Lecture 5: Stock Market and Stock Valuation

GBUS 718A: Managerial Finance

Prof. Emmanuel N. Gyam…

GIMPA Business School

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Learning Objectives

At the end of this session, you should be able to:

Di¤erentiate between debt and equity.

Discuss the features of both common and preferred stock.

Explain the concept of market e¢ ciency and basic stock valuation

using zero-growth, constant-growth, and variable growth models.

Discuss the free cash ‡ow valuation model and liquidation value, and
price/earnings (P/E) multiple approaches.

Explain the relationships among …nancial decisions, return, risk, and

the …rm’s value

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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”

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Bonds and Stocks: Di¤erences

From the …rm’s perspective: a bond is a long-term debt and stock is

equity

From the …rm’s perspective: a bond gets paid o¤ at the maturity

date; stock continues inde…nitely.

We will discuss the mix of bonds (debt) and stock (equity) in a future
lecture entitled capital structure

A bond has coupon payments and a lump-sum payment; stock has

dividend payments forever

Coupon payments are …xed; stock dividends change or “grow” over

time

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Di¤erences between Deb and Equity

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Features of Common Stock

Voting Rights

Proxy voting

Classes of stock

Other Rights
Share proportionally in declared dividends
Share proportionally in remaining assets during liquidation
Preemptive right
…rst shot at new stock issue to maintain proportional ownership if
desired

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Dividend Characteristics

Dividends are not a liability of the …rm until a dividend has been
declared by the Board

Consequently, a …rm cannot go bankrupt for not declaring dividends

Dividends and Taxes

Dividend payments are not considered a business expense; therefore,

they are not tax deductible

The taxation of dividends received by individuals depends on the

holding period

Dividends received by corporations have a minimum 70% exclusion

from taxable income
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Features of Preferred Stock

Dividends

Stated dividend that must be paid before dividends can be paid to

common stockholders

Dividends are not a liability of the …rm, and preferred dividends can be
deferred inde…nitely

Most preferred dividends are cumulative

any missed preferred dividends have to be paid before common
dividends can be paid

Preferred stock generally does not carry voting rights

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Common and Preferred Stock Di¤erences

Both common and preferred stock are forms of equity capital.

However, preferred stock has some features that di¤erentiates it from

common stock.

Preferred stockholders are promised a …xed periodic dividend.

Preferred stockholders are not normally given a voting right

Preferred stockholders are also given preference over common

stockholders in the liquidation of assets in a legally bankrupt …rm

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Stock Market, Dealers vs. Brokers

Dealer

trades with inventory for bid and ask prices

Broker

matches buyers and sellers for a fee

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Stock Market

New York Stock Exchange (NYSE)

Largest stock market in the world

License holders (1,366)

Commission brokers
Specialists
Floor brokers
Floor traders

Operations

Floor activity

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NASDAQ
Not a physical exchange
it is a computer-based quotation system
Multiple market makers
Electronic Communications Networks

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NASDAQ

Three levels of information:

Level 1
median quotes, registered representatives

Level 2
view quotes, brokers & dealers

Level 3
view and update quotes, dealers only

A large portion of technology stocks are bought and sold each day on
NASDAQ

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Listing and raising capital -IPO

O¤er for sale

Shares are o¤ered at a …xed price

Institutional and individual shareholders are invited to subscribe

Sponsor underwrites the share issue

O¤er for sale by tender

Investors specify the price they are willing to pay

Sponsor determines strike price

Those who o¤ered above the strike price get to buy at the strike price

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Listing and raising capital -IPO

O¤er for subscription

Partially underwritten

Share issue can be aborted if not enough money is raised

Placing

Shares are placed with clients of the issuing house

Becoming more popular as cheaper

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Valuation of Bonds

A visual representation of a bond with a coupon payment (C) and a

maturity value (M)

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Valuation of Bonds

A visual representation of a share of common stock with dividends

(D) forever

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Comparison Valuations

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Comparison Valuations...con’t
Notice these di¤erences:
The “C’s” are constant and equal
The bond ends (year 5 here)
There is a lump sum at the end

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Comparison Valuations...con’t

Notice these di¤erences:

The dividends are di¤erent
The stock never ends
There is no lump sum

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Cash Flows for Stockholders

If you buy a share of stock, you can receive cash in two ways:

1 The company pays dividends

2 You sell your shares, either to another investor in the market or back
to the company

Like bonds, shares are valued by bringing all the future cash‡ows
and/or share price to the present.

Thus, the sum of the PV of the dividends and/or share price

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Valuation of Stocks - One-Period Example

Problem
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?

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Compute the Present Value

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Valuation of Stocks - Two-Period Example

Problem
Now, what if you decide to hold the stock for two years? In addition
to the dividend in one 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?

