = 50$

Dividend Characteristics

• Liability Status: Dividends are not a liability until declared; firms cannot declare bankruptcy for not issuing dividends.

• Tax Implications:
    - Dividend payments are not tax-deductible as firm expenses.
    - Taxed as ordinary income for individuals with certain exclusions for corporate holders.

Quick Quiz: Part 1

• Explore scenarios and calculations related to required returns based on stock price and dividends.

Quick Quiz: Part 2

• Identify key characteristics of common vs. preferred stock and solve valuation problems based on expected dividend growth rates.