LN10Titman 449327 12 LN10

Chapter 10
Stock
Valuation
Slide Contents
Learning Objectives
Principles Applied in This Chapter
1. Common Stock
2. The Comparables Approach to Valuing Common
Stock
3. Preferred Stock
4. The Stock Market
Key Terms
Copyright 2014 Pearson Education, Inc. All rights reserved.
10-2
Learning Objectives
1. Identify the basic characteristics and features
of common stock and use the discounted cash
flow model to value common shares.
2. Use the price-to-earnings (P/E) ratio to value
common stock.
3. Identify the basic characteristics and features
of preferred stock and value preferred shares.
4. Use the secondary markets for common stock.
10-3
Principles Applied in This Chapter

Principle 1: Money Has a Time Value.
Principle 2: There is a Risk-Reward Tradeoff.
Principle 3: Cash Flows are the Source of
Value.
Principle 4: Market Prices Reflect
Information.
Principle 5: Individuals Respond to
Incentives.
10-4
10.1 COMMON STOCK
10-5
Common Stock
Common stockholders are the owners of the
firm. They elect the firms board of directors
who in turn appoint the firms top
management team. The firms management
team then carries out the day-to-day
management of the firm.
10-6
Common Stock Characteristics

Claim on Income Common stockholders have
the right to the firms income after
bondholders and preferred stockholders have
been paid. The common stockholders either
receive dividends or any increase in value that
results from the reinvested earnings.
10-7

(cont.)
Claim on Assets In case of liquidation,
common stockholders have residual claim
on assets.
Voting Rights In general, common
shareholders are the only security holders
given the right to vote. Most shareholders
vote by proxy.
10-8

(cont.)
Agency Costs and Common Stock
Shareholders elect the board. In reality,
board members are nominated by the
management. As a result, management
effectively elects the board. This may
lead to agency problems.
10-9
Valuing Common Stock Using the

Discounted Dividend Model
Like bonds, common stocks value is equal to
the present value of all future cash flows that
the stockholder expects to receive from
owning the shares of stock. However, unlike
bonds, the future cash flows in the form of
dividends are not fixed and there is no
maturity date.
10-10
Three Step Procedure for Valuing

Common Stock
Step 1: Estimate the amount and timing of the
receipt of the future cash flows the common
stock is expected to provide.
Step 2: Evaluate the riskiness of the common

stocks future dividends to determine the
stocks required rate of return.
10-11
Three Step Procedure for Valuing

Common Stock (cont.)
Step 3: Calculate the present value of the
expected dividends by discounting them back
to the present at the stocks required rate of
return.
The three steps show that the value of a
common stock is equal to the present value of
all future dividends.
10-12
The Constant Dividend Growth Rate

Model
If a firms cash dividend grow by a constant
rate, then the common stock can be valued as
follows:
10-13
CHECKPOINT 10.1:
CHECK YOURSELF
Valuing Common Stock
10-14
The Problem
What is the value of a share of common stock
that paid $6 dividend at the end of last year
and is expected to pay a cash dividend every
year from now to infinity, with that dividend
growing at a rate of 5 percent per year, if the
investors required rate of return is 12% on
that stock?
10-15
Step 1: Picture the Problem

With a perpetuity, a timeline goes on for
ever with the growing cash flow occurring
every period.
i=12%
Years
Cash flows
$6
$6(1.05)
Value of common
stock = Present
Value of Expected
Dividends.
$6(1.05)2
The growing
dividends go on
forever
10-16
Step 2: Decide on a Solution

Strategy
The value of a share of stock can be viewed
as a the present value of a growing
perpetuity.
Here we know the expected dividends, the
growth rate, and investors required rate of
return.
We can use equation 10-2 to determine the
value of a share of common stock.
10-17
Step 3: Solve
We need to first determine D1, the dividend
next period.
Since dividends at the end of last year was
$6 and dividends are expected to grow at a
rate of 5%, dividends for next period will
be:
D1 = D0 (1+g) = $6 (1.05) = $6.30
10-18
Step 3: Solve (cont.)
Vcs = $6.30 (0.12-0.05) =
$6.30 0.07
= $90
10-19
Step 4: Analyze
Equation 10-2 is based on the assumption
that dividends will grow at a constant rate for
ever. While not a realistic assumption, it
enables us to determine the value of common
stock easily and also helps us to identify the
factors that move the stock prices.
10-20
What Causes Stock Prices to Go Up

and Down?
Equation 10-2 indicates that there are three
variables that drive share value:
The most recent dividend (D0),
Investors required rate of return (rcs ), and
Expected rate of growth in future dividends (g).
10-21
What Causes Stock Prices to Go Up

and Down? (cont.)
Since most recent dividend (D0) has already
been paid, it cannot affect price. Thus the
other two variables, rcs and g, can vary and
lead to changes in stock prices.
10-22
Determinants of the Investors

