Keown Chapter 8 Ppt

Chapter 8

Stock Valuation

Financial ManagementFinancial ManagementArthur J. KeownArthur J. Keown John D. MartinJohn D. MartinJ. William PettyJ. William Petty David F. Scott, Jr.David F. Scott, Jr.

Chapter 8 Valuation and Characteristics of Stocks

Pearson Prentice HallFoundations of Finance8 - 2

Learning ObjectivesLearning Objectives

Identify the basic characteristics and Identify the basic characteristics and features of preferred stock.features of preferred stock.

Value Preferred Stock.Value Preferred Stock. Identify the basic characteristics and Identify the basic characteristics and

features of common stock.features of common stock.



Learning ObjectivesLearning Objectives

Value common stock.Value common stock.

Calculate a stockCalculate a stock’’s expected rate s expected rate of return.of return.



Principles Used in this ChapterPrinciples Used in this Chapter

• Principle 1Principle 1: The Risk-Return Trade-off : The Risk-Return Trade-off –– We WonWe Won’’t Take on Additional Risk Unless t Take on Additional Risk Unless We Expect to Be Compensated with We Expect to Be Compensated with Additional Return.Additional Return.

• Principle 2Principle 2: The Time Value of Money : The Time Value of Money –– A A Dollar Received Today is Worth More Dollar Received Today is Worth More Than a Dollar Received in the FutureThan a Dollar Received in the Future

• Principle 3Principle 3: Cash-Not Profits-Is King.: Cash-Not Profits-Is King.



StockStock

• Two types:Two types:– Preferred and commonPreferred and common



Preferred StockPreferred Stock

• Preferred stock is often referred to as a Preferred stock is often referred to as a hybrid securityhybrid security because it has many characteristics of both common stock because it has many characteristics of both common stock and bonds.and bonds.

• Like common stocksLike common stocks– No fixed maturity dateNo fixed maturity date– Failure to pay dividends does not bring on bankruptcyFailure to pay dividends does not bring on bankruptcy– Dividends are not deductible Dividends are not deductible

• Like BondsLike Bonds– Dividends are for a limited timeDividends are for a limited time



Features of Preferred StocksFeatures of Preferred Stocks

• Multiple series of preferred stockMultiple series of preferred stock• Preferred stockPreferred stock’’s claim on assets and s claim on assets and

incomeincome• Cumulative dividendsCumulative dividends• Protective provisionsProtective provisions• ConvertibilityConvertibility• Retirement FeaturesRetirement Features



Claim on Assets and IncomeClaim on Assets and Income

• Preferred stock has priority over Preferred stock has priority over common stock with regard to claim on common stock with regard to claim on assets in the case of bankruptcy.assets in the case of bankruptcy.

• Honored before common stockholders, Honored before common stockholders, but after bonds.but after bonds.

• Must pay dividends to preferred Must pay dividends to preferred stockholders before it pays common stockholders before it pays common stockholder dividends.stockholder dividends.



Cumulative DividendsCumulative Dividends

• Cumulative features require that all Cumulative features require that all past, unpaid preferred stock past, unpaid preferred stock dividends be paid before any dividends be paid before any common stock dividends are common stock dividends are declared.declared.



Protective ProvisionsProtective Provisions

• Protective provisions generally Protective provisions generally allow for voting rights in the event allow for voting rights in the event of nonpayment of dividends, or of nonpayment of dividends, or they restrict the payment of they restrict the payment of common stock dividends if sinking-common stock dividends if sinking-funds payments are not met or if funds payments are not met or if the firm is in financial difficulty.the firm is in financial difficulty.



ConvertibilityConvertibility

• Convertible preferred stock can, at the Convertible preferred stock can, at the discretion of the holder, be converted discretion of the holder, be converted into a predetermined number of shares into a predetermined number of shares of common stock.of common stock.

• Almost one-third of preferred issued Almost one-third of preferred issued today is convertible preferred. today is convertible preferred.

