Stocks (Equity) Characteristics and Valuation

1
Stocks (Equity)Characteristics and Valuation

• What is equity?
• What factors affect stock prices?
• How are stock prices determined?
• How are stock returns determined?
• What techniques do investors use to value stocks?

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Basic Types of Stock

• Preferred stock hybrid
• Common stock

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Preferred Stock Features

• Par value
• The nominal or face value of a stock or bond
• Dividends
• Generally fixed, like debt based on the par
  value
• Cumulative dividends
• Preferred dividends not paid in previous periods
  must be paid before common dividends can be paid
• Maturity
• No specific maturity date
• Priority to assets and earnings
• Preferred stockholders are paid before common
  stockholders

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Preferred Stock Features

• Control of the Firm (Voting Rights)
• Most preferred stock is nonvoting, unless
  dividends are not paid for a particular number of
  periods
• Convertibility
• Can be converted to common stock
• Call provision
• Firm has the right to call in preferred stock for
  redemption
• Sinking fund
• A fund used to retire a given amount of the stock
  each year
• Participating
• Shares earnings with common stockholders

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Common Stock Features

• Par value
• Stockholders minimum financial obligation
• Dividends
• No legal obligation to pay dividends
• Maturity
• No specific maturity date
• Priority to assets and earnings
• Receive distributions last
• Preemptive right
• Right to buy new issues
• Control of the firm
• Vote on board of directors, stockholder
  proposals, etc.

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Types of Common Stock

• Classified Stock
• Special designations, such as Class A, Class B,
  etc., used to meet special needs of the company
• Founders Shares
• Classified stock
• A class of stock owned by the firms founders who
  have sole voting rights for a particular time
  period

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Equity Instruments in International Markets

• American Depository Receipts
• Certificates that represent ownership in stocks
  of foreign companies
• Foreign Equity
• Yankee stockissued by foreign firm and traded in
  the United States
• Euro stocktraded outside of home country,
  excluding the United States

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Stock Valuation

• Stock value Present value of the dividends that
  the company is expected to pay during its life.
• If the stock never pays a dividendwhether a
  regular dividend or a liquidating dividendthen
  its value is 0.

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Stock ValuationTerms
D0 the most recently paid dividend
P0 current market price
g growth rate
rs the rate of return investors require to
purchase the firms common stock
(hat) an expected valuethat is, a value that
is forecasted to occur in the future.
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Stock Valuation
Stock ownership entitles the investor to the
future cash flows, called dividends, that are
paid by the firm

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Stock Valuation
rs required return on stock

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Stock ValuationConstant Growth, g
If growth is constant such that g g1 g2
g8

Value of a constant-growth stock
Required g constant rs gt g
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Stock ValuationConstant Growth, g

• The most recent dividend paid (D0) by a firm was
  2 the firm is expected to grow at a constant
  rate (g) equal to 4 percent and the required
  rate of return (rs) on similar risk investments
  is 12 percent.

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Stock ValuationConstant Growth, g

• D0 2 g 4 rs 12

1 2.0800 2.00(1.04)1 1.8571
2 2.1632 2.00(1.04)2 1.7245
3 2.2497 2.00(1.04)3 1.6013
5 2.4333 2.00(1.04)5 1.3807
10 2.9605 2.00(1.04)10 0.9532
50 14.2134 2.00(1.04)50 0.0492
100 101.0099 2.00(1.04)100 0.0012

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Stock ValuationConstant Growth, g0
g 0

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Stock ValuationConstant Growth, g0
The preferred stock of a company pays a constant
dollar dividend equal to 4 per share. The
required rate of return on similar risk
investments is 8 percent.
Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0
8.0
12.0
Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0 80.00


Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0 80.00
8.0 50.00

Relationship between value and rs Relationship between value and rs
Required Return, rs Stock Value
5.0 80.00
8.0 50.00
12.0 33.33
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Stock ValuationNonconstant Growth
gnorm constant, or normal, growth

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Stock Valuation with Nonconstant GrowthExample
D0 1.25 g1 25 g2 20 g3 10 g4
-4 g5 5 g6 g8 rs 14
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Stock Valuation with Nonconstant GrowthExample

• D0 1.25 rs 14

25
1.3706
1.2500(1.25)
1.5625
1

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Stock Valuation with Nonconstant GrowthExample

• Because the dividends grow at a constant rate
  after Year 4, we can apply the constant growth
  model such that

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ValuationCash Flow Time Line
14
1.5625
1.8750
2.0625
1.9800
5.3778
23.10
13.6771

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Stock ValuationNonconstant Growth

• The key to computing the value of a stock that
  exhibits nonconstant growth is to assume constant
  growth occurs at some point in the futureit
  might start in five years, 50 years, or 100
  years
• Apply the constant growth model to compute the
  value of the expected dividends from that point
  forward.
• Compute the present value of the stocks value at
  the point where you assume constant growth
  begins.
• Prior to the point where constant growth begins
• Compute the dividend for each year
• Find the present value of each dividend
• Sum the PV results.

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Stock Return
Expected dividend yield
Expected growth rate (capital gains yield)
Expected rate of return



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Stock Return

• P0 30.00 D0 1.50 g 6.0

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Stock Return

• In one year, the price of the stock is expected
  to be

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Stock Return

• Because the value of the stock is expected to
  increase from 30.00 to 31.80 during the year,

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Valuation Using P/E Ratios

• P/E ratio Price EPS price multiple
• Normal P/E
• Example A firms P/E is normally 8.0x. If its
  EPS 7, then the value of its stock should be
  56 7 x 8

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Valuation Using EVA

• Economic Value Added EVA
• Earnings must be sufficient to pay those who
  provide funds to the firm otherwise the value of
  the firm should decrease.

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Stocks (Equity)Characteristics and Valuation

• What is equity?
• Stock/ownership.
• What factors affect stock prices?
• Investors change their expectations about the
  returns the firm will generate in the future.
• How are stock prices determined?
• The price is equal to the present value of the
  dividends stockholders expect to receive during
  the companys life.

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Stocks (Equity)Characteristics and Valuation

• How are stock returns determined?
• Returns are based on the dividend the company
  pays and the change in the market value of the
  stock during the year
• What techniques do investors use to value stocks?
• P/E Ratio
• Economic Value Added (EVA)