Equity markets and share valuationChapter 7

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Key concepts and skillsUnderstand how stock prices depend on future dividends and dividend growthBe able to compute stock prices using the dividend growth modelUnderstand how corporate directors are electedUnderstand how stock markets workUnderstand how stock prices are quoted

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Chapter outlineOrdinary share valuationSome features of ordinary and preference sharesThe share markets

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Cash flows for stockholdersIf you own a share of stock, you can receive cash in two ways:1. The company pays dividends.2. You sell your shares, either to another investor in the market or back to the company.As with bonds, the price of the stock is the present value of these expected cash flows.Dividends cash incomeSelling capital gains

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

One-period exampleSuppose you are thinking of purchasing the stock of Moore Oil Inc. You expect it to pay a $2 dividend in one year. You believe you can sell the stock for $14 at that time. You require a return of 20% on investments of this risk. What is the maximum you would be willing to pay?

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

One-period example (cont.)D1 = $2 dividend expected in one year R = 20%P1 = $14CF1 = $2 + $14 = $16Compute the PV of the expected cash flows

Calculator:16 [FV]; 20 [I/Y]; 1 [N]; [CPT] [PV] = -13.337-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Two-period exampleNow, what if you decide to hold the share for two years? In addition to the dividend in one year, you expect a dividend of $2.10 and a share price of $14.70 at the end of year 2. Now how much would you be willing to pay?

Calculator:CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; [NPV]; I = 20; [CPT][NPV] = $13.33

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Three-period exampleWhat if you decide to hold the stock for three years? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and a share price of $15.435. Now how much would you be willing to pay?

Calculator:CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; [NPV]; I = 20; [CPT] [NPV] = $13.33

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Developing the modelYou could continue to push back when you would sell the share.You would find that the price of the share is really just the present value of all expected future dividends.

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Stock value = PV of dividendsHow can we estimate all future dividend payments?7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Estimating dividends: Special casesConstant dividendThe firm will pay a constant dividend foreverThis is like a preference shareThe price is computed using the perpetuity formulaConstant dividend growthThe firm will increase the dividend by a constant percentage every periodSupernormal growthDividend growth is not consistent initially, but settles down to constant growth eventually

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Zero growthIf dividends are expected at regular intervals forever, this is like a preference share and is valued as a perpetuityP0 = D/RSuppose a share is expected to pay a $0.50 dividend every half-year and the required return is 10% with half-yearly compounding. What is the price?P0 = .50 / (0.1 / 2) = $10

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Constant growth stockDividends are expected to grow at a constant percentage per period.D1 = D0(1+g)1D2 = D0(1+g)2Dt = Dt(1+g)tD0 = Dividend JUST PAIDD1 Dt = Expected dividends

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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Dividend growth model (DGM)P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 +

P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + (with a constant dividend growth g)

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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DGMExample 1Suppose Outback Ltd 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, how much should the share be selling for?D0= $0.50g = 2%R = 15%

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

DGMExample 2Suppose Deep Pirates Ltd is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?D1 = $2.00g = 5%r = 20%

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Share price sensitivity to dividend growth (g)D1 = $2; R = 20%7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Share price sensitivity to required return (R)D1 = $2; g = 5%7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Example 7.3Gordon Growth Company IGordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.What is the current price?

Remember that we already have the dividend expected next year, so we dont multiply the dividend by 1+g.

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Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Example 7.3Gordon Growth Company IIWhat is the price expected to be in year 4?P4 = D4(1 + g) / (R g) = D5 / (R g)P4 = 4(1+.06)4 / (.16 - .06) = 50.50What is the implied return given the change in price during the 4-year period?50.50 = 40(1+return)4; return = 6% -40[PV]; 50.50[FV]; 4[N]; [CPT][I/Y] = 6%The price grows at the same rate as the dividends.7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Constant growth model conditions Dividend expected to grow at g forever.Stock price expected to grow at g forever.Expected dividend yield is constant.Expected capital gains yield is constant and equal to g.Expected total return, R, must be > g.Expected total return (R): = expected dividend yield (DY) + expected growth rate (g) = dividend yield + g

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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Non-constant growth problem statementSuppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the share?Remember that we have to find the PV of all expected future dividends.

7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Non-constant growth problemSolutionCompute the dividends until growth levels offD1 = 1(1.2) = $1.20D2 = 1.20(1.15) = $1.38D3 = 1.38(1.05) = $1.449Find the expected future priceP2 = D3 / (R g) = 1.449 / (.2 - .05) = $9.66Find the present value of the expected future cash flowsP0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = $8.67

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Non-constant + Constant growthBasic PV of all future dividends formula

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Dividend growth model

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Non-constant + Constant growth (cont.)7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Non-constant growth followed by constant growth7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

01.00000.95836.7083123rs=20% 8.6667 = P0g = 20%g = 15%g = 5%D0 = 1.00 1.201.38 1.449$1.449

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Quick quiz: Part 1What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?

What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return remains at 15%.