• Reduces the cost of the preferred stock Reduces the cost of the preferred stock to the issueto the issue



Retirement FeaturesRetirement Features

• Although preferred stock has no set Although preferred stock has no set maturity associated with it, issuing maturity associated with it, issuing firms generally provide for some firms generally provide for some method of retiring the stock.method of retiring the stock.



Callable PreferredCallable Preferred

• A call provision entitles a company to A call provision entitles a company to repurchase its preferred stock (or bonds) repurchase its preferred stock (or bonds) from their holders at stated prices over from their holders at stated prices over a given time period.a given time period.

• Call feature usually involves an initial Call feature usually involves an initial premium of 10% above par valuepremium of 10% above par value

• Premium declines over timePremium declines over time• Allows the issuing firm to plan for the Allows the issuing firm to plan for the

retirement of its preferred stock at retirement of its preferred stock at predetermined prices.predetermined prices.



Sinking-Fund ProvisionSinking-Fund Provision

• Sinking-fund provision requires the Sinking-fund provision requires the firm to set aside an amount of firm to set aside an amount of money periodically for the money periodically for the retirement of its preferred stock.retirement of its preferred stock.

• Money used to purchase the Money used to purchase the preferred stock in the open market preferred stock in the open market or to call the stock, whichever or to call the stock, whichever method is cheaper.method is cheaper.



Valuing Preferred StockValuing Preferred Stock

• The value of a preferred stock is The value of a preferred stock is the present value of all future the present value of all future dividends.dividends.

• Calculate the value of preferred Calculate the value of preferred stock:stock:= Annual dividend / required rate of = Annual dividend / required rate of

returnreturn



Valuing Preferred StockValuing Preferred Stock

VVpsps= = annual dividendannual dividend = = DD

required rate of return krequired rate of return kpsps

Example: Xerox’s Series C preferred stock Example: Xerox’s Series C preferred stock pays an annual dividend of $6.25 and the pays an annual dividend of $6.25 and the investors required rate of return is 5%.investors required rate of return is 5%.

VVpsps= = D D = = $6.25 $6.25 = $125.00= $125.00

kkpsps 0.050.05



Common StockCommon Stock

• Certificate that indicates ownership Certificate that indicates ownership in a corporationin a corporation

• Common stockholders are the true Common stockholders are the true owners of the firmowners of the firm



Common StockCommon Stock

• Common stock is a certificate that indicates Common stock is a certificate that indicates ownership in a corporation.ownership in a corporation.

• Has no maturity dateHas no maturity date• No upper limit on dividendsNo upper limit on dividends• Dividend payments must be declared each Dividend payments must be declared each

period (usually quarterly) by the firmperiod (usually quarterly) by the firm’’s board of s board of directors.directors.

• In the event of bankruptcy, common In the event of bankruptcy, common stockholders will not receive any payment until stockholders will not receive any payment until the creditors, including the bondholders and the creditors, including the bondholders and preferred stockholders, have been satisfied.preferred stockholders, have been satisfied.



Features of Common StockFeatures of Common Stock

• Claim on incomeClaim on income• Claim on assetsClaim on assets• Voting rightsVoting rights• Preemptive rightsPreemptive rights• Limited liabilityLimited liability



Claim on IncomeClaim on Income

• Common shareholders have the Common shareholders have the right to residual income after right to residual income after bondholders and preferred bondholders and preferred stockholders have been paid.stockholders have been paid.

• Can be in the form of dividends or Can be in the form of dividends or retained earnings. retained earnings.



Claim on AssetsClaim on Assets

• Common stock has a residual claim Common stock has a residual claim on assets after claims of debt on assets after claims of debt holders and preferred stockholders.holders and preferred stockholders.

• If bankruptcy occurs, claims of the If bankruptcy occurs, claims of the common shareholders generally go common shareholders generally go unsatisfied.unsatisfied.



Voting RightsVoting Rights

• Common shareholders are entitled Common shareholders are entitled to elect the board of directorsto elect the board of directors

• Most often are the only security Most often are the only security holders with a voteholders with a vote

• Can approve any change in the Can approve any change in the corporate chartercorporate charter



Voting RightsVoting Rights

• Voting for directors and charter changes occur Voting for directors and charter changes occur at the corporationat the corporation’’s annual meeting.s annual meeting.

