Financial Management

Theory and Practice

Tenth Edition

Eugene F. Brigham

Michael C. Ehrhardt

Chapter 10

Stocks and their Valuation

Instructor: Sanam TaimoorInstitute of Business Management

Topics• Advantages and disadvantages of common stock

as a source of fund and investment• Rights and privileges of common stock holders• Types of common stock• Common Stock valuation• Characteristics of preferred stock • Evaluation of preferred stock as an investment

and a source of funds• Understand preferred stock valuation process

Stock Financing: Corporations

• Advantages:– Dividends are not fixed and are not legal

obligations– Permanent capital equity does not have to be

repaid • Disadvantages:– Most expensive form of capital– Dividends are paid out of after-tax earnings– Underwriting fees greater than those of debt– Dilutes ownership and control

Stock Financing: Investors

• Advantages:– Potentially highest return investment for a given

firm– Taxes can be deferred on price appreciation (due

only when the stock is sold) – Investors have input regarding company operation

Stock Financing: Investor

• Disadvantages:– Highest risk investment for a given firm– Dividend payments are not fixed and legal

obligations– Lowest priority of claims in case of bankruptcy– The firm has no obligation to repurchase stock

Characteristics and Legal Rights of Common Stockholders

• Represents ownership.• Ownership implies control.• Stockholders elect directors.• Directors elect management.• Management’s goal: Maximize stock price.

Privileges of Common Stockholders

• Preemptive Right: A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities).

Types of stock market transactions

• Secondary Markets: the market in which “used” stocks are traded after they have been issued by corporations

• Primary Markets: the market in which firms issue new securities to raise corporate capital– A firm “goes public” through an IPO when the

stock is first offered to the public.

Common Stock Valuation

• Valuation Process– Estimate future cash flows (amt./timing).– Assess the riskiness of future cash flows.– Incorporate risk level into the discount rate (adjust

the discount rate).– Find the present value of future cash flows.

• The value of a share of common stock is equal to the PV of all future cash flows that it is expected to provide over the number of years

• What cash flows will a shareholder receive when owning shares of common stock?– Future dividends

Common Stock Valuation

• Basic dividend valuation model accounts for the PV of all future dividends

Dividend Valuation ModelDividend Valuation Model

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Divt = Cash Dividend at time tKe = Investor’s required rate of return

• The dividend valuation model requires the forecast of all future dividends. The following dividend growth rate assumptions simplify the valuation process– Constant Growth– No Growth– Growth Phases

Dividend Growth Pattern AssumptionsDividend Growth Pattern Assumptions

• The constant growth model assumes that dividends will grow forever at the rate g

Constant Growth ModelConstant Growth Model

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D1: Dividend paid at time 1.

g : The constant growth rate.

ke: Investor’s required return.

• Stock CG has an expected growth rate of 8%. Each share of stock just received an annual $3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock?

D1 = $3.24 ( 1 + 0.08 ) = $3.50

VCG = D1 / ( ke - g )

= $3.50 / ( 0.15 - 0.08 ) = $50

Constant Growth ModelConstant Growth Model

• The zero growth model assumes that dividends will grow forever at the rate g = 0.

Zero Growth ModelZero Growth Model

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D1: Dividend paid at time 1.

ke: Investor’s required return.

• Stock ZG has an expected growth rate of 0%. Each share of stock just received an annual $3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock?

D1 = $3.24 ( 1 + 0 ) = $3.24

VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )

= $21.60

Zero Growth ModelZero Growth Model

Growth Phases Model

• The growth phases model assumes that dividends for each share will grow at two or more different growth rates

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• Stock GP has an expected growth rate of 16% for the first 3 years and 8% thereafter. Each share of stock just received an annual $3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock under this scenario?

Growth Phases Model

Stock GP has two phases of growth. The first, 16%, starts at time t=0 for 3 years and is followed by 8% thereafter starting at time t=3. We should view the time line as two separate time lines in

the valuation.

Stock GP has two phases of growth. The first, 16%, starts at time t=0 for 3 years and is followed by 8% thereafter starting at time t=3. We should view the time line as two separate time lines in

the valuation.

0 1 2 3 4 5 6

D1 D2 D3 D4 D5 D6

Growth of 16% for 3 years Growth of 8% to infinity!

Growth Phases Model

• Steps to calculate VGP, we take following steps– Find the annual dividends– Find the PV of the dividends during the period of

non-constant growth– Find the price of the stock at the end of the no-

constant growth period and discount this price back to present

– Add these two components to find the value of stock

Growth Phases Model

• Determine the annual dividends. D0 = $3.24 (this has been paid already)

D1 = D0(1+g1)1 = $3.24(1.16)1 =$3.76

D2 = D0(1+g1)2 = $3.24(1.16)2 =$4.36

D3 = D0(1+g1)3 = $3.24(1.16)3 =$5.06

D4 = D3(1+g2)1 = $5.06(1.08)1 =$5.46

Growth Phases Model

• We determine the PV of cash flows– PV(D1) = D1(PVIF15%, 1) = $3.76 (.870) = $3.27– PV(D2) = D2(PVIF15%, 2) = $4.36 (.756) = $3.30– PV(D3) = D3(PVIF15%, 3) = $5.06 (.658) = $3.33– P3 = $5.46 / (.15 - .08) = $78 [CG Model]– PV(P3) = P3(PVIF15%, 3) = $78 (.658) = $51.32

VGP = $3.27+$3.30+$3.33+$51.32 = $61.22

Growth Phases Model

Determining the Yield on Common Stock

• Assuming the constant growth model, determine the yield on the stock

P0 = D1 / ( ke - g )

Solving for ke such that

ke = ( D1 / P0 ) + g

• Assume that the expected dividend (D1) on each share of common stock is $3. Each share of common stock is currently trading at $30 and has an expected growth rate of 5%. What is the yield on common stock?

ke = ($3/$30) + 5%

ke = 15%

Determining the Yield on Common Stock

Preferred Stock

• Characteristics of preferred stock– Preferred is a hybrid. Preferred dividends are

fixed, but they may be omitted without placing the firm in default

– Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears.

– Preferred dividends are usually cumulative, up to a limit

• Advantages– Fixed financial cost of equity (fixed amount of

shared profits)– Avoid danger of bankruptcy– Limited loss of control

• Disadvantages–Higher after-tax cost than debt

Preferred Stock Financing: Corporations

• Advantages– Steadier more assured income than common

stock– Preference over common in the event of

liquidation– Seventy percent of preferred dividends received

by corporations are not taxable• Disadvantages– Limited sharing of profits – No enforceable right to dividends for individuals

Preferred Stock Financing: Investor

Preferred Stock Valuation• Preferred stock pays fixed dividends at regular

intervals has no stated maturity date similar to a perpetual bond

• Present value of a Preferred stock:-

• Yield on Preferred Stock:-d

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• Stock PS has an 8%, $100 par value issue outstanding. The appropriate discount rate is 10%. What is the value of the preferred stock?

DivP = $100 ( 8% ) = $8.00kP = 10%.VP = DivP / kP

= $8.00 / 10% = $80

Preferred Stock Valuation