Keown Valuation and Charactheristic of Stock

Foundations of Finance
Arthur J. Keown John D. Martin

J. William Petty David F. Scott, Jr.
Chapter 8
Valuation and Characteristics of
Stocks
Chapter 8 Valuation and Characteristics of Stocks
Learning Objectives
 Identify the basic

characteristics and features of
preferred stock.
 Value Preferred Stock.
 Identify the basic
characteristics and features of
common stock.
8-2 Foundations of Finance Pearson Prentice Hall

Learning Objectives
 Value common stock.
 Calculate a stock’s expected

rate of return.

Principles Used in this Chapter
• Principle 1: The Risk-Return Trade-

off – We Won’t Take on Additional
Risk Unless We Expect to Be
Compensated with Additional Return.
• Principle 2: The Time Value of Money
– A Dollar Received Today is Worth
More Than a Dollar Received in the
Future
• Principle 3: Cash-Not Profits-Is King.

Stock
• Two types:
– Preferred and common

Preferred Stock
• Preferred stock is often referred to

as a hybrid security because it has
many characteristics of both
common stock and bonds.
• Like common stocks
– No fixed maturity date
– Failure to pay dividends does not bring
on bankruptcy
– Dividends are not deductible
• Like Bonds
– Dividends are for a limited time
Features of Preferred Stocks
• Multiple series of preferred stock

• Preferred stock’s claim on assets
and income
• Cumulative dividends
• Protective provisions
• Convertibility
• Retirement Features

Claim on Assets and Income
• Preferred stock has priority over

common stock with regard to claim
on assets in the case of bankruptcy.
• Honored before common
stockholders, but after bonds.
• Must pay dividends to preferred
stockholders before it pays common
stockholder dividends.

Cumulative Dividends
• Cumulative features require that

all past, unpaid preferred stock
dividends be paid before any
common stock dividends are
declared.

Protective Provisions
• Protective provisions generally

allow for voting rights in the
event of nonpayment of
dividends, or they restrict the
payment of common stock
dividends if sinking-funds
payments are not met or if the
firm is in financial difficulty.
8 - 10 Foundations of Finance Pearson Prentice Hall
Convertibility
• Convertible preferred stock can, at

the discretion of the holder, be
converted into a predetermined
number of shares of common stock.
• Almost one-third of preferred issued
today is convertible preferred.
• Reduces the cost of the preferred
stock to the issue

Retirement Features
• Although preferred stock has no

set maturity associated with it,
issuing firms generally provide
for some method of retiring the
stock.

Callable Preferred
• A call provision entitles a company

to repurchase its preferred stock (or
bonds) from their holders at stated
prices over a given time period.
• Call feature usually involves an initial
premium of 10% above par value
• Premium declines over time
• Allows the issuing firm to plan for the
retirement of its preferred stock at
predetermined prices.

Sinking-Fund Provision
• Sinking-fund provision requires

the firm to set aside an amount
of money periodically for the
retirement of its preferred
stock.
• Money used to purchase the
preferred stock in the open
market or to call the stock,
8 whichever
- 14 method is cheaper.
Foundations of Finance
Pearson Prentice Hall
Valuing Preferred Stock
• The value of a preferred stock is

the present value of all future
dividends.
• Calculate the value of preferred
stock:
= Annual dividend / required rate of
return

Valuing Preferred Stock
Vps= annual dividend = D

required rate of return kps
Example:
Xerox’s Series C preferred stock

pays an annual dividend of $6.25 and
the investors required rate of return
8 is
- 16 5%. Foundations of Finance Pearson Prentice Hall
Vps= D = $6.25 = $125.00

kps 0.05

Practice 1
• Telkom Series C preferred stock

pays an annual dividend of $ 15
and the investors required rate
of return is 12%.
• Find the value of preffered

Stock!

Practice 2
• Margana Cipher Corp have a

preffered stock. The nominal
value is $100 and the deviden is
9%.
• If the required rate of return is
14%, how much is the value of
the preffered stock?

Common Stock
• Certificate that indicates

ownership in a corporation
• Common stockholders are the
true owners of the firm

Common Stock
• Common stock is a certificate that

indicates ownership in a corporation.
• Has no maturity date
• No upper limit on dividends
• Dividend payments must be declared each
period (usually quarterly) by the firm’s
board of directors.
• In the event of bankruptcy, common
stockholders will not receive any payment
until the creditors, including the
bondholders and preferred stockholders,
have been satisfied.

Features of Common Stock
• Claim on income
• Claim on assets
• Voting rights
• Preemptive rights
• Limited liability

Claim on Income
• Common shareholders have the

right to residual income after
bondholders and preferred
stockholders have been paid.
• Can be in the form of dividends
or retained earnings.

Claim on Assets
• Common stock has a residual

claim on assets after claims of
debt holders and preferred
stockholders.
• If bankruptcy occurs, claims of
the common shareholders
generally go unsatisfied.

Voting Rights
• Common shareholders are

entitled to elect the board of
directors
• Most often are the only security
holders with a vote
• Can approve any change in the
corporate charter

Voting Rights
• Voting for directors and charter changes

occur at the corporation’s annual meeting.
• A proxy gives a designated party the
temporary power of attorney to vote for the
signee at the corporation’s annual meeting.
• Proxy fights - battles between rival groups
for proxy votes.
• Cumulative voting - each share of stock
allows the stockholder a number of votes
equal to the number of directors being
elected.

Preemptive Rights
• Preemptive right entitles the

common shareholder to maintain a
proportionate share of ownership in
the firm.
• Rights - certificates issued to the
shareholders giving them an option
to purchase a stated number of new
shares of stock at a specified price
during a two- to ten-week period.
Limited Liability
• Liability of the shareholder

is limited to the amount of
their investment.
• Limited liability feature aids
the firm in raising funds.

