Stock Valuation

1. Steve Paulone Facilitator Stock Valuation

2. Features of Stock (Equity) • Like bonds, stocks are securities that corporations issue to raise capital to invest in the firm. Stocks represent an equity ownership in the firm. When I purchase 100 shares of Coca Cola, I am an owner of the company. However, unlike bonds, stocks have no final maturity and the corporation has no obligation to pay interest or dividends. As a shareholder I am entitled to a residual interest in the earnings of the firm. Residual earnings are the earnings that are left over after all obligations including interest payments to debt holders and tax payments have been met.

3. Features of Common Stock • Shareholders have the right to elect corporate directors who set corporate policy and select operating management. • Other rights usually include: 1. Sharing proportionately in dividends paid 2. Sharing proportionately in any liquidation value 3. Voting on matters of importance (e.g., mergers) 4. The right to purchase any new stock sold – the preemptive right • Dividends – return on shareholder capital. 1. Payment of dividends is at the discretion of the board. A firm cannot default on an undeclared dividend, nor can it be forced to file for bankruptcy because of nonpayment of dividends. 2. Dividends are not tax deductible for the paying firm. 3. Dividends received by individuals are taxed based on the holding period of the stock (see the Bonus Tip below), while dividends received by a corporation are at least 70% tax-exempt.

4. Features of Preferred Stock • Preferred stock has precedence over common stock in the payment of dividends and in liquidation. Its dividend is usually fixed and the stock is often without voting rights. The stated value is the value paid to preferred stockholders in the event of liquidation. • Cumulative dividends – current preferred dividend plus all arrearages (unpaid dividends) to be paid before common stock dividends can be paid. Non-cumulative dividend preferred does not have this feature. • Preferred stock represents equity in the firm, but has many features of debt, including a stated yield, preference in terms of cash flows and liquidation, and some issues are callable and/or convertible into common shares.

5. Valuing Stocks When valuing stocks, we use the same analytical techniques that we use to value bonds, namely, we calculate the present value of future cash flows. However, stocks are harder to value because the future cash flows are not precisely known. With bonds we have a know cash flow schedule. Interest payments are pre-determined and the final maturity is known. Assuming the issuer does not default, we will get our money back plus interest. This is not the case with stocks. As anyone who has ever invested in stocks knows, the value can fluctuate widely. Dividend payments can be reduced or be eliminated altogether and in the case of bankruptcy investors can lose their entire investment with no recourse to the issuer. In reality, most large corporations pay at least a small dividend. Dividends represent the primary cash flow from stocks. The other source of cash flow is the proceeds from the sale of the stock at some point in the future.

6. Valuing Stock • To illustrate the concept of valuing stock let’s first discuss the idea of return and then work through a simple example. • The return on a stock is equal to the total dividend payments I receive plus capital gains. Capital gains are the difference between what I buy a stock for and what I sell it at. We can express the return for a stock in percentage form as follows: Return = D1 + (P1-P0) P0 Where: D1 is the annual dividend, P1 is the future selling price, and P0 is the purchase price

7. Valuing Stock For example, suppose I buy one share of stock at $10 per share. The stock pays a $1.00 dividend. If I sell the stock one-year from now at 11.00 per share my return would be: R = 1.00 + (11- 10) 10 R = 2.00 10.00 R = .20 or 20 %

8. Valuing Stocks • Now that we have an idea of return let’s look at how to value a stock. Assume I want to buy 1 share of Proctor and Gamble Stock. P & G pays a dividend of 1.40 per share and currently sells for $ 80 per share. I estimate that in three years I can sell P & G for $100 per share. The cash flows will look like this: T0 T1 T2 T3 ? 1.40 1.40 1.40 + 100 • Now let’s assume that the minimum return I would expect from investing in P & G stock would be the historical market rate of return which is about 12%. Twelve per cent is my required rate of return and it is the rate we will discount our future cash flows at. How the required return is derived is beyond the scope of this course. However, the required rate of return should reflect the minimum rate of return I would expect to compensate me for the time value and risk of holding the stock.

9. Valuing Stocks Taking the present value of our cash flows at 12 % T0 T1 T2 T3 ? 1.40 1.40 1.40 + 100 1.12 (1.12) ^2 (1.12) ^3 ? = 1.25 + 1.12 + 72.17 = 74.54 We see that the value of a share of Proctor and Gamble stock is equal to the present value of the future dividend payments plus the proceeds I receive when I will sell it in three years. The present value in this case is $74.54, which is less than the $80 price the stock is selling for. Thus the market price is trading dear to the estimated present value of the stock. In this case paying $80 for a stock that I think is worth $74.54 wouldn’t make sense, unless there are extraneous circumstances that justify the higher price. Our basic stock valuation model can be refined to accommodate a number of situations unique to stocks. These are detailed on pages 240-243 of our text.

10. Valuing Stocks The primary adjustment we have to make with stocks is to account for the growth rate of dividends. Most companies like to increase their dividends in line with increases in earnings. The general case of the constant growth dividend discount model is: Po = D1 (r-g) Where: Po = the current stock price D1 = the next scheduled dividend r = required rate of return g = the expected growth rate of dividends Using our earlier example of Proctor and Gamble stock, I can value this stock using the constant growth dividend discount model. It is applied as follows: Current Dividend: $1.40 Constant growth rate 10% Discount rate 12% Po = (1.40)1.10 .12-.10 Po = 1.54 .02 Po = $77

11. Valuing Stocks • The value of a stock, as with any financial asset, is equal to the present value of the sum of the future cash flows. • We often hear stocks quoted in terms of their price earnings ratios or P/E. The price earnings ratio is the ratio of the stocks selling price to the latest or next period’s forecasted earnings per share or EPS. The price earnings ratio is a convenient way to estimate the value of a stock. Stocks that sell for higher P/E’s have higher earnings growth prospects while low P/E’s stocks have lower growth prospects for future earnings. Note: the P/E ratio is not inconsistent with our basic valuation model. Both models relate the price of the stock to a valuation of future earnings. Most professional analysts will use both the PE ratio and present value analysis to arrive at value for a stock.

12. Valuing Stocks Capital is for the purchase of assets that provide for streams of revenue. These revenues streams must be profitable. As a matter of fact they have to cover the cost of the capital and return to the company a profit equal to a reasonable growth rate for the company. That is why cost of capital is closely related to shareholder return which is linked to a reasonable growth rate and risk to the shareholder of getting the returns.