CH 7: Stock Valuation, Part 1
Is preferred stock equity or debt?
- Equity - Economically, it is like a perpetual bond because it has a promised cash flow to holders and there are consequences if those cash flows are not paid. However, unlike debtholders, preferred shareholders cannot force the firm into bankruptcy. Preferred shareholders stand in line in front of common shareholders for annual dividends, but behind regular bondholders, because interest is paid before dividends. If the firm is bankrupt, the same priority is followed in settling claims: bondholders, preferred shareholders, and then common shareholders. Finally, as long as the firm is meeting its preferred dividend obligations, the preferred shareholders have none of the control rights of owners, such as voting on directors or other important matters. However, despite all these similarities to debt, preferred shares are, for all tax and legal purposes, treated as equity.
What is capital gain? What is the capital gain rate? What are their formulas?
- capital gain: the investor will earn on the stock, which is the difference between the expected sale price and the original purchase price for the stock P1 - P0 - capital gain rate: divide the capital gain by the current stock price to express the capital gain as a percentage return (P1 - P0)/P0
Consider a company with expected dividends of $2.00, $2.50, and $3.00 in each of the next three years. After that point, its dividends are expected to grow at a constant rate of 5%. If its equity cost of capital is 12%, find the current price.
- first find the price in year 3 Pn = (Div{n = 1} + 1)/(re - g) = 3.00(1.05)/0.12 - 0.05 - next calculate the current price as a PV of the three years' dividends and then the price at the end of year three P0 = 2.00/1.12 + 2.50/1.12^2 + 3.00/1.12^3 + 45.00/1.12^3 = 37.94
Crane Sporting Goods expects to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these expectations of no growth, Crane's current share price is $60. Suppose Crane could cut its dividend payout rate to 75% for the foreseeable future and use the retained earnings to open new stores. The return on its investment in these stores is expected to be 12%. If we assume that the risk of these new investments is the same as the risk of its existing investments, then the firm's equity cost of capital is unchanged. What effect would this new policy have on Crane's stock price?
- to figure out the effect of this policy on Crane's stock price, we need to know several things. First, we need to compute its equity cost of capital. Next, we must determine Crane's dividend and growth rate under the new policy. re = 6.00/60.00 + 0 = 0.10 - to justify Crane's stock price under its current policy, the expected return of other stocks in the market with equivalent risk must be 10%. Div 1 = EPS1 x 75% = 6 x 75% = 4.50 g = 0.25 x 0.12 = 0.03 or 3% P0 = Div1/(re - g) = 4.50 /(0.10 - 0.3) - cranes share price should increase from 60.00 to 64.29
What are the two kinds of preferred stock?
1. cumulative: any unpaid dividends are carried forward. In this case, if the company fails to pay its preferred dividend for several years, its obligation to its cumulative preferred shareholders accumulates, and it cannot pay any dividends to common shareholders until it has paid all the unpaid preferred dividends 2. non-cumulative: missed dividends do not accumulate, and the firm can pay current dividend payments first to preferred and then to common stock shareholders. Almost all preferred stock is cumulative. Some preferred stock also gives preferred shareholders the right to elect one or more directors to the board if the firm is substantially in arrears on preferred dividends
What are three ways can increase its dividend?
1. increase earnings (net income) 2. increase payout rate 3. decrease number of shares outstanding
What are two limitations of the dividend discount model?
1. its reliance on dividend forecasts 2. lack of applicability to non-dividend-paying stocks
What are the two potential sources of cash flows from owning a stock?
1. the firm might pay out cash to its shareholders in the form of a dividend. 2. the investor might generate cash by selling the shares at some future date.
Why can't you use the constant dividend growth model for young firms?
1. these firms often pay no dividends when they are young. 2. their growth rate continues to change over time until they mature.
What is the difference between a market and limit order?
A market order means you do not specify a price, rather you want the order to execute immediately at the most favorable price available. If instead you wanted to specify a maximum price you were willing to pay, and you were willing to wait until the shares were available at that price, you would place a limit order
What is the formula for change in earnings?
Change in Earnings = New Investment x Return on New Investment
What is the formula for earnings growth rate?
Earnings Growth Rate = Change in Earnings/Earnings = Retention Rate x Return on New Investment
What is the formula for new investment?
Earnings x Retention Rate * retention rate = fraction of current earnings that the firm retains
Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs' stock have an expected return of 6.80%, what is the most you would pay today for Longs' stock? What dividend yield and capital gain rate would you expect at this price?
P0 = (0.56 + 45.00)/1.068 = 43.13 dividend yield: 0.56/43.13 = 0.012984 or 1.30% expected capital gain: 45.50 - 43.13 = 2.37 per share capital gain rate: 2.37/43.13 = 0.054950 or 5.50% expected total return: 1.30% + 5.50% = 6.80% which is the most we would be willing to pay
What is the formula for stock price in one year?
P0 = (Div1 + P1)/(1 + re) * if the current stock price were less than this amount, the cost would be less than the PV of the benefits, so investors would rush in and buy it, driving up the stock's price. If the stock price exceeded this amount, selling would be attractive and the stock price would quickly fall.
Consolidated Edison, Inc. (Con Ed) is a regulated utility company that services the New York City area. Suppose Con Ed plans to pay $2.30 per share in dividends in the coming year. If its equity cost of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate the value of Con Ed's stock.
