Topic 4: Stock Valuation

Stocks defined The importance of stock valuation Valuation Methods

Stock Defined
Stock / securities / shares generally carries the same meaning. In certain cases it may differs due to it type and nature and purpose of issuances.

Stock Defined Main category of stock

STOCK

Common Stock

Preferred Stock

Common Stock

Common stock is a certificate that indicates ownership in a corporation. When you buy a share, you buy a part/share of the company and attain ownership rights in proportion to your share of the company. Common stockholders are the true owners of the firm. Bondholders and preferred stock holders can be viewed as creditors.

Stock Defined Common stock

Initial financing for most companies typically comes from the founders in the form of a common stock.

Common stock is a certificate indicates ownership in a company. When you buy a share, you buy a part/share of the company and attain ownership rights in proportion to your share of the company.
Common stockholders are the true owners of the firm.

Stock Defined Common stock

Paid-up capital : represent the (no of units stock) X (par value common stock) which the owner of the company invested in the company. Par value

Par value or the initial price per unit of stock the shareholder of the company paid to each unit of stock (e.g; RM 1.00, 50 cent, 20 cent, 10 cent or any amount decided by the owner of the company)

 Illustration
Company A : issue 1,000,000 units of common stock at par value @50 cent Shareholder 1: Mr. A bought (invest) 600,000 units and fully paid. Shareholder 2: Mr. B bought 400,000 units and fully paid

Mr. A
600,000 units

Mr. B
400,000 units

ABC Sdn Bhd 1 mil units@50sen

Paid up capital: 1 mil units X 50 sen = RM 500K
Share holding [ Mr. A= 60% Mr. B=40%

Balance Sheet :

Share Capital account

Common Stock: in-brief

Status: Owners Life: No maturity date Rights to votes and assets: In proportion to number of shares held Liability: Limited to amount of investment Source of Return: Dividends (if paid) and Capital gain (if sold at a higher price) Dividends: Neither fixed nor guaranteed. Seniority: In the event of bankruptcy, common stockholders will not receive any payment until all the creditors, including the bondholders and preferred stockholders, have been satisfied.

Features of Common Stocks

Claim on income Claim on assets Voting rights Preemptive rights

Claim on Income

Common shareholders have the right to residual income after bondholders and preferred stockholders have been paid. Residual income can be paid in the form of dividends or retained within the firm and reinvested in the business. Claim on residual income implies there is no upper limit on income, but it also means that on the downside, shareholders are not guaranteed anything and may have to settle for zero income in some years.

Claim on Assets

Common stock has a residual claim on assets in the case of liquidation.

Residual claim implies that the claims of debt holders and preferred stockholders have to be met prior to common stockholders.

Generally, if bankruptcy occurs, claims of the common shareholders are typically not satisfied.

Voting Rights

Most often, common stockholders are the only security holders with a vote.

Majority of shareholders generally vote by proxy. Proxy fights are battles between rival groups for proxy votes.

Common shareholders are entitled to:

elect the board of directors approve any change in the corporate charter

Voting Rights

Voting for directors and charter changes occur at the corporations annual meeting. With majority voting each share of stock allows the shareholder one vote. Each position on the board is voted on separately. With cumulative voting each share of stock allows the stockholder a number of votes equal to the number of directors being elected.

Voting for Board of Directors

In the real world, shareholders do not really pick the board rather they simply select from a list of nominees chosen by the management. This opens the door for management favored boards, which may not be in the best interest of shareholders.

Preemptive Rights

Preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the firm. Thus, if a shareholder currently owns 5% of the shares, she/he has the right to purchase 5% of the shares when new shares are issued. These rights are issued in the form of certificates that give shareholders the option to buy new shares at a specific price during a 2- to 10- week period. These rights can be exercised, sold in the open market, or allowed to expire.

 Preferred stock is often referred to as a hybrid security because it has many characteristics of both common stock and bonds A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders. The shares usually do not have voting rights

Hybrid nature of Preferred stocks

Like common stocks, preferred stocks

Have no fixed maturity date Failure to pay dividends does not lead to bankruptcy Dividends are not a tax-deductible expense

Like Bonds

Dividends are fixed in amount (either as a RM amount or as a % of par value)

The followings are the characteristics of preferred stock:

Multiple Series

If a company desires, it can issue more than one series of preferred stock, and each series can have different characteristics (such as different protective provisions and convertibility rights).

Claim on Assets and Income

Claim on Assets: Preferred stock has priority over common stock with regard to claim on assets in the case of bankruptcy.

Preferred stockholders claims are honored before common stockholders, but after bonds.

Claim on Income: Preferred stock also has priority over common stock with regard to dividend payments.

Thus preferred stocks are safer than common stock but riskier than bonds.

Cumulative Dividends

Cumulative feature (if it exists) requires that all past, unpaid preferred stock dividends be paid before any common stock dividends are declared.

Protective Provisions

Protective provisions generally allow for voting rights in the event of nonpayment of dividends, or they restrict the payment of common stock dividends if sinking-funds payments are not met or if the firm is in financial difficulty.

Convertibility

Convertible preferred stock can, at the discretion of the holder, be converted into a predetermined number of shares of common stock. Almost one-third of preferred stock issued today is convertible preferred.

