Investment Decision

Chapter 5
Common Stock

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© LMS SEGi education group
Monday, October 3, 2022
 Learning objectives
On successful completion of this topic students should understand the
following:
• Discuss the basic features of common stocks
• Understand the different kind of common stock values
• Discuss common stocks dividends, types of dividends and types of
common stocks
• Explain the role that a company’s future plays in the stock valuation
process
• Determine the underlying value of stock using the zero growth,
constant growth and variable growth dividend valuation models
• Use other types of present value based model to derive the value of
stock
 INTRODUCTION
• Shareholders a part owner of the firm and has claim on wealth created by
company.
• Common shareholders are the residual owners of the company.
• Common stocks is prospects that they will increase in value over time and
generate significant capital gains.
• Looking for past performance is to gain insight about the firm’s future direction.
• It gives us good idea of a company’s strength and weakness.
• Eg: Company’s history
• Value of share of stock depends on the company’s future performance.
 PROS AND CONS OF STOCK OWNERSHIP
PROS
• Substantial returns offered
• Protection from inflation
• Easy to buy and sell
• Information is widely disseminated in the news & social media
• Unit cost fairly low
Cons
• Risk
• Difficult to eliminate risk
• Returns highly volatile
• Complex selection process
• Distribute less current income than some other investments
 CHARACTERISTICS OF COMMON STOCKS
1. Corporate Security
• Issuing new shares
• Stock spin-offs
• Stock Splits
• Treasury stocks
• Classified common stock
2. Buying and Selling Stocks
• Reading the quotes
• Transaction costs
3. Common Stock values
• Par value
• Book value
• Market value
• Investment value
 TYPES OF DIVIDENDS
1. Cash Dividend
• Increase over time as companies’ earning grow
• Amount of dividend received measured by dividend yield

• Dividend payout ratio measure the percentage of earnings that a firm pays in
dividend.
 TYPES OF DIVIDENDS (CONT’D)

2. Stock Dividend
• Firm pays its dividend by distributing additional shares of stock.
• Similar to stock splits
• Not taxed until sell the stocks
 TYPES OF COMMON STOCKS

• Blue chip stocks

• Income stocks
• Growth stocks
• Tech Stocks
• Speculative stocks
• Cyclical stocks
• Defensive stocks
• Market-cap stocks
 THE VALUATION PROCESS
• Valuation- process by which an investor determines the worth of a security
the trade-off between risk and return.
• Applied on any assets that produces a stream of cash – a share of stocks, a
bond, real estate.
• To establish the value of an asset – future cash flows, timing of cash flows
and rate of return.
• Common stock – worth of stock, estimated cash flows to shareholders and
amount of risk.
• Employ various types of stock valuation models
• Two conditions worthwhile investment candidate:
• Expected rate return equals or exceed the return
• Intrinsic value equal or greater than market price.
 STOCK VALUATION MODELS

1. Dividend valuation model

• Intrinsic value of any investment equals the present value of its expected cash benefits
• Value of a share of stock is a function of its future dividend
• Three version dividend valuation model
a) Zero growth – assume the dividends will not grow over time
b) Constant growth – assume the dividends will grow by a constant rate over time
c) Variable growth – assume the rate of growth in dividends will vary over time
 STOCK VALUATION MODELS CONT’D

a) Zero growth
• Dividend stay the same year in and year out; expected to do so in future.
• Present value of its annual dividends
• Present value = annual dividends/ required rate of return
• Eg: Suppose a stock pays a dividends of $3 per share each year, and you
don’t expect that dividend to change. If you want a 10% return on your
investment, how much should you be willing to pay for the stock?
Value of stock = $3/0.10 = $30
 STOCK VALUATION MODELS CONT’D

b) Constant growth
• Expected to grow forever at a constant rate of growth.

D1 = D0 (1+g)1
D2 = D0 (1+g)2

Dt = D0 (1+g)t
 STOCK VALUATION MODELS CONT’D

• Eg : The food company General Mills increased its dividend payments by

about 7% per year. The food industry is not one where we would expect
explosive growth. In April 2015 General Mills was paying an annual
dividend of $1.76 per share, so for 2016 investors were expecting
increase in dividend in over the coming year to $1.88. If the required rate
is 10%, what is the value of the stock.
= = $62.67
 STOCK VALUATION MODELS CONT’D

• Eg: if the stock’s market price is $56, the next dividend is $1.88 and the
dividend growth rate is 7%, estimate the required rate return,r.

56
r= 10.36%
 STOCK VALUATION MODELS CONT’D

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the
next 3 years, and their PVs.