Required Rate of Return
The investors required rate of return is
determined by two key factors:
1.The level of interest rates in the economy;
2.The risk of the firms stock.
10-23
Determinants of the Investors

Required Rate of Return (cont.)
CAPM suggests that if risk-free rate and/or
systematic risk (beta) rises, the investors
required rate of return will rise and the stock
price will fall.
10-24
Determinants of the Growth Rate of

Future Dividends
The growth rate of future dividends (g) can
also change and lead to a change in the stock
price. The two key determinants of a firms
growth opportunities relate to:
the return on equity (ROE), and
the retention ratio (b)
10-25
Determinants of Growth Rate of

Future Dividends (cont.)
The growth rate is formally expressed as
follows:
g = the expected rate of growth of dividends

D1/E1 = the dividend payout ratio
b = the proportion of firms earnings that are
retained and reinvested in the firm.
ROE = the return on equity earned when the firm
reinvests a portion of its earning back into the firm.
10-26
10.2 THE COMPARABLES

APPROACH TO VALUING
COMMON STOCK
10-27
The Comparables Approach to

This method estimates the value of the firms
stock as a multiple of some measure of firms
performance. The most common metric is
earnings per share. Thus values are
determined from the price-to-earnings ratio
of comparable firms.
10-28
Defining the P/E Ratio Valuation

Model
Vcs = the value of common stock of the

firm.
P/E1 = the price earnings ratio for the firm
based on the current price per share divided
by earnings for end of year 1.
E1 = estimated earnings per share of
common stock for the end of year 1.
10-29
CHECKPOINT 10.2:
CHECK YOURSELF
Using the P/E Ratio
10-30
The Problem
After some careful analysis and reflection on
the valuation of the Heals shares the
company CFO suggested that the earnings
projection are too conservative and earnings
for the coming year could easily jump to
$2.00. What does this do for your estimate of
the value of Heals shares?
10-31
EPS
= $2.00
P/E
Multiple
Stock Price
10-32

Strategy
The common stock value can be computed
by multiplying the firms estimated earnings
per share for the coming year by what the
analyst estimates to be an appropriate P/E
ratio.
We can use equation 10-4 to estimate the
value of common stock.
10-33
Step 3: Solve
Vcs
= 18.20 $2
= $36.40
10-34
Step 4: Analyze
We estimated the value of Heales shares
based on the P/E ratios of three comparable
firms. However, this estimate is contingent
on the appropriateness of the comparable
set of companies to the Heals Shoe
Company.
Furthermore, if the market conditions
change by the time the shares are sold in
the market, the price estimate will not be
appropriate.
10-35
What Determines the P/E Ratio for a

Stock?
Using Equation 10-5a and 10-5b, there are
two fundamental determinants of a firms P/E
ratio:
1. Growth Rate in Dividends (higher the
growth rate, higher the P/E ratio), and
2. Investor-Required Rates of Return
(higher the required rate, lower the P/E
ratio)
10-36
10.3 PREFERRED STOCK
10-37
Features of Preferred Stock

Dividend: In general, size of preferred
stock dividend is fixed, and it is either
stated as a dollar amount or as a
percentage of the preferred stocks par
value.
Multiple Classes: A company can issue
more than one class of preferred stock, and
each class can have different characteristics.
10-38
Features of Preferred Stock (cont.)

Claims on Assets and Income: Preferred
stockholders have priority over those of
common stockholders for payment of
dividends and in settlement of claims at
bankruptcy. Most preferred stock carry a
cumulative feature i.e. all past unpaid
dividends must be paid before any common
stock dividends can be declared.
10-39
Features of Preferred Stock (cont.)

Preferred Stock as a Hybrid Security:
Like common stocks, preferred stocks do not
have a fixed maturity date. Also, like common
stocks, nonpayment of dividends does not bring
on bankruptcy, and dividends are not deductible
for tax purposes.
Like debt, preferred stocks have a fixed dividend.
Also, most preferred stocks are periodically
retired even though there is no stated maturity
date.
10-40
Valuing Preferred Stock

Because preferred stocks are perpetuities
(non-maturing), and because the cash
dividend is the same every period, they can
be valued using the present value of
perpetuity equation introduced in chapter 6
(equation 6-5).
10-41
Valuing Preferred Stock (cont.)
Vps = the value of a share of preferred stock

Dps = the annual preferred stock dividend
rps = the market yield or the rate of return
on the preferred stocks promised dividend
10-42
Estimating the Markets Required