P0 = 2.30/(0.07 - 0.02) = 46.00
Suppose Crane Sporting Goods decides to cut its dividend payout rate to 75% to invest in new stores. But now suppose that the return on these new investments is 8%, rather than 12%. Given its expected earnings per share this year of $6 and its equity cost of capital of 10% (we again assume that the risk of the new investments is the same as its existing investments), what will happen to Crane's current share price in this case?
P0 = DIV1/(re - g) = 4.50/(0.10 - (0.25 x 0.08)) = 56.25 - even though Crane will grow under the new policy, the return on its new investments is too low. The company's share price will fall if it cuts its dividend to make new investments with a return of only 8%. By reinvesting its earnings at a rate (8%) that is lower than its equity cost of capital (10%), Crane has reduced shareholder value.
What is the formula for the stock price in two years?
P0 = Div1/(1 + re) + (Div2 + P2)/(1 + re)^2 * the formula for the stock price for a two-year investor is the same as that for a sequence of two one-year investors
What is the formula for the constant dividend growth model?
P0 = Div1/(re - g) re = (Div 1/P0) + g {where g = the expected capital gain rate)
What is the formula for the future share price of a stock (Pn) once a firm matures?
Pn = (Div{n = 1} + 1)/(re - g)
Small Fry, Inc., has just invented a potato chip that looks and tastes like a french fry. Given the phenomenal market response to this product, Small Fry is reinvesting all of its earnings to expand its operations. Earnings were $2 per share this past year and are expected to grow at a rate of 20% per year until the end of year 4. At that point, other companies are likely to bring out competing products. Analysts project that at the end of year 4, Small Fry will cut its investment and begin paying 60% of its earnings as dividends. Its growth will also slow to a long-run rate of 4%. If Small Fry's equity cost of capital is 8%, what is the value of a share today?
We can use Small Fry's projected earnings growth rate and payout rate to forecast its future earnings and dividends. After year 4, Small Fry's dividends will grow at a constant 4%, so we can use the constant dividend growth model (Eq. 7.13) to value all dividends after that point. Finally, we can pull everything together with the dividend-discount model (Eq. 7.4). P3 = Div4/(re - g) = 2.49/0.08 - 0.04 = 62.25
What is the dividend-discount model? What is its formula?
a model that values the shares of a firm according to the present value of the future dividends the firm will pay - as an annuity (more common): P0 = Div1/(1 + re) + Div2/(1 + re)^2 + ... + Divn/(1 + re)^n + Pn/(1 + re)^n - as a perpetuity: P0 = Div 1/(1 + re) + Div2/(1 + re)^2 + Div3/(1 + re)^3 + ... * the price of the stock is equal to the present value of all of the expected future dividends it will pay
What is a floor broker?
a person who holds a trading license at the NYSE and works to get the best execution possible for investors
What is common stock?
a share of ownership in the corporation gives its owner rights to any common dividends as well as rights to vote on the election of directors, mergers, and other major events
What is a ticker symbol?
a unique abbreviation assigned to a publicly traded company used when its trades are reported on the ticker (a real-time electronic display of trading activity) Ex: Disney's is DIS and Nike's is NKE
What is a proxy?
a written authorization for someone else to vote your shares
What are classes?
different types of common stock for the same company, often carrying different voting rights Ex: Nike has Class A and Class B stock. Phil Knight, Nike's founder, owns almost all the Class A stock, which carries the rights to elect 9 of the company's 12 directors. Alphabet Inc. (Google) has Class A, Class B, and Class C stock. Class A stock has been sold to the public, while Google's founders and managers hold all the Class B stock, each share of which carries 10 times the voting power of a share of Class A stock. Class C stock, which was split from Class A stock in April 2014, has no voting rights
What is straight voting?
each shareholder has as many votes for each director as shares held Ex: shareholder 1 has 600 shares and shareholder 2 has 400. For each director, shareholder 1 will have 600 votes and shareholder 2 has 400
What is cumulative voting?
each shareholder's total vote allocation for all directors is equal to the number of open spots multiplied by his or her number of shares Ex: shareholder 1 has 600 shares and shareholder 2 has 400. Shareholder 2 is allocated a total of (x directors) × (400 votes) = 4000 votes. Shareholder 1 is allocated (x directors) × (600 votes) = 6000 votes to use across the 10 director spots.
What is the formula for growth rate (g)?
g = Retention Rate x Return on New Investment
What is preferred stock?
has preference over common shares in the distribution of dividends or cash during liquidation
What is discussed at an annual meeting?
managers and directors answer questions from shareholders, and shareholders vote on the election of directors and other proposals
What is total return? What is its formula?
sum of the dividend yield and the capital gain rate re = (Div1 + P1)/P0 - 1 = Div1/P0 + (P1 - P0)/P0 * the stock's total return should equal the equity cost of capital. In other words, the expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk.
What is an example of a stock valuation method?
the dividend-discount model
What is a stock's dividend yield? What is its formula?
the expected annual dividend of the stock divided by its current price. The dividend yield is the percentage return the investor expects to earn from the dividend paid by the stock Div1/P0
What is the equity cost of capital (re)?
the expected return of other investments available in the market with equivalent risk to the firm's shares
What is a firm's dividend payout rate?
the fraction of its earnings that the firm pays as dividends each year Div{t} = Earnings{t}/Shares Outstanding{t} x Dividend Payout Rate{t} * t = date * EPS = Earnings{t}/Shares Outstanding{t}
What is a proxy contest?
when two or more groups are competing to collect proxies to prevail in a matter up for shareholder vote (such as election of directors)