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Topic 4: Stock Valuation
Stocks defined
The importance of stock valuation Valuation Methods
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Stock Defined
Stock / securities / shares generally carries the
same meaning. In certain cases it may differs due to it type and
nature and purpose of issuances.
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Common Stock
Common stock 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 stockholders are the true owners of the firm.
Bondholders and preferred stock holders can be
viewed as creditors.
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Stock DefinedCommon stock
Initial financing for most companies typically comes
from the foundersin the form of a common stock.
Common stock is a certificate indicates ownershipin a
company. 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 stockholders are the true owners of the firm.
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Stock DefinedCommon stock
Paid-up capital : represent the (no of units stock)X (par
value common stock) which the owner of the company
invested in the company.
Par value
Par value or the initial price per unit of stock the
shareholder of the company paid to each unit of stock
(e.g; RM 1.00, 50 cent, 20 cent, 10 cent or any
amount decided by the owner of the company)
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Illustration
Company A : issue 1,000,000 units of common stock at
par value @50 cent
Shareholder 1: Mr. A bought (invest) 600,000 units and
fully paid.
Shareholder 2: Mr. B bought 400,000 units and fully paid
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Mr. A Mr. B
ABC Sdn Bhd
1 mil units@50sen
400,000 units600,000 units
Paid up capital: 1 mil units X 50 sen = RM 500K
Share holding [ Mr. A= 60% Mr. B=40%
Balance
Sheet:
Share
Capital
account
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Features of Common Stocks
Claim on income
Claim on assets
Voting rights
Preemptive rights
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Claim on Income
Common shareholders have the right to residual incomeafter bondholders and preferred stockholders have beenpaid.
Residual income can be paid in the form of dividends orretained within the firm and reinvested in the business.
Claim on residual income implies there is no upper limit onincome, but it also means that on the downside,shareholders are not guaranteed anything and may haveto settle for zero income in some years.
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Claim on Assets
Common stock has a residual claimon assets in the
case of liquidation.
Residual claim implies that the claims of debt holders and
preferred stockholders have to be met prior to commonstockholders.
Generally, if bankruptcy occurs, claims of the common
shareholders are typically not satisfied.
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Voting Rights
Most often, common stockholders are the only security
holders with a vote.
Majority of shareholders generally vote by proxy. Proxy
fights are battles between rival groups for proxy votes. Common shareholders are entitled to:
elect the board of directors
approve any change in the corporate charter
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Voting for Board of Directors
In the real world, shareholders do not really pick
the board rather they simply select from a list of
nominees chosen by the management.
This opens the door for management favoredboards, which may not be in the best interest of
shareholders.
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Preemptive Rights
Preemptive right entitles the common shareholder tomaintain a proportionate share of ownership in the firm.
Thus, if a shareholder currently owns 5% of theshares, she/he has the right to purchase 5% of theshares when new shares are issued.
These rights are issued in the form of certificates thatgive shareholders the option to buy new shares at aspecific price during a 2- to 10- week period. These
rights can be exercised, sold in the open market, orallowed to expire.
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Preferred stock is often referred to as a hybrid
securitybecause it has many characteristics of both
common stock and bonds
A class of ownership in a corporation that hasa higher claim on the assets and earnings than
common stock. Preferred stock generally has a
dividend that must be paid out before dividends to
common stockholders. The shares usually do not havevoting rights
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Hybrid nature of Preferred stocks
Like common stocks, preferred stocks
Have no fixed maturity date
Failure to pay dividends does not lead to bankruptcy
Dividends are not a tax-deductible expense Like Bonds
Dividends are fixed in amount (either as a RM amount or asa % of par value)
The followings are the characteristics of preferredstock:
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Multiple Series
If a company desires, it can issue more than one
series of preferred stock, and each series can have
different characteristics (such as different protective
provisions and convertibility rights).
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Cumulative Dividends
Cumulative feature (if it exists) requires that all past,
unpaid preferred stock dividends be paid before
any common stock dividends are declared.
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Protective Provisions
Protective provisions generally allow for voting
rightsin the event of nonpayment of dividends, or
they restrict the payment of common stock dividendsif sinking-funds payments are not met or if the firm
is in financial difficulty.
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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 stock issued today is
convertible preferred.