Yield
Estimating the Market Yield: We can use
equation 10-6 to solve for the markets
required yield.
rps
Dps Vps
10-43
CHECKPOINT 10.3:
CHECK YOURSELF
Valuing Preferred Stock
What is the present value of a share of
preferred stock that pays a dividend of
$12 per share if the markets yield on
similar issues of preferred stock is 8%?
10-44

Preferred stocks are constant for all years
and form a level perpetuity.
rps=8%
Years
Dividends
Value of Preferred
Stock = Present
Value of promised
dividends.
2
$12
3
$12
$12
$12
The annual
$12 dividends
go on
forever.
10-45

Strategy
Step 3: Solve
We can determine the present value of share
of preferred stock using equation 10-6.
Vps
= $12 0.08 = $150
10-46
Step 4: Analyze
Since preferred stock is a level perpetuity, its
value on any future date will be the same as
its present value today as long as the
promised rate of return on the share remains
the same.
10-47
10.4 THE STOCK MARKET
10-48
The Stock Market

As discussed in chapter 2, new securities
trade in the primary market while currently
outstanding securities trade in the secondary
market. There are two types of secondary
markets: organized exchanges and over-thecounter markets.
10-49
Organized Exchanges
The New York Stock Exchange (NYSE),
also called the Big Board, is the oldest of all
organized exchanges. While the NYSE is
considered an organized exchange because of
its physical location, the majority of its trades
are done electronically without a face-to-face
meeting of traders.
10-50
Organized Exchanges (cont.)

To be listed on the NYSE, a firm must meet
strict requirements dealing with profitability
and market value, and be widely owned.
Much of the trading on the NYSE is made up
of block trades i.e. transactions involving
10,000 shares or more by a single individual
or institution.
10-51
Organized Exchanges (cont.)

The American Stock Exchange (AMEX) is
the nations second largest, floor-based
exchange. However, in terms of trading
volume, the AMEX is a distant number two
with less than 3% of that on the NYSE.
Although AMEX merged with NASDAQ in
1998 it continues to operate as a separate
entity.
10-52
Over-the-Counter (OTC) Market

The over-the-counter market is a network
of dealers that has no listing or membership
requirements. Today, the OTC market is
electronic rather than personal, with Nasdaq
leading the way. It is also the primary market
for bonds.
10-53

(cont.)
Nasdaq debuted in 1971 and was the
worlds first electronic stock market. While
Nasdaq lists more companies than the
NYSE, they are relatively smaller companies
(with a few exceptions)
There are about 1,000 market participants,
in general trading firms that are linked
electronically, with price and trading
information broadcast to over 350,000
terminals worldwide.
10-54

(cont.)
The Nasdaq stock market has two tiers of
listed companies:
Nasdaq National Markets, made up of around
4,000 companies like Dell (D), Intel (INTC); and
Nasdaq Smallcap Market, which includes over
1,000 smaller emerging growth companies.
10-55
Key Terms
American Stock Exchange

Block holding
Block trade
Constant dividend growth rate model
Cumulative preferred stock
Cumulative voting
Initial public offering
10-56
Key Terms (cont.)
Majority voting
Markets required yield
Nasdaq
New York Stock Exchange (NYSE)
Over-the-counter (OTC) market
Price-earnings ratio
Proxy
10-57

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Chapter 10

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Principles Applied in This Chapter

Copyright 2014 Pearson Education, Inc. All rights reserved.

10.1 COMMON STOCK

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Common Stock Characteristics

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Common Stock Characteristics

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Common Stock Characteristics

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Valuing Common Stock Using the

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Three Step Procedure for Valuing

Step 2: Evaluate the riskiness of the common

Copyright 2014 Pearson Education, Inc. All rights reserved.

Three Step Procedure for Valuing

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Constant Dividend Growth Rate

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Picture the Problem

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Step 2: Decide on a Solution

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Solve (cont.)

Vcs = $6.30 (0.12-0.05) =

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Copyright 2014 Pearson Education, Inc. All rights reserved.

What Causes Stock Prices to Go Up

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What Causes Stock Prices to Go Up

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Determinants of the Investors

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Determinants of the Investors

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Determinants of the Growth Rate of

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Determinants of Growth Rate of

g = the expected rate of growth of dividends

10.2 THE COMPARABLES

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The Comparables Approach to

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Defining the P/E Ratio Valuation

Vcs = the value of common stock of the

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Picture the Problem

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Step 2: Decide on a Solution

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Copyright 2014 Pearson Education, Inc. All rights reserved.

What Determines the P/E Ratio for a

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10.3 PREFERRED STOCK