• A A proxy proxy gives a designated party the gives a designated party the temporary power of attorney to vote for the temporary power of attorney to vote for the signee at the corporationsignee at the corporation’’s annual meeting.s annual meeting.

• Proxy fights - battles between rival groups for Proxy fights - battles between rival groups for proxy votes.proxy votes.

• Cumulative voting - each share of stock allows Cumulative voting - each share of stock allows the stockholder a number of votes equal to the the stockholder a number of votes equal to the number of directors being elected.number of directors being elected.



Preemptive RightsPreemptive Rights

• Preemptive right entitles the common Preemptive right entitles the common shareholder to maintain a proportionate shareholder to maintain a proportionate share of ownership in the firm.share of ownership in the firm.

• Rights - certificates issued to the Rights - certificates issued to the shareholders giving them an option to shareholders giving them an option to purchase a stated number of new shares purchase a stated number of new shares of stock at a specified price during a of stock at a specified price during a two- to ten-week period.two- to ten-week period.



Limited LiabilityLimited Liability

• Liability of the shareholder is Liability of the shareholder is limited to the amount of their limited to the amount of their investment.investment.

• Limited liability feature aids the Limited liability feature aids the firm in raising funds.firm in raising funds.



Valuing Common StockValuing Common Stock

• Two Methods:Two Methods:– Present value of all future Present value of all future

dividendsdividends– Free cash flow methodFree cash flow method



Present Value of Future DividendsPresent Value of Future Dividends

• Growth factorGrowth factor– Infusion of capitalInfusion of capital

•Financing, debt, common stockFinancing, debt, common stock

– Internal growthInternal growth•Management retains some or all of Management retains some or all of

the firmthe firm’’s profits for reinvestment in s profits for reinvestment in the firmthe firm



Internal GrowthInternal Growth

gg= = ROEROE x x rrWhereWhere gg = = the growth rate of future earnings the growth rate of future earnings

and the growth in the common and the growth in the common stockholder stockholder’’s investment in the s investment in the firm firm ROEROE = the return on equity = the return on equity (net income/common book value)(net income/common book value) rr = = the company the company’’s percentage ofs percentage of profits retained - profits retained - profit retention profit retention rate rate



Valuing of Common StockValuing of Common Stock

• Dividend Valuation Method:Dividend Valuation Method:Common stock value =Common stock value =

•dividend in year 1 / (required rate of dividend in year 1 / (required rate of return return –– growth rate) growth rate)




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

Dividends are expected to grow at 10% Dividends are expected to grow at 10% and the investors required rate of return and the investors required rate of return is 15%.is 15%.




1.1. The dividend last year was $2. The dividend last year was $2. Compute the new dividend by:Compute the new dividend by:

DD11 = D = D00((1+1+g)g)

= $2(= $2(1+.10)=$2.201+.10)=$2.20

2. 2. VVcscs= D= D11/ (k/ (kcs cs – g)– g)

= $2.20/(.15-.10)= $2.20/(.15-.10)

= $44= $44




• Free Cash Flow Method:Free Cash Flow Method:Shareholder value = firm value Shareholder value = firm value –– debt / number of shares outstandingdebt / number of shares outstanding•Where firm value is the present value Where firm value is the present value

of free cash flows discounted a the of free cash flows discounted a the companycompany’’s cost of capitals cost of capital



Expected Rate of ReturnExpected Rate of Return

• The expected rate of return on a The expected rate of return on a security is the required rate of return of security is the required rate of return of investors who are willing to pay the investors who are willing to pay the market price for the security.market price for the security.

• Preferred Stock Expected Return:Preferred Stock Expected Return:– Annual dividend/market priceAnnual dividend/market price

• Common Stock Expected ReturnCommon Stock Expected Return– (Dividend in year 1 / market price) + (Dividend in year 1 / market price) +

dividend growth ratedividend growth rate

Keown Chapter 8 Ppt

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