FIN3218 CORPORATE FINANCE

CHAPTER 5: STOCK VALUATION

 LEARNING OUTCOMES

 Common stock (div not fixed) and preferred stock(div is not fixed)
 Explain the characteristics of preference share
 Compute the value of the preference share
 Explain the characteristics of common share
 Compute the value of common share
 DIFFERENT GROWTH
 PREFERRED SHARE

 Preferred share is often referred to as a hybrid security (ranking number 2) because it

has many characteristics of both common share(get dividends) and bonds (get coupon
payments). Hybrid- between bonds& div. ranking is no.2
 The first priority- to whom? To lender.
 Like common shares, preferred shares:
 have no fixed maturity date
 failure to pay dividends does not lead to bankruptcy
 dividends are not a tax-deductible expense

 Dividends are fixed in amount (either as a $ amount or as a % of par value )

 THE CHARACTERISTICS OF
PREFERRED SHARES

Have rights to claim when Preferred Combine payments for this

the company goes stock’s claim Cumulative
year and next year (certain
bankrupt. on assets and dividends
income form of protection)

Preff share can be converted

Protective into common share. Inv can
Convertibility
provisions buy oref share and convert to
common stock, diff set of
financial instrument. Bonds
can be converted.
 THE CHARACTERISTICS OF
PREFERRED SHARES

 Claim on Assets and Income

 Claim on Assets: Preferred stock has priority over common stock with regard to claim on
assets in the case of bankruptcy.
 Claim on Income: Preferred stock also has priority over common stock with regard to
dividend payments
 Cumulative Dividends
 Cumulative feature (if it exists) requires that all past, unpaid preferred stock dividends be
paid before any common stock dividends are declared. Any past payments should be
settled.
 THE CHARACTERISTICS OF
PREFERRED SHARES

 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 (if no backup fund, protect
their preff share holders)
 Convertibility
 Convertible preferred stock can, at the discretion of the holder, be converted into a
predetermined number of shares of common stock (not only for preff stock but bonds too).
 VALUING PREFERRED SHARE

 The economic or intrinsic value of a preferred share is equal to the present value of all
future dividends
 Value of preferred share:
 VALUING PREFERRED STOCK (EXAMPLE)

 Example: Assume PG&E preferred stock pays an annual dividend of $1.25 and the
investors required rate of return is 5%.
 VALUING PREFERRED STOCK (EXAMPLE)

 Xerox preferred pays an 8.25% dividend on a $50 par value. Suppose our required
rate of return on Xerox preferred is 9.5%.
What is the value of the preferred stock?
1. Find the dividend in money. (dividend vale, then divide by ROR value)

D= 0.0825 x 50 = $4.125
Vps = 4.125/0.095 = $43.42
 VALUING PREFERRED STOCK (REQUIRED RETURN)

 If we know the preferred stock price is $40, and the preferred dividend is $4.125, the
expected (required) return is:
(dividend/ stock price)
40 = 4.125 / x
40x = 4.125
x = 4.125 / 40
x = 0.1031 or 10.31%
or
=4.125/40 = 10.31%
 COMMON SHARES

 Common share is a certificate that indicates ownership in a corporation. When you

buy a share, you buy a “part/share” of the company and attain ownership rights in
proportion to your “share” of the company
 Common shareholders are the true owners of the firm. Bondholders and preferred
share holders can be viewed as creditors
CHARACTERISTICS OF COMMON SHARES

Claim Claim
on on
Income Assets

Limited Voting
Liability Rights
 CHARACTERISTICS OF COMMON SHARES

 Claim On Income
 Common shareholders have the right to residual income after bondholders and preferred
stockholders have been paid
 Residual income can be paid in the form of dividends or retained within the firm and
reinvested in the business
 Claim on residual income implies there is no upper limit on income, but it also means that,
on the downside, shareholders are not guaranteed anything and may have to settle for zero
income in some years
 CHARACTERISTICS OF COMMON SHARES

 Claim On Assets
 Common stock has a residual claim on assets in the case of liquidation
 Residual claim implies that the claims of debt holders and preferred stockholders have to be met prior to
common stockholders
 Generally, if bankruptcy occurs, claims of the common shareholders are typically not
satisfied
 CHARACTERISTICS OF COMMON SHARES

 Limited Liability
 The liability of shareholders is limited to the amount of their investment
 The limited liability helps the firm in raising funds

 Voting Rights
 Most often, common stockholders are the only security holders with a vote
 Common shareholders are entitled to elect the board of directors or approve any change in the
corporate charter
 VALUATION OF COMMON STOCKS

