Stocks And Their

CHAPTER 9
Valuation

Reported By:
Ma. Angelica Ovillo Ma. Angelica Ovillo
L i r a C l e o Po r c a r e
Lira Cleo Porcare
 By the time we finish this chapter, we should be able to
• In do the following:
Chapter 7, we examined bonds and their
valuation. We now turn to stocks, both
common andthepreferred.
 Discuss legal rightsBecause the cash
of stockholders.
flows provided by bonds are set by contract, it
 Explaineasy
is generally the to
distinction between
predict their a stock’s price and its intrinsic value.
cash flows.
 Identify
• Preferred the two
stock models are
dividends that also
can besetused
by to estimate a stock’s intrinsic
value:
contract, which makes them similar to bonds,
and• they
theare
discounted
valued individend
much themodel
sameandway.the corporate valuation model.
 List thecommon
• However, key characteristics of preferred
stock dividends are notstock, and describe how to
estimate the value
contractual—they of preferred
depend on the stock.
firm’s
earnings, which in turn depend on many
random factors, making their valuation more
difficult.
2
Searching For the
Right Stock ?
 Stock valuationStock
is interesting in its own
Valuation is interesting right,
in its own
but you also need toyou
right, but understand
also need tovaluation
understand
when estimating a firm’s
valuation when cost of capital
estimating for
a firm’s cost
use in its ofcapital
capital forbudgeting
use in its capitalanalysis,
budgeting
analysis, which is probably a firm’s most
which is probably a firm’s most important
important task.
task.
 Legal Right and Privileges of Common FR
Stockholders
A. Control Of The Firm

A firm’s common stockholders have the right to elect its

directors, who in turn elect the officers who manage the
business. In a small firm, usually the major stockholder is also
the president and chair of the board of directors.

In large publicly owned firms, the managers typically have

some stock , but their personal holdings are generally
insufficient to give them voting control. Thus, the
managements of most publicly owned firms can be removed by
the stockholders if the management team is not effective.

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Proxy
 A document giving one person the
authority to act for another ,
Typically the power to vote shares
of common stock
Takeover
 An Action whereby a person or group
Proxy Fight succeeds in ousting a firm’s management
and taking control of the company.
 An attempt by a person or group to
gain control of a firm by getting its
stockholders to grant that person or
group the authority to vote its shares
to replace the current management.

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B. THE PREEMPTIVE RIGHT

Common stockholders often have the right, called
the preemptive right, to purchase on a pro rata
basis any additional shares sold by the firm. In
some states, the preemptive right is automatically
included inPreemptive Rightin other
every corporate charter;
states, it must be specifically inserted into the
charter.  A provision in the corporate charter or bylaws
that gives common stockholders the right to
purchase on a pro rata basis new issues of
common stock (or convertible securities).

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Types of Common Stock

Although most firms have only one type of co0mmon stock, in

some instances, classified stock is used to meet special needs.

Generally, when special classifications are used, one type is

designated Class A, Another Class B, and so forth. Small, new
companies seeking funds from outside sources frequently use
different types of common stock.

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Classified Stock
 Common stock that is given a special designation such as Class A
or Class B to meet special needs of the company.

Founder’s Shares
 Stock owned by the firm’s founders that enables them to maintain
control over the company without having to own a majority of stock.

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Stock Price versus Intrinsic Value

The stock price is simply the current market price, and it is easily observed for
publicly traded companies. By contrast, intrinsic value, which represents the
“true” value of the company’s stock, cannot be directly observed and must
instead be estimated.

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WHY DO INVESTORS
AND COMPANIES CARE
ABOUT INTRINSIC
VALUE ?

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Investors obviously
Investors care about
obviously intrinsic
care about value,value,
intrinsic but but managers also
managersneedalsoto need to understand
understand how intrinsic
how intrinsic value is estimated. First,
value is estimated.
managers needFirst, managers
to know need to know
how alternative actions are likely to affect
how alternative
stock prices;actions are likely
the models of to affect value
intrinsic stock that we cover help
prices;demonstrate
the models of theintrinsic valuebetween
connection that we cover
managerial decisions and
help firmdemonstrate
value. Second,the managers
connection
shouldbetween
consider whether their stock
managerial decisionsundervalued
is significantly and firm or value. Second,
overvalued before making certain
managers should consider whether their stock is
decisions.
significantly undervalued or overvalued before
making certain decisions.

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Two basic models are used to estimate intrinsic values:

themodels
Two basic discounted dividend
are used model
to estimate and values:
intrinsic the corporate
valuation dividend
the discounted model. model
The dividend
and themodel focuses on
corporate
dividends,
valuation model. while the corporate
The dividend model model
focusesgoeson beyond
dividends
dividends, while and focuses onmodel
the corporate sales, goes
costs, beyond
and free cash
flows.
dividends and focuses on sales, costs, and free cash
flows.

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The Discounted Dividend

Model
The value of a share of common stock depends on the
cash flows it is expected to provide, and those flows
consist of two elements: (1) the dividends the investor
receives each year while he or she holds the stock and
(2) the price received when the stock is sold. The final
price includes the original price paid plus an expected
capital gain.

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Constant Growth
(Gordon) Model

 Used to find the value of

a constant growth stock.

 The constant growth, or Gordon,

model, named after Myron J.
Gordon, who did much to develop
and popularize it.

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EXPECTED DIVIDENDS AS THE BASIS FOR STOCK VALUES FR

In our discussion of bonds, we used Equation 7.1 to find the value of a

bond; the equation is the present value of interest payments over the
bond’s life plus the present value of its maturity (or par) value:

Equation 7.1

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The term is the required rate of return, which is a riskless rate plus a
risk premium. However, we know that if the stock is in equilibrium, the
required rate of return must equal the expected rate of return, which is
the expected dividend yield plus an expected capital gains yield.

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If rRF = 7%, rM = 12%, and b = 1.2, what is the
required rate of return on the firm’s stock?

• Use the SML to calculate the required

rate of return (rs):

rs = rRF + (rM – rRF)b

= 7% + (12% - 7%)1.2
= 13%
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 If D0 = $2 and g is a constant 6%, find the FR
DIVIDENDS
expected VERSUS GROWTH
dividend stream for the next 3
years, and their PVs.
The discounted dividend model as expressed in
Equation 9.2 shows that, other things held
0
constant, a higher value for D1 increases a 1
stock’s 2 3
g = 6%
price. However, Equation 9.2 shows that a higher
growth rate also increases the
D0 =stock’s
2.00 price. But
2.12 2.247 2.382
now recognize the following: 1.8761
rs = 13%
1.7599
● Dividends are paid out of earnings.
● Therefore, growth in dividends requires growth
1.6509
in earnings.

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^
P1  P0 (1.06)  $32.10
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 What are the expected dividend yield, FR
capital gains yield, and total return during
the first year?

• Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
• Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
• Total return (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
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 What would the expected price FR
today be, if g = 0?
• The dividend stream would be a perpetuity.

0 1 2 3
rs = 13%
...
2.00 2.00 2.00

^ PMT $2.00
P0    $15.38
r 0.13

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 TO Be Continued…………
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