Chapter Stock Valuation 8-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • • • • • 8-2 Bond and Stock Differences Common Stock Valuation Features of Common Stock Features of Preferred Stock The Stock Markets Chapter Outline • • • • • 8-3 Bond and Stock Differences Common Stock Valuation Features of Common Stock Features of Preferred Stock The Stock Markets Bonds and Stocks: Similarities • Both provide long-term funding for the organization • Both are future funds that an investor must consider • Both have future periodic payments • Both can be purchased in a marketplace at a price “today” 8-4 Bonds and Stocks: Differences • From the firm’s perspective: a bond is a long-term debt and stock is equity • From the firm’s perspective: a bond gets paid off at the maturity date; stock continues indefinitely • We will discuss the mix of bonds (debt) and stock (equity) in a future chapter entitled capital structure 8-5 Bonds and Stocks: Differences • A bond has coupon payments and a lump-sum payment; stock has dividend payments forever • Coupon payments are fixed; stock dividends change or “grow” over time 8-6 A visual representation of a bond with a coupon payment (C) and a maturity value (M) $C $C $C $C $C $M 8-7 A visual representation of a share of common stock with dividends (D) forever $D 8-8 $D $D $D $D ∞ $D ∞ Comparison Valuations Bond P0 C C C M Common Stock P0 8-9 D1 D2 D3 D ∞ Notice these differences: • • • The “C’s” are constant and equal The bond ends (year here) There is a lump sum at the end $C $C $C $C $C $M 8-10 NASDAQ • Not a physical exchange – it is a computer-based quotation system • Multiple market makers • Electronic Communications Networks 8-71 NASDAQ • • Three levels of information: • Level – median quotes, registered representatives • Level – view quotes, brokers & dealers • Level – view and update quotes, dealers only A large portion of technology stocks are bought and sold each day on NASDAQ 8-72 Work the Web • Electronic Communications Networks provide trading in NASDAQ securities • 8-73 Click on the web surfer and visit Instinet Reading Stock Quotes 8-74 Work the Web • Click on the web surfer to go to Bloomberg for current stock quotes 8-75 Ethics Issues  The status of pension funding (i.e., over- vs under-funded) depends heavily on the choice of a discount rate When actuaries are choosing the appropriate rate, should they give greater priority to future pension recipients, management, or shareholders?  How has the increasing availability and use of the internet impacted the ability of stock traders to act unethically? 8-76 Quick Quiz  What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?  What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15% 8-77 Comprehensive Problem  XYZ stock currently sells for $50 per share The next expected annual dividend is $2, and the growth rate is 6% What is the expected rate of return on this stock?  If the required rate of return on this stock were 12%, what would the stock price be, and what would the dividend yield be? 8-78 Terminology Bonds versus Common Stock Cash Dividends Capital Gain Yield & Dividend Yield Dividend Growth Model (DGM) Preferred Stock Stock Market – NYSE Electronic Exchange – NASDAQ Stock Quotes 8-79 Formulas Value of a Perpetuity: P0 = D R Value of a Share of Common Stock using the DGM: D (1 + g) D1 P0 = = R -g R -g 8-80 D (1 + g) D1 R= +g= +g P0 P0 Formulas Value of a Share of Common Stock using Multiples Pt = Benchmark PE ratio X EPSt Pt = Benchmark price-sales ratio X Sales per sharet 8-81 Key Concepts and Skills • Compute the future dividend stream based on dividend growth • Use the Dividend Growth Model (DGM) to determine the price of stock • • 8-82 Explain how stock markets work Describe the workings of a stock exchange What are the most important topics of this chapter? A stock’s value is the present value of all expected future earnings Computing the future dividends of a stock is the key to understanding its value 8-83 Issuing stock provides the firm long-term funding What are the most important topics of this chapter? The Dividend Growth Model (DGM) provides us help with infinite dividend streams Stocks are bought and sold each business day with reporting via stock quotes 8-84 Questions? 8-85 [...]... Example Receiving one future dividend and one future selling price of a share of common stock 8-18 One-Period Example Suppose you are thinking of purchasing the stock of Moore Oil, Inc You expect it to pay a $2 dividend in one year, and you believe that you can sell the stock for $14 at that time If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay?... Differences Common Stock Valuation Features of Common Stock Features of Preferred Stock The Stock Markets Our Task: To value a share of Common Stock 8-13 And how will we accomplish our task? 8-14 8-15 B Bring A All E Expected F Future E Earnings I Into P Present V Value T Terms Just remember: BAEFEIPVT 8-16 Cash Flows for Stockholders If you buy a share of stock, you can receive cash in two ways: 1... year, you expect a dividend of $2.10 in two years and a stock price of $14.70 at the end of year Now how much would you be willing to pay? 8-24 Visually this would look like: R = 20% 1 D1 = $2 2 D2 = $ 2.10 P2 = $14.70 8-25 Compute the Present Value R = 20% $1.67 1 D1 = $2 2 D2 = $ 2.10 $1.46 $ 10.21 $ 13.34 = P0 8-26 P2 = $14.70 What is the Observed Pattern? We value a share of stock by bring back all... then level off to a constant growth rate 8-32 2 Constant Growth Rate of Dividends Dividends are expected to grow at a constant percent per period 2 3 P0 = D1 /(1+R) + D2 /(1+R) + D3 /(1+R) + … 2 2 P0 = D0(1+g)/(1+R) + D0(1+g) /(1+R) + 8-33 3 3 D0(1+g) /(1+R) + … 2 Constant Growth Rate of Dividends With a little algebra this reduces to: D 0 (1 + g) D1 P0 = = R -g R -g 8-34 2 Constant Growth Rate of Dividends... future dividends when given the growth rate of those dividends, whether the growth is zero, constant, or unusual first and then levels off to a constant growth rate 8-28 So how do you compute the future dividends? Three scenarios: 1 A constant dividend (zero growth) 2 The dividends change by a constant growth rate 3 We have some unusual growth periods and then level off to a constant growth rate 8-29 So... 8-29 So how do you compute the future dividends? Three scenarios: 1 A constant dividend (zero growth) 2 The dividends change by a constant growth rate 3 We have some unusual growth periods and then level off to a constant growth rate 8-30 1 Constant Dividend – Zero Growth • The firm will pay a constant dividend forever • This is like preferred stock • The price is computed using the perpetuity formula:... What happens if g > R? B What happens if g = R? 8-35 Dividend Growth Model (DGM) Assumptions To use the Dividend Growth Model (aka the Gordon Model), you must meet all three requirements: 1 The growth of all future dividends must be constant, 2 The growth rate must be smaller than the discount rate ( g < R), and 3 The growth rate must not be equal to the discount rate ≠ R) 8-36 (g ... Features of Common Stock Features of Preferred Stock The Stock Markets Chapter Outline • • • • • 8-3 Bond and Stock Differences Common Stock Valuation Features of Common Stock Features of Preferred... future dividend and one future selling price of a share of common stock 8-18 One-Period Example Suppose you are thinking of purchasing the stock of Moore Oil, Inc You expect it to pay a $2 dividend... and Stock Differences Common Stock Valuation Features of Common Stock Features of Preferred Stock The Stock Markets Our Task: To value a share of Common Stock 8-13 And how will we accomplish our