 The value of any asset is the present value of its expected future cash flows
 Stock ownership produces cash flows from:
 Dividends (keeping the shares)
 Capital Gains (sell the shares)

 Valuation of Different Types of Stocks:

 Zero Growth (div doesn’t grow)
 Constant Growth (div is fixed)
 Differential Growth (
 ZERO GROWTH

 Assume that dividends will remain at the same level forever (similar to preferred
equity)
𝐷1 =𝐷2 =𝐷3 =⋯
 D0= recently paid dividend, D1= next year
 D1= D0* (1+g)
 Since future cash flows are constant, the value of zero-growth stock is the present value
a perpetuity: D1 D2 D3
P0 = + 2
+ 3
+⋅⋅⋅
1+ R ( 1+R ) ( 1+R )
 CONSTANT GROWTH
 Assume that dividends will grow at a constant rate, g, forever, i.e.,
Let’s try this:
= 1.575 D0=$1.5;
= =1. g=5%
=2.009 Compute D1, D2, D3
 Since future cash flows grow at a constant rate forever, the value of a constant growth stock
is the present value of a growing perpetuity:
𝐷1
𝑃0=
= D0(1 + g) / (kcs – g)
𝑅−𝑔 Determine D1 if the current dividend
payment D0 is $0.45. Assume the
=kcs is R
dividend growth is 5%.
Note: D1 is from D0(1 + g) D1 = 0.45(1+0.05) = $0.4725
 EXAMPLE
 Suppose Big D, Inc., just paid a dividend of $0.50. It is expected to increase its
dividend by 2% per year. If the market requires a return of 15% on assets of this risk
level, how much should the stock be selling for?

0.50 (1.02)
𝑃0=
 Answer: $3.92 0.15− 0.02
 EXAMPLE

 XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10%
per year indefinitely. What would we be willing to pay if our required return on XYZ
stock is 15%?
D0 = $5, so [D1= 5(1+0.10)= $5.50]
= 5.50 / (0.15 – 0.1) = $110
 Answer: $110
 EXAMPLE

 Sarah Corporation will pay a $3.00 dividend next year(d1) and has a current stock price
of $27 and an expected growth rate of 5%. Determine the required rate of return.

27 = 3 / (x – 0.05)
27x – 1.35 = 3
27x = 4.35
x = 4.35/27
x = 0.1611 or 16.11%

Answer: 16.11%
 DIFFERENTIAL GROWTH

 Assume that dividends will grow at different rates in the foreseeable future and then
will grow at a constant rate thereafter.
 To value a differential growth stock, we need to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock becomes a constant growth stock.
 Compute the total present value of the estimated future dividends and future stock price at
the appropriate discount rate.
 DIFFERENTIAL GROWTH

 Assume that dividends will grow at rate g1 for N years and grow at rate g2 thereafter.

D1 =D0 ( 1+g1 )
 DIFFERENTIAL GROWTH

 Dividends will grow at rate g1 for N years and grow at rate g2 thereafter
 G 1 is initial growth,
 DIFFERENTIAL GROWTH

 We can value this as the sum of:

a T-year annuity growing at rate g1

[ ]
T
𝐶 ( 1+𝑔1 )
PA= 1−
𝑅 − 𝑔1 ( 1+ 𝑅 )T
 plus the discounted value of a perpetuity growing at rate g2 that starts in year T+1

𝑃 𝐵=
(
𝐷T +1
𝑅 − 𝑔2 )
¿¿
 DIFFERENTIAL GROWTH

 Consolidating gives:

𝐶
𝑃= ¿
𝑅 − 𝑔1
 DIFFERENTIAL GROWTH (CASH FLOW METHOD)
 A common stock just paid a dividend of $2. The dividend is expected to grow at 8% for 3
years, then it will grow at 4% in perpetuity. What is the stock worth? Assume the discount
rate is 12%.
The 0.08 there is the deduction from
(k-g2), which is 0.12-0.04: 0.08
The 0.08 is not g1

The constant growth phase

beginning in year 4 can be
valued as a growing
perpetuity at time 3.
$ 2.16 $ 2.33 $ 2.52+ $ 32.75
𝑃0= + + =$ 28.89
1.12 ( 1.12 ) 2
( 1.12 ) 3
 DIFFERENTIAL GROWTH (FORMULA METHOD)

 A common stock just paid a dividend of $2. The dividend is expected to grow at
g1=8% for 3 years, then it will grow at g2=4% in perpetuity. What is the stock worth?
Assume the discount rate is 12%. K=0.12-0.04 (g)

$ 2 ×(1.08)
𝑃= ¿
0.12 − 0.08