topic 4 valuation of stock

8/14/2019 Topic 4 Valuation of Stock

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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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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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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

topic 4 valuation of stock

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