FIN2014 FINANCIAL

MANAGEMENT

LECTURE 3
Share Valuation
 RECAP FROM PREVIOUS LECTURE

 Characteristics of bonds
 Bond is a form of long-term debt financing used by companies
 Bond valuation & introduction to conversion bond
 Credit ratings and yield can affect the cost of capital for a firm
 The relationship between bond price and interest rates
 Learning Objectives

1. Understand the characteristics of equity and be able to compare the difference with
debt (bonds)
2. Be able to understand and compare the difference between common stocks and
preferred stocks
3. Understand all four dividend valuation models and calculate three valuation models
 Dividend Discount Model (DDM)
 Zero growth dividend model
 Constant growth dividend model
 Two-stage dividend growth model
4. Understand and explain the trade-offs between dividends & investments and growth
5. Understand the rationale behind total payout model and be able to calculate it
 Characteristics of equity

 Shareholders are the equity owners of the company.

 Permanent in nature
 Equity ownership is transferable
 Equity holders are entitled to dividends payments
 Cost of equity ( measures the returns demanded by investors who are part of the
company’s ownership structure.
 Shareholders (equity holders) can be further categorized into two type
(1) Common shareholders
(2) Preferred shareholder
 Characteristics of
common shares Common shares

 Common shares represents ownership in the company

 Voting privileges are primary characteristic of common shares
 Have a say in electing Board of Directors
 Corporate policies
 When a company faces bankruptcy, common shareholders are the last in line to
claim assets
Hierarchy of a company’s asset claim in bankruptcy: (1) Debt/Bondholders
(2) Preferred stockholders  (3) common stockholders 
Characteristics of
preferred stocks
Preferred stock: Why is preferred stock called “preferred”?

 Also refers to ownership or equity in a firm

 Have a higher claim to fixed dividends compared common stockholders
 Preference means only that the holder of the preferred shares must receive a dividend before
common stockholders are entitled to anything
 Companies issue preferred shares to manage balance sheets
 Issuing preferred shares can help a company achieve a lower debt-to-equity ratio compared to
issuing debt (as it has hybrid features of bond & equity)
 In the event of a liquidation (bankruptcy), preferred stockholders have priority to claim to
assets
 Hierarchy of a company’s asset claim in bankruptcy: (1) Debt/Bondholders (2) Preferred
stockholders  (3) common stockholders
Characteristics of
preferred stocks Preferred stock: Why is preferred stock called “preferred”? (con’t)

Preferred shareholders does not have voting rights

In exchange for dividend-first privileges, preferred shareholders does not have
a say in electing the Board of Directors of changes in corporate policies
Voting rights are privileges exclusive to common stockholders
 Valuing a common stock cash flow vs bond cash flow

 Shares are more difficult to value than a bond for several reasons
 Promised cash flows are not known in advance.
 Life of the investment is forever (because no maturity) – The formal term used is
“perpetuity”
 Rate of return required by market not easily observed, uses cost of equity (more on
this in Week 9)
Characteristics of stocks
Sources of capital
Capital

Debt Equity
(Week 2)
(1) Internal
(2) External

Retained Earnings
Issue shares
Used for:
• Common shares
• Dividend's payouts
• Preferred shares
• Re-Investments
(more positive NPV
projects)
Dividend Valuation
models
Basic: Dividend Discount Model (DDM)

• There are two potential sources of cash flow from owning a stock
(1) Dividend
(2) Potential cash flows in the future

Future dividend payment + stock price is

1-year investor not known with certainty

0 1 𝐷𝑖 𝑣 1 + 𝑃 1
𝑃0=
1+𝑟 𝑒

− 𝑃0 𝐷𝑖 𝑣 1+ P1
Because both future dividend & stock price not known with
certainty, we discount with equity cost of capital , not risk-free
rate. Uncertainty = risk
 Dividend Valuation Dividend yields, capital gain, and total returns
models

𝐷𝑖𝑣 1 + 𝑃 1 𝐷𝑖𝑣 1 𝑃 1 − 𝑃 0
𝑟 𝐸= − 1= +
𝑃0 𝑃0 𝑃0

Dividend Capital Gain Rate

yield
Dividend yield
• The expected annual dividend of the stock divided by its current price
• The dividend yield is a percentage return the investors expects to earn from the dividend paid by the stock

Capital gain rate

• Capital gain is what the investor will earn on the stock, which is the difference between the expected sale price and
purchase price from the stock price When we divide the capital gain by the stock price to express the capital gain as a
percentage return, it is called capital gain rate

Total return
• Dividend yield + capital gain rate = total return
• Total return is the expected return that investor will earn for