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Compute the Present Value

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Break (15 mins)

BREAK TIME

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Future Dividends

So the key is to determine the future dividends when given the growth
rate of those dividends, whether the growth is zero, constant, or
unusual …rst and then levels o¤ to a constant growth rate.

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 o¤ to a
constant growth rate

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1. Constant Dividend – Zero Growth

The …rm will pay a constant dividend forever

This is like preferred stock

The price is computed using the perpetuity formula:

D
P0 =
r

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Constant Dividend – Zero Growth Example

Problem
What is the value of the common stock of WZ Ltd if it pays a dividend of
c/0.4 per share? The dividend is expected to stay ‡at for the foreseeable
future and the required return on the company’s common stock is 14%.

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Constant Dividend – Zero Growth Example

Solution
D
P0 =
r

0.4
P0 =
0.14

P0 = 2.86

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2. Constant Growth Rate of Dividends

Dividends are expected to grow at a constant percent per period.

D0 (1 + g ) D0 (1 + g )2 D0 (1 + g )3
P0 = + + ...
(1 + r ) (1 + r )2 (1 + r )3

With a little algebra this reduces to:

D0 ( 1 + g ) D1
P0 = =
r g r g

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Dividend Growth Model (DGM) Assumptions

To use the Dividend Growth Model (aka the Gordon Model), you must
meet all three requirements:

The growth of all future dividends must be constant,

The growth rate must be smaller than the discount rate (g < r ), and

The growth rate must not be equal to the discount rate (g 6= r )

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DGM – Example 1

Problem
Suppose Big D, Inc., just paid a dividend (D0 ) of $0.50 per share. It is
expected to increase its dividend by 2% per year. If the market requires a
return of 15% on assets of this risk, how much should the stock be selling
for?

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DGM – Example 1 Solution

Solution
D0 ( 1 + g ) D1
P0 = =
r g r g

0.50(1 + 0.02)
P0 =
0.15 0.02
0.51
P0 =
0.13

P0 = 3.92

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DGM – Example 2

Problem
Suppose Moore Oil Inc., is expected to pay a $2 dividend in one year. If
the dividend is expected to grow at 5% per year and the required return is
20%, what is the price?

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DGM – Example 2 Solution
Solution
D0 ( 1 + g ) D1
P0 = =
r g r g

2.00
P0 =
0.20 0.05

2.00
P0 =
0.15

P0 = 13.34
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3. Unusual Growth; Then Constant Growth

Just draw the time line with the unusual growth rates identi…ed and
determine if/when you can use the Dividend Growth Model.

Deal with the unusual growth dividends separately.

Problem
Suppose a …rm is expected to increase dividends by 20% in one year and
by 15% for two years. After that, dividends will increase at a rate of 5%
per year inde…nitely. If the last dividend was $1 and the required return is
20%, what is the price of the stock?

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Non-constant Growth Problem Statement

Draw the time line and compute each dividend using the
corresponding growth rate:

D1 = ($1.00) (1 + 20%) = $1.00 1.20 = $1.20

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Non-constant Growth Problem Statement

D2 = ($1.20) (1 + 15%) =$1.20 1.15 =$1.38

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Non-constant Growth Problem Statement

D3 = ($1.38) (1 + 15%) =$1.38 1.15 =$1.59

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Non-constant Growth Problem Statement
Now we can use the DGM starting with the period of the constant
growth rate at our time frame of year 3:

D4 D3 ( 1 + g ) 1.59(1 + 0.05)
P3 = P3 = = = 11.13
r g r g 0.20 0.05
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Non-constant Growth Problem Statement

We now have all of the dividends accounted for and we can compute
the present value for a share of common stock:

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Non-constant Growth Problem Statement

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Stock Price Sensitivity to Dividend Growth, g

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Stock Price Sensitivity to Required Return, r

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Using the DGM to Find r

Start with the DGM and then algebraically rearrange the equation to solve
for r:
D0 ( 1 + g ) D1
P0 = =
r g r g

D0 ( 1 + g )
r = +g
P0
D1
r = +g
P0

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Finding the Required Return - Example

Problem
Suppose a …rm’s stock is selling for $10.50. It just paid a $1 dividend, and
dividends are expected to grow at 5% per year.

a) What is the required return?

b) What is the dividend yield?

c) What is the capital gains yield?

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Finding the Required Return - Example

Solution
a) required return

D0 ( 1 + g ) 1(1 + 0.05)
r= +g = + 0.05 = 15%
P0 10.50
b) dividend yield

D0 ( 1 + g ) 1(1 + 0.05)
= = 10%
P0 10.50
a) capital gains yield
g = 5%

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Stock Valuation Alternative

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Valuation Using Multiples

We can use the PE ratio and/or the price-sales ratio:

Pt = Benchmark PE ratio EPSt

Pt = Benchmark price-sales ratio sales per sharet

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End...Question time

QUESTION TIME

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