Lecture: Stock Valuation What is an investor’s required return if a PS (preferred stock) can be purchased for

Stock valuation $40 and it pays a dividend of $3.20?

value of a share of CS = PV of future cash flows Return on preferred Stock (Rps) = dividend
= PV dividends + PV of future price Stock price
= 3.20
Rights of the common stockholder: 40
1) voting: elect the board of directors (proxy) = 8%
2) pre-emptive right
*important if ur a current stockholder. Common stock valuation:
3) liquidation value 1. Book value
* last in line to receive any monies when a company is liquidating its assets. 2. Liquidation value
4) dividends 3. Market value = selling price
4. P/E (price earnings) multiple: selling price = P/E * EPS
Some firms may have different classes of common stock 5. Zero Growth = dividend
*A shares (founding shares) maybe pay a dividend required return
*B shares maybe don’t pay a dividend 6. Normal growth rate model
ex. Brookshire Hathaway have 2 different stocks A is more expensive than B shares Constant growth rate model
Preferred stock is considered a “hybrid” security with some of the following features: Gordon Model
1) cumulative: all dividends in arrears (past due) must be paid before any common stock Vcs (value of common stock) = D
dividend can be paid Rcs - g
2) participating: the preferred stockholder may share in an extra or bonus dividend with D I = next yr’s dividend
the common stockholder Rcs = required return
3) callable: the firm can notify the stockholder & force them to sell back the stock (retire g = growth rate of earnings and/or dividends
the stock) ex. What is the value of a share of CS (common stock) that has a $2.40 projected
4) convertible: the preferred stockholder may convert their preferred stock into a dividend (D ), a growth rate of 7% (g) when investors’ have a required return
specified # of common stock shares of 12% (Rcs)?
5) terms: the dividend is usually fixed & based on par Vcs = 2.40
0.12 - 0.07
*long-term securities (stocks & bonds) are traded in the Capital Markets = $48.00
*short-term securities (T-bills & commercial paper) are traded in the Money Market ex. What would happen to the stock price if investor’s required a higher return of
15%? (Y would they need a higher return?)
Primary market
Vcs = 2.40
*the first time a security is sold
0.15 - 0.07
*IOP
= $30.00
Secondary market
(as risk increases, Rcs increases resulting in a lower stock price)
*the reselling of an existing security
ex. What is the value of CS with a current (or recently paid) dividend of $3.00, a
*stockbroker
growth rate of 10% when investors’ require a return of 15%?
Preferred Stock Valuation: Vcs = 3.00 (1 + 0.10) = DI
Value of Preffered stock(Vps) = dividend = 3.30
Required return 0.15 - 0.10
Ex. What is the value of an $80 par value PS with a 9% coupon (dividend) if investors = $66.00
only require an 8.5% return? ex. What is the required return for CS that has a current dividend of $3.00, a
VPs = 0.09(80) projected growth rate of 15% that is selling for $70?
0.085 Rcs = D 1 +g D = 3.00 (1 + 0.15)
= 7.20 price =3.45
0.085 = 3.45 + .15
= $84.71 70
=0.199 = 19.9%
 What is the required return if the stock is selling for $55 a share? Dividend in yr 4 = 1.728 (1 + 0.12)
Rcs = 3.45 + 0.15 =2.709
55 = 2.71
= 0.213 or 21.3% Vcs = 2.71
7. Variable growth rate model 0.14 - 0.12
Vcs = PV dividends + PV future stock price = $135.50
=135.50(PVIF 14% @ 3 = 0.675)
What is the following stock worth to an investor?
= $91.46
*current dividend is $2.55
= 4.65 + 91.46
*projected 3 yr super normal growth rate of 25%
= $96.11
* growth rate after yr 3 to fall & remain constant at 10%
*required return of 15% Stock Valuation problems
Step 1: PV dividends during the initial growth period 1) investors require a 12 % return on Builtrite preferred stock. The stock pays a 10% dividend
t D. FVIF . D * FVIF = D PVIF Pvdiv based on the stock’s $80 par value. What is the value of the preferred stock to investors?
1 2.55 25% @ 1 = 1.250 2.55 * 1.250 = 3.19 15% @ 1 = 0.870 3.19 * 0.870 = $2.78
D. r (par value) Ups dividend
2 2.55 25% @ 2 = 1.562 2.55 * 1.562 = 3.98 15% @ 2 =0.756 3.98 * 0.756 = $3.01
= =

3 2.55 25% @ 3 = 1.953 2.55 * 1.953 = 4.98 15% @ 3 = 0.658 4.98 * 0.658 = $3.28 D
. =
. 10(80) required return
-

Step 2: FV of the stock after the initial growth period (end of yr 3)

$9.07 =
G
- -

=
$66 67
dividend in yr 4 = 4.98 (1 + 0.10) .

= 5.48
2) Builtrite common stock is currently selling for $32 & recently paid a dividend of $2.00.
Vcs = D I
The stock has a projected constant growth rate of 9%. If u purchase this stock, what is ur
Rcs - g
expected rate of return?
= 5.48
0.15 - 0.10
D =
Do(1 g) +
Ras
= $109.60 . =
Di
Step 3: PV of the future stock price
=
2 00 .
09)
(1 +

Stock price
+
8
=109.60 (PVIF 15% @ 3 yrs = 0.658) 2 00 (1 09)
=
. .

2 18
= $72.12
=
+ 0 09
.

=
2 18 32
Step 4: current value of the stock
.

9.07 + 72.12 = $81.19

=
0 068125 + 0 09
. .

=
0 155125
.

What would an investor be willing to pay for the following stock?

.

*current dividend is $1.40

=
15 8% .

*projected 3 yr super normal growth rate of 20%

3) Builtrite preferred stock pays 6.5% dividend based on a par value of $40. The stock is
*growth rate after yr 3 to fall & remain constant at 12%
currently selling at $38.50. If u purchase the stock, what is ur expected return?
*investors’ required return is 14%
t D FVIF D * FVIF = Dt PVIF Pvdiv D r (par value)
DPS
8 O
, =

1 1.40 20% @ 1 = 1.200 1.40 * 1.200 = 1.68 14% @ 1 = 0.877 1.68 * 0.877 = 1.47
2 1.40 20% @ 2 = 1.440 1.40 * 1.440 = 2.016 14% @ 2 = 0.769 2.016 * 0.769 = 1.55
= 0 065(40)
.
price
3 1.40 20% @ 3 = 1.728 1.40 * 1.728 = 2.4192 14% @ 3 = 0.675 2.4192 * 0.675 = 1.63
=
2 60 .
=
2 60 .

4.65 38 50 .

=
8 06753
.

=
6 75 %
.
4) Builtrite common stock is current selling for $56 a share & has a PE of 14. The stock also
pays a dividend of $1.80 per yr. What are the retained earnings per share?

EPS =
Stock price Retained Earnings = EPS-D
.

PE =
4 00
.
-

1 80
.

=
$2 20

-
.

=
$4
5) Given the following information, calculate the current value of the stock: Current
dividend is $2.00, projected super normal growth for 3 yrs at 30%, growth rate after yr 3
should remain constant at 12% & u want to earn a 15% annual return. What should u pay for
the stock?
PV dividends
Table I Do :
FVIf Table 3 Dt PVIF ·

t Do FVIF Da PVIF Pudiv

1 2 00 . 30% & =
1 300
.
2 00 1 . . 300 =
2 60 . 15 %& 1 =
0 .
870 . 60 0 870
2 ·
.
= 2 26
.

2 2 0030%92 = 1 690
. . 2 00 1 690
.
.
=
3 38 . 15 %22 = 0 756 . 3 38 0 756
.
·
.
= 2 56
.

32 0030% 93 2 197
.
:
.
2 00 2 197
.
.
= 4 3915 %& 3
.
=
0 6584 39
. .
.
0 . 658 = 2 89
.

.71
7

Dividends in Vr 4 =
4 . 39 (1 + 0 . 12)
=
4 9168 .

=
4 92
.

Vos =
Di
Rcs
&
-

=
4 92
.

.
15-12
=
164 00.

PV of future Stock =
164 00 (PVIF 15%& 3
.
:
0 . 658)
=
107 912 .

=
$107 91 .

Current value of stock price

=
7 71 .
+ 107 91.

=
$115 .
62
AI problmes:Stock Valuation Practice 5) A stock has just paid a dividend of $2.00. The dividend is expected to grow at a
1) ABC Corp’s preferred stock pays an annual dividend of 6.5% based on a $100 par value. If supernormal rate of 20% for 2 years, then drop to a constant 8% growth rate. If the
investors require an 8% return, what is the value of this preferred stock? investor’s required return is 12%, what is the stock’s current value?
t Do FVIf Do ·

FVIF Da : PrIf Dt PVIF =

Pudiv

D. =
r(parvalue) Ups = D
. 1 2 00
. 20 % 21 =
1 200
. 2 .
00 1 . 200 = 2 40 .
12% 91
=
0 893
. 2 40
.
·
0 893 =
. 2 14
.

065(100) required 20 %& 2 1 440 12% 92 230

=
=
0 . return 2 2 00
.
=
.
2 00.
·
1 440
.
=
2 88
.
0 . 797 2 88 0 797 :
.
:
.

4 44
0 50
.

=
.
=
6 50 .

0 . 88 Dividends Yr 3 =
D+ (1 +
g)
=
$81 25 .
=
2 .
88/1 0 08) + .

2) A share of common stock just paid a dividend of $1.80. The dividends are expected to =
3 1104
.

grow at a constant rate of 6% annually. If the current stock price is $36, what is the =
3 1)
investor’s required rate of return?
.

Vas =
Di
RCs
Do(1 g) &
-

=D price
,
D = +
Ras
&
=
1 80 (1 + 0 . 04)
=
3 11 .

2-0
.

=
1 908
.
=
1 908
08) .

+ 0 04 =
77 75
.

36
.

=
0 053 .
+ 0 0
PV of future Slock = Vcs (PVIf 12% &2 =
0 .
797)
77 75(0 797)
.

113
.

0
.
=
.

=
01 96675
.

11 3 %
=
.

=
61 97 .

3) What is the value of a share of common stock that is projected to pay a $3.50 dividend PV of future Stock
Current Value of Stock price =
+ Total of Pudiv
next year, has a 5% growth rate, and the required return is 11%? =
61 . 97 + 4 44
.

VCs = Di =
$66 41 .

Rcs-g
6) XYZ preferred stock is trading at $92 and pays a fixed dividend of $8 annually. What is
06) the expected return?

$58 33 dividend
Rps
=
=
.

Perferred Stock

4) A company’s stock is currently trading at $72 & has a P/E ratio of 18. If the dividend is =
8
$2.20 per share, what are the earnings per share (EPS) & retained earnings?
92
Eps =
Stock price
RE =
EPS-Di =
0 08495652174
.

PE
4 2 20 09
=
= -

=
.
.

=
$1 80 .
= 9%
=
4