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Using the DGM to find RStart with the DGM:

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Rearrange and solve for R:

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Finding the required return ExampleSuppose a firms shares are selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return?R = [1(1.05)/10.50] + .05 = 15%What is the dividend yield?1(1.05) / 10.50 = 10%What is the capital gains yield?g = 5%

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Summary of share valuationTable 7.17-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Features of ordinary sharesVoting rightsStockholders elect directorsCumulative voting vs straight votingProxy votingClasses of shareOne share, one vote7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Features of ordinary shares (cont.)Other rightsShare proportionally in declared dividendsShare proportionally in remaining assets during liquidationPre-emptive right Right of first refusal to buy new stock issue to maintain proportional ownership if desired

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Dividend characteristicsDividends are not a liability of the firm until declared by the Board of DirectorsA firm cannot go bankrupt for not declaring dividendsDividends and taxesDividends are not tax deductible for a firmTaxed as ordinary income for individuals Dividends received by corporations have a minimum 100% exclusion from taxable income

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Features of preference sharesDividendsStated dividend must be paid before dividends can be paid to ordinary shareholdersDividends are not a liability of the firm and preference dividends can be deferred indefinitelyMost preference dividends are cumulative any missed preference dividends have to be paid before ordinary dividends can be paidPreference shares generally do not carry voting rights

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The share marketsPrimary vs secondary marketsPrimary = new-issue marketSecondary = existing shares traded among investorsDealers vs brokersDealer: Maintains an inventory Ready to buy or sell at any time Think Used car dealerBroker: Brings buyers and sellers together Think Real estate broker

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Australian Stock Exchange (ASX)Australian Stock Exchange (ASX)1987Result of amalgamation of state-based exchanges1987Introduction of Stock Exchange Automated Trading System (SEATS)1998Demutualisation of ASX2006Merger with Sydney Futures Exchange and now called Australian Securities Exchange New Zealand Stock ExchangeCreated in 19741991Introduction of Computer Based Trading SystemDemutualised in 2002

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ASX and NZX operationsOperational goal = Attract order flowBoth ASX and NZX are auction marketsAgency tradingBrokers buying and selling for clients Principal tradingBrokers buying and selling their own accountsOrdersLimit orderspecified sell/buy priceMarket orderat best market priceTrading in both ASX and NZX takes place on computer network

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Share market reportingFigure 7.27-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Work the WebClick on the information icon to go to Search for other equities like the one in the last exampleUnderstand the reported figures7-*Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

Quick quiz: Part 2You observe a share price of $18.75. You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return?What are some of the major characteristics of ordinary shares?What are some of the major characteristics of preference shares?

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Chapter 77-*

END

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al

******Note the use of Cash Flow key in calculator.

*****Remind students to adjust the rate to the period, i.e. if the dividend is paid quarterly then the discount rate must be a quarterly rate.Here D1=D2=D3=... D = constant.**Dividend growth modelA model that determines the current price of a share as its dividend next period divided by the discounted rate less the dividend growth rate.

***As the growth rate approaches the required return, the stock price increases dramatically.

*As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.

**Point out that the formula is completely general. The dividend in the numerator is always for one period later than the price we are computing. This is because we are computing a present value, so we have to start with a future cash flow. This is very important when discussing supernormal growth.

We know the dividend in one year is expected to be $4 and it will grow at 6% per year for four more years. So, D5 = 4(1.06)(1.06)(1.06)(1.06) = 4(1.06)4

***Point out that P2 is the value, at year 2, of all expected dividends from year 3 on.The final step is exactly the same as the 2-period example at the beginning of the chapter. We can look at it as if we buy it today, receive the $1.20 dividend in 1 year, receive the $1.38 dividend in 2 years and then immediately sell it for $9.66.

***The example from the textbook with its time line can also be used to explain this slide. **Point out that D1 / P0 is the dividend yield and g is the capital gains yield.

***Shareholders have the right to vote for the board of directors and on other important issues.Cumulative voting increases the likelihood of minority shareholders getting a seat on the board.

Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote.

Different classes of stock can have different rights. Owners may want to issue a non-voting class of stock if they want to make sure that they maintain control of the firm.

Australian and New Zealand stock markets do not allow for more than one type of ordinary share and each share has one vote.**Dividend exclusion: If corporation A owns less than 20% of corporation B stock, then 30% of the dividends received from corporation B are taxable. If A owns between 20% and 80% of B, then 20% of the dividends received are taxable. If A owns more than 80%, a consolidated statement can be filed and dividends received from B are essentially untaxed.

***SEATSThe computer network allowing brokers to place buy and sell orders and to execute transactions electronically.*The term order flow means the flow of customer orders to buy and sell shares. The customers of the ASX are the millions of individual investors and tens ofthousands of institutional investors who place their orders to buy and sell shares in ASX-listed companies.*Sample share market quote from Sydney Morning Heralds website .

The quote on the left reports the last sale price, the change in last sale price from the previous closing price with date and time of the price and a graph showing change in price over the day.

The middle column reports the opening price and the high and low price of the day.

The final column gives the other fundamentals of the stock, such as volume, or number of shares sold over the day, and value, or total value of shares traded over the day, followed by ratios such as Price to earning and EPS.

A good website at which to get share prices is .

**r = [1.5(1.05)/18.75] + .05 = 13.4%

**