Common Stock Second right claim on assets and dividends after preferred stock Entitle for voting right Can not be converted to preferred stock Commonly representing the majority of paid up capital in company

Preferred Stock First right claim on assets and dividends No voting right Can be issued in series for different purpose Can be convertible to common stock Only small % of company of total paid up capital

Purpose of valuation Investing in capital market: to estimate the price per units of company listed on the stock market As a basis to value the business or company for take over of merger As a basis for selling or buying company / business

Purpose of valuation For initial public offering (IPO) For purpose of seeking funding Other investment and business purposes

Preferred Stock: The economic or intrinsic

value of a preferred stock is equal to the

Example: Assume ABC Co.s preferred stock pays an annual dividend of $3.75 and the investors required rate of return is 6%.

Preferred Stock:
Example: ABC Co.s preferred stock pays an annual dividend of $3.75 and the investors required rate of return is 6%.

Valuing Common Stock

Like bonds and preferred stock, the value of common stock is equal to the present value of all future expected cash flows (i.e. dividends in this case). However, dividends are neither fixed nor guaranteed, which makes it harder to value common stocks compared to bonds and preferred stocks.

Dividend Model

Unlike preferred stock, common stock dividend is not fixed. Dividend pattern varies among firms, but dividends generally tend to increase with the growth in corporate earnings.

How can a company grow?

Through Infusion of capital by borrowing or issuing new common stock. Through Internal growth. Management retains some or all of the firms profits for reinvestment in the firm, resulting in future earnings growth and value of stock. Internal growth directly affects the existing stockholders and is the only growth factor used for valuation purposes.

Internal Growth
g = ROE pr
where: g = the growth rate of future earnings and the growth in the common stockholders investment in the firm ROE = the return on equity (net income/common book value) pr = % of profits retained (profit retention rate)

Dividend Valuation Model (growth model)

Value of Common stock = PV of future dividends Vcs = D1/(rcs g)

Vcs Common stock value D1 = dividend in year 1 rcs = required rate of return g = growth rate

Example: Dividend valuation model (growth model)

Consider the valuation of a common stock that paid RM1.00 dividend at the end of the last year and is expected to pay a cash dividend in the future. Dividends are expected to grow at 10% and the investors required rate of return is 17%.

Example: Dividend valuation model

1. The dividend last year was RM1. Compute the new dividend (D1 ) by: D1 = D0(1 + g) = RM1(1 +0.10) = RM1.10 2. Vcs = D1/(rcs g) = RM1.10/(0.17 0.10) = RM15.71

Expected Rate of Return of stockholders

The expected rate of return on a security is the required rate of return of investors who are willing to pay the market price for the security. Preferred Stock Expected Return: = Annual dividend/market price Example: If the current market price of preferred stock is RM75, and the stock pays RM5 dividend, the expected rate of return = RM5/RM75 = 6.67%

Expected Rate of Return of stockholders

Common Stock Expected Return = (Dividend in year 1 / market price) + dividend growth rate = Dividend Yield + growth Rate Example: The current market price of stock is RM90 and the stock pays dividend of RM3 with a growth rate of 5%.

Expected Rate of Return of stockholders

Historically, most of the returns on stocks has come from price appreciation or capital gains. The S&P 500 Index has returned an average annual return of 10% since 1926, with dividend yield accounting for only about 2% of the return.

Price versus expected return

Typically, an investor is not concerned with the value of a stock. Rather, investor would like to know the expected rate of return if the stock is bought at its current market price. Given the price and expected rate of return, investor has to decide if the expected return compensates for the risk.

`Basic model
Zero Growth Model
Constant Growth Model
Variable Growth

The value of a share of common stock is equal to the PV of all future cash flows (dividends) that it is expected to provide.

where P0 = value of common stock

Dt = per-share dividend expected at the end of year t Rs = required return on common stock (note: ks ) P0 = value of common stock

The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

where Dt = dividend per share at end of year t rs = required rate of return on common stock P0 = Price or value of stock today.

If g = 0, the dividend stream is a perpetuity, dividend is $2 per annum, r=13%, calculate the Price of stock

0 r=13%

1 r=13% 2.00 g=0

2 r=13% 3 2.00 g=0 2.00

PMT $2.00 P0 = = = $15.38. R 0.13

If dividend = $ 2.40 per share, g=0 r , required of return = 12 % What is the price of the common stock?

2.40 / 0.12 = $20

The constant-growth model is a widely cited dividend valuation approach that assumes that dividends will grow at a constant rate, but a rate that is less than the required return.

The Gordon model is a common name for the constant-growth model that is widely cited in dividend valuation.

 If dividend = $2.40 per share, g=5% annually r , required of return = 12 % What is the price of the common stock?

= 2.40 / (0.12-0.05) = 2.40 /0.07 =$34.28

Variable Growth Model

Step 1. Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 though N. Dt = D0 (1 + g1)t

2012 Pearson Education

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Step 2. Find the present value of the dividends expected during the initial growth period.

Step 3. Find the value of the stock at the end of the initial growth period, PN = (DN+1)/(rs g2), which is the present value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth rate, g2.

Step 4. Add the present value components found in Steps 2 and 3 to find the value of the stock, P0.

 g = the growth rate of future earnings and the growth in the common stockholders investment in the firm

Dividends and Earnings Per Share Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis
Earnings are important to stock price Earnings help determine dividend payouts