0 1 2 3

2.12 2.247 2.382

D0 = 2.00
1.8761
1.7599
1.6509
 STOCK VALUATION MODELS CONT’D

What is the stock’s market value?

• Using the constant growth model:

D1 $2.12
P0  
k s - g 0.13 - 0.06
$2.12

0.07
 $30.29
 STOCK VALUATION MODELS CONT’D

What is the expected market price of the stock, one year from now?

•D will have been paid out already. So, P1 is the present

1
value (as of year 1) of D2, D3, D4, etc.

^
D2 $2.247
P1  
k s - g 0.13 - 0.06
 $32.10

• Could also find expected P 1 as:

^
P1  P0 (1.06)  $32.10
 STOCK VALUATION MODELS CONT’D
What is the expected dividend yield, 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 (k ) s
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
 STOCK VALUATION MODELS CONT’D

c) Variable growth

• Current dividend is $4, Required rate of return is 16%. The

dividend is expected to grow at 30% over next 3 years.
Thereafter, at 6% per year.

• Calculate the stock value.

 STOCK VALUATION MODELS CONT’D

• Step 1
Year Expected dividend
D1 D0(1+g) = 4(1+0.3) = 5.2
D2 D1(1+g) = 5.2(1+0.3) = 6.76
D3 D2(1+g) = 6.76(1+0.3) = 8.79
D4 D3(1+g) = 8.79(1+0.06) = 9.32
 STOCK VALUATION MODELS CONT’D

• Step 2
P3 = D 4
k-g
= 9.32
0.16 - 0.06
= $93.2
 STOCK VALUATION MODELS CONT’D

• Step 3
P0 = D1 + D2 + D3 + P3
(1+k)1 (1+k)2 (1+k)3 (1+k)3

P0 = $5.2 + $6.76 + $8.79 + $93.2

(1+0.16)1 (1+0.16)2 (1+0.16)3 (1+0.16)3

P0 = $74.84
 STOCK VALUATION MODELS CONT’D

2) Other approaches to stock valuation

a) Free cash flow to Equity
• The cash flow that remains after a firm pays all of its expenses and makes necessary
investment in working capital and fixed assets.

Free cash flow = after-tax earning +depreciation – investments in working capital –

investment in fixed assets
 STOCK VALUATION MODELS CONT’D

• Zero growth in Free Cash flow

Victor’s Secret sauce is a speciality retail company that sells a variety of
bottled sauce for home cooks. Last year (2015) the company generated $2.2
million after tax earnings. Victor’s took depreciation charges against its fixed
assets equal to $250,000 and it invested $50,000 in new working capital and
$40,000 in new fixed assets. The firm’s expected rate of return is 9% and 4
million outstanding shares.
 STOCK VALUATION MODELS CONT’D

Free cash flow = $2,200,000+$250,000 -$50,000-$40,000 = $2,360,000

PV of future cash flow = $2,360,000 ÷ 0.09= $26,222,222
Value of common share = $26,222,222 ÷ 4,000,0000 = $6.56
 STOCK VALUATION MODELS CONT’D

• Constant growth in free cash flow.

Now, Victor’s free cash flow to grow over time at constant rate of 2%
PV future cash flows = cash flow ÷ (r-g)
= 2,360,000 (1+0.02) ÷ (0.09-0.02)
= $34, 388,571
Value of common shares = $34,388,571 ÷ 4,000,000 = $ 8.60 per share
 STOCK VALUATION MODELS CONT’D

• Variable growth in free cash flow

Suppose that Victor’s cash flow grows 20% next year, 10% the year after and 2% per year for all
subsequent
Yearyears Cash flow Present value
2016 $2,360,000(1.20) = $2,832,000/1.09 =
$2,832,000 $2,598,165

2017 $2,832,000 (1.10) = $3,115,200/1.09 = $

$3,115,200 2,622,002

PV (2017) = FCF(1+g)/(r-g) = 3,115,200 (1+0.02)/(0.09-0.02) = $45,392, 914

Pv (2015)= $45,392,914 = $38,206,308
PV of all future cash flows = $2,598,165+$2,622,002+$38,206,308 = $43,426,474
Value of common shares = $43,426,474/4,000,000 = $10.86 per share
 REFERENCES

• Gitman, L.J., Joehnk, M.D., Smart, S., & Juchau, R.H. (2017). Fundamentals
on investing. Pearson Education.
• Bodies, Z., Kane, A., Marcus, A.J. (2011). Investments (9th ed.). New York:
McGraw-Hill.
• Reilly, F. K., Brown, K.C. (1997). Investment analysis and portfolio
management (5th ed.). Fort Worth: Dryden Press.