Valuing Common Stock
• Two Methods:
– Present value of all future
dividends
– Free cash flow method

Present Value of Future Dividends
• Growth factor
– Infusion of capital
• Financing, debt, common stock
– Internal growth
• Management retains some or all
of the firm’s profits for
reinvestment in the firm

Internal Growth
g= ROE x r
Where g = the growth rate of future earnings
and the growth in the common
stockholder’s investment in the
firm
ROE = the return on equity
(net income/common book value)
r = the company’s percentage of
profits retained - profit retention
rate
Valuing of Common Stock
1. If we plan to hold for only one year

• Vcs Today is :
dividend in year 1 + Price in year 1

(1+ Kcs) (1+ Kcs)
D1 = D0(1+g)

D1 = D0 (1+ g)

If we plan to hold for only one year

• The last dividend is $1.75 the
devidend expected to growth at 10%
and is expected to have a price of
$50 in one year when we plan to sell
it.
• If the investor required rate of return
is 15% from investing in the stock,
• Find the value of the stock!
2. If we plan to hold for Two years

• The last dividend is $2 the devidend
expected to growth at 10% and is
expected to have a price of $50 in
two years when we plan to sell it.
• If the investor required rate of return
is 15% from investing in the stock,
• Find the value of the stock!

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

3. Constant devidend growth rate model Indifinite

time
• Dividend Valuation Method:
Common stock value =
dividend in year 1
(required rate of return – growth
rate)


Constant devidend growth rate model Indifinite time

Consider the valuation of a common
stock that paid $2.00 dividend at the
end of the last year and is expected
to pay a cash dividend in the future.
Dividends are expected to grow at

10% and the investors required rate
of return is 15%.
Constant devidend growth rate model Indifinite time

1. The dividend last year was $2.
Compute the new dividend by:
D1 = D0(1+g)
= $2(1+.10)=$2.20
2. Vcs= D1/ (kcs – g)
= $2.20/(.15-.10)
= $44
Value of stock in
Supernormal growth, then

constant
• For example if you have a stock
which pays a $3 dividend which
is expected to grow at 10%
for three years then at a
constant 5% into the future.
• The investor’s required rate of
return is 12%.
• Find the Stock Value!
Value of stock in
Supernormal growth and then

constant
• For example if you have a stock
which pays a $2 dividend which
is expected to grow at 10%
for five years then at a constant
6% into the future.
• The investor’s required rate of
return is 14%.
• Find the Stock Value!
• Free Cash Flow Method:

Shareholder value = firm value –
debt / number of shares
outstanding
• Where firm value is the present
value of free cash flows
discounted a the company’s cost of
capital

Expected Rate of Return
• The expected rate of return on a

security is the required rate of
return of investors who are willing to
pay the market price for the security.
• Preferred Stock Expected Return:
– Annual dividend/market price
• Common Stock Expected Return
– (Dividend in year 1 / market price) +
dividend growth rate

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Foundations of Finance

Arthur J. Keown John D. Martin

 Identify the basic

8-2 Foundations of Finance Pearson Prentice Hall

 Value common stock.

 Calculate a stock’s expected

8-3 Foundations of Finance Pearson Prentice Hall

Principles Used in this Chapter

• Principle 1: The Risk-Return Trade-

8-4 Foundations of Finance Pearson Prentice Hall

8-5 Foundations of Finance Pearson Prentice Hall

• Preferred stock is often referred to

Features of Preferred Stocks

• Multiple series of preferred stock

8-7 Foundations of Finance Pearson Prentice Hall

Claim on Assets and Income

• Preferred stock has priority over

8-8 Foundations of Finance Pearson Prentice Hall

• Cumulative features require that

8-9 Foundations of Finance Pearson Prentice Hall

• Protective provisions generally

• Convertible preferred stock can, at

8 - 11 Foundations of Finance Pearson Prentice Hall

• Although preferred stock has no

8 - 12 Foundations of Finance Pearson Prentice Hall

• A call provision entitles a company

8 - 13 Foundations of Finance Pearson Prentice Hall

• Sinking-fund provision requires

Valuing Preferred Stock

• The value of a preferred stock is

8 - 15 Foundations of Finance Pearson Prentice Hall

Valuing Preferred Stock

Vps= annual dividend = D

Xerox’s Series C preferred stock

Vps= D = $6.25 = $125.00

8 - 17 Foundations of Finance Pearson Prentice Hall

• Telkom Series C preferred stock

• Find the value of preffered

8 - 18 Foundations of Finance Pearson Prentice Hall

• Margana Cipher Corp have a

8 - 19 Foundations of Finance Pearson Prentice Hall

• Certificate that indicates

8 - 20 Foundations of Finance Pearson Prentice Hall

• Common stock is a certificate that

8 - 21 Foundations of Finance Pearson Prentice Hall

Features of Common Stock

8 - 22 Foundations of Finance Pearson Prentice Hall

• Common shareholders have the

8 - 23 Foundations of Finance Pearson Prentice Hall

• Common stock has a residual

8 - 24 Foundations of Finance Pearson Prentice Hall

• Common shareholders are

8 - 25 Foundations of Finance Pearson Prentice Hall

• Voting for directors and charter changes

8 - 26 Foundations of Finance Pearson Prentice Hall

• Preemptive right entitles the

• Liability of the shareholder

8 - 28 Foundations of Finance Pearson Prentice Hall

Valuing Common Stock

8 - 29 Foundations of Finance Pearson Prentice Hall

Present Value of Future Dividends

8 - 30 Foundations of Finance Pearson Prentice Hall

Valuing of Common Stock