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Common Stock
Second right claim on assets
and dividends after
preferred stock Entitle for voting right
Can not be converted to
preferred stock
Commonly representing themajority of paid up capital
in company
Preferred Stock
First right claim on assets
and dividends
No voting right
Can be issued in series for
different purpose
Can be convertible to
common stock Only small % of company of
total paid up capital
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Purpose of valuation
Investing in capital market:
to estimate the price per
units of company listed onthe stock market
As a basis to value the
business or company for
take over of merger
As a basis for selling or
buying company / business
Purpose of valuation
For initial public offering
(IPO)
For purpose of seekingfunding
Other investment and
business purposes
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Preferred Stock: The economic or intrinsicvalue of a preferred stock is
equal to the
Example: Assume ABC Co.s preferred stock pays an
annual dividend of $3.75 and the investors required
rate of return is 6%.
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Preferred Stock:
Example: ABC Co.s preferred stock pays an annualdividend of $3.75 and the investors required rate of
return is 6%.
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Valuing Common Stock
Like bonds and preferred stock, the value ofcommon stock is equal to the present value of allfuture expected cash flows (i.e. dividends in thiscase).
However, dividends are neither fixed norguaranteed, which makes it harder to value commonstocks compared to bonds and preferred stocks.
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Dividend Model
Unlike preferred stock, common stock dividend is
not fixed.
Dividend pattern variesamong firms, but dividends
generally tend to increase with the growth incorporate earnings.
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Internal Growth
g = ROEpr
where:
g = the growth rate of future earnings and the
growth in the common stockholdersinvestment in the firm
ROE= the return on equity(net income/common book value)
pr=% of profits retained (profit retention rate)
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Dividend Valuation Model (growth model)
Value of Common stock = PV of future dividends
Vcs= D1/(rcsg)
Vcs Common stock value
D1 = dividend in year 1
rcs= required rate of return
g= growth rate
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Example: Dividend valuation model (growth model)
Consider the valuation of a common stock that paid
RM1.00 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 theinvestors required rate of return is 17%.
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Example: Dividend valuation model
1. The dividend last year was RM1. Compute thenew dividend (D1) by:
D1
= D0
(1 + g)= RM1(1 +0.10) = RM1.10
2. Vcs = D1/(rcsg)
= RM1.10/(0.170.10)= RM15.71
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Expected Rate of Return of stockholders
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
Example: If the current market price of preferred
stock is RM75, and the stock pays RM5 dividend, the
expected rate of return = RM5/RM75 = 6.67%
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Expected Rate of Return of stockholders
Common Stock Expected Return= (Dividend in year 1 / market price) + dividend growthrate= Dividend Yield + growth Rate
Example: The current market price of stock is RM90 andthe stock pays dividend of RM3 with a growth rate of 5%.
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Expected Rate of Return of stockholders
Historically, most of the returns on stocks has come
from price appreciation or capital gains.
The S&P 500 Index has returned an average annual
return of 10% since 1926, with dividend yieldaccounting for only about 2% of the return.
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`Basic model
Zero Growth Model
Variable Growth
Constant Growth Model
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The value of a share of common stock is equal to the
PV of all future cash flows (dividends)that it is
expected to provide.
where
P0 = value of common stockDt = per-share dividend expectedat the end of year tRs = required return on common stock (note: ks)
P0 = value of common stock
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The zero dividend growth model assumes that the stockwill pay the same dividend each year, year after year.
where
Dt= dividend per share at end of year t
rs= required rate of return on common stock
P0= Price or value of stock today.
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If dividend = $ 2.40 per share, g=0
r , required of return = 12 %
What is the price of the common stock?
2.40 / 0.12 = $20
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The constant-growth model is a widely cited dividend
valuation approach that assumes that dividends will grow at a
constant rate, but a rate that is less than the required return.
The Gordon modelis a common name for the constant-growth
model that is widely cited in dividend valuation.
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If dividend = $2.40 per share, g=5% annually
r , required of return = 12 %
What is the price of the common stock?
= 2.40 / (0.12-0.05)= 2.40 /0.07
=$34.28
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Variable Growth Model
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2012 Pearson Education 7-48
Step 1. Find the value of the cash dividends at the end
of each year,Dt, during the initial growth period, years
1 thoughN.
Dt=D0 (1 +g1)t
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Step 2. Find the present value of the dividends expected
during the initial growth period.
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Step 3. Find the value of the stock at the end of the
initial growth period,PN= (DN+1)/(rsg2), which is the
present value of all dividends expected from yearN + 1
to infinity, assuming a constant dividend growth rate,g2.
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Step 4. Add the present value components found in
Steps 2 and 3 to find the value of the stock,P0.
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g = the growth rate of future earnings and the
growth in the common stockholders
investment in the firm
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Dividends and Earnings Per Share
Earnings Per Share: the amount of annualearnings available to common stockholders,stated on a per-share basis
Earnings are important to stock price Earnings help determine dividend payouts