Stock Valuation: Pricing Stocks Based on Future Dividends and Dividend Growth - Prof. Ahma, Study notes of Business Finance

Download Stock Valuation: Pricing Stocks Based on Future Dividends and Dividend Growth - Prof. Ahma and more Study notes Business Finance in PDF only on Docsity! Chapter 8 Stock Valuation Chapter Outline • Common Stock Valuation • Some Features of Common and Preferred Stocks • The Stock Markets 8-2 One-Period Example • 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? – Compute the PV of the expected cash flows – Price = (14 + 2) / (1.2) = $13.33 – Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33 8-5 Chapter 8 Stock Valuation Chapter Outline • Common Stock Valuation • Some Features of Common and Preferred Stocks • The Stock Markets 8-2 One-Period Example • 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? – Compute the PV of the expected cash flows – Price = (14 + 2) / (1.2) = $13.33 – Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33 8-5 Two-Period Example • 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 2. Now how much would you be willing to pay? – PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33 8-6 Three-Period Example • Finally, what if you decide to hold the stock for three years? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and the stock price is expected to be $15.435. Now how much would you be willing to pay? – PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33 8-7 Zero Growth • If dividends are expected at regular intervals forever, then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formula – P0 = D / R • Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price? – P0 = .50 / (.1 / 4) = $20 8-10 Dividend Growth Model • Dividends are expected to grow at a constant percent per period. – P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + … – P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + … • With a little algebra and some series work, this reduces to: g-R D g-R g)1(D P 100    8-11 DGM – Example 1 • Suppose Big D, Inc., just paid a dividend 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? • P0 = .50(1+.02) / (.15 - .02) = $3.92 8-12 Stock Price Sensitivity to Required Return, R 0 50 100 150 200 250 0 0.05 0.1 0.15 0.2 0.25 0.3 Growth Rate St oc k P ri ce D1 = $2; g = 5% 8-15 Example 8.3 Gordon Growth Company - I • Gordon Growth Company is expected to pay a dividend of $4 next period, and dividends are expected to grow at 6% per year. The required return is 16%. • What is the current price? – P0 = 4 / (.16 - .06) = $40 – Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g 8-16 Example 8.3 – Gordon Growth Company - II • What is the price expected to be in year 4? – P4 = D4(1 + g) / (R – g) = D5 / (R – g) – P4 = 4(1+.06)4 / (.16 - .06) = 50.50 • What is the implied return given the change in price during the four year period? – 50.50 = 40(1+return)4; return = 6% – PV = -40; FV = 50.50; N = 4; CPT I/Y = 6% • The price is assumed to grow at the same rate as the dividends 8-17 Quick Quiz – Part I • What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%? • What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15%. 8-20 Using the DGM to Find R • Start with the DGM: g P D g P g)1(D R g-R D g - R g)1(D P 0 1 0 0 10 0       8-21 Finding the Required Return - Example • Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend, and dividends are expected to grow at 5% per year. What is the required return? – R = [1(1.05)/10.50] + .05 = 15% • What is the dividend yield? – 1(1.05) / 10.50 = 10% • What is the capital gains yield? – g =5% 8-22 Dividend Characteristics • Dividends are not a liability of the firm until a dividend has been declared by the Board • Consequently, a firm 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 8-25 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 firm, and preferred dividends can be deferred indefinitely – 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 8-26 Stock Market • Dealers vs. Brokers • 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 8-27 • Sample Quote • What information is provided in the stock quote? • Click on the web surfer to go to Bloomberg for current stock quotes. Reading Stock Quotes 8-30 Quick Quiz – Part II • You observe a stock price of $18.75. You expect a dividend growth rate of 5%, and the most recent dividend was $1.50. What is the required return? • What are some of the major characteristics of common stock? • What are some of the major characteristics of preferred stock? 8-31 Ethics Issues • The status of pension funding (i.e., over- vs. under-funded) depends heavily on the choice of a discount rate. When actuaries are choosing the appropriate rate, should they give greater priority to future pension recipients, management, or shareholders? • How has the increasing availability and use of the internet impacted the ability of stock traders to act unethically? 8-32