Stock Valuation

Stock Valuation Learning Module
•Firms obtain their long-term sources of equity financing by issuing common and preferred stock.
•The payments of the firm to the holders of these securities are in the form of dividends.
•The common stockholders are the owners of the firm and have the right to vote on important matters to the firm, such as the election of the Board of Directors.•Preferred stock, on the other hand, is a hybrid form of financing, sharing some features with debt and some with common equity.
•The value of these securities, as with other assets, is based upon the discounted value of their expected future cash flows. The value of a share of stock is often calculated as the present value of the stream of dividends the stock is expected to provide in the future.
•We will illustrate the valuation of a constant growth stock, i.e.,a stock whose dividends are growing at a rate.
•Preferred stock is a perpetuity and is a little easier to value than common stock.
•Constant Growth Stock Price:
P0= [D0(1+g)]/(r –g) = D1/(r-g)
•You can also solve for the expected return: r = (D1/P0) + g
•Preferred Stock:
P p= D p/ r
•where:
= the stock price at time 0
–P
= the current dividend
–D
= the next dividend (i.e.,at time 1) –D
1
–g = the growth rate of the dividends
–r = the required return on the stock
–Note that g < r.
–P p= the preferred stock price
–D p= the preferred dividend
Constant Growth Stocks
• A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the forseeable future.
•This condition fits some established firms, which tend to grow over the long run at the same rate as the economy.
•There are numerous, more complicated models which we will not discuss in this learning module.
•Find the stock price given that the current dividend is $2 per share, dividends are expected to grow at a rate of 5% in the forseeable future, and the required return is 10%
•Step 1 –Draw Timeline 0Infinity $5g = 5%
r = 10%
•Step 2 –Write equation
P0= D0(1+g)/(r –g) = D1/(r –g)
•Step 3 –Fill in equation
P0= $2 (1 + 5%)/(10% -5%)
•Step 4 –Solve equation
P0= $2.10/5% = $2.10/0.05 = $42
•This means that the value of the stock at time zero is $42 dollars given a required rate of return of 10%, a growth rate of 5% and a dividend at time zero of $2.
Preferred Stock
•Preferred stock is defined as equity with priority over common stock with respect to the payment of dividends and the
distribution of assets in a liquidation.
•Preferred stock has the following features:
–Par Value-The par value represents the claim of the preferred stockholder against the value of the firm.
–Preferred Dividend / Preferred Dividend Rate-The preferred dividend rate is expressed as a percentage of the par value of the preferred stock. The
annual preferred dividend is determined by multiplying the preferred
dividend rate times the par value of the preferred stock.
•Since preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock with a dividend growth rate equal to zero.
An Example
•Find the price of a share of preferred stock given that the par value is $100 per share, the preferred dividend rate is 10%, and the required return is 12%.
• A timeline is not really needed, because the dividends of preferred stock are fixed. However, you can always draw one if it helps.
•Step 2 –Write equation
P p= D p/r
Note: The formula is the same as a constant growth stock with g = 0, so
P0= D1/(r –g) = P p= D p/r when g = 0.
An Example
•Step 3 –Fill In Equation P p= $10/12%
•Step 4 –Solve Equation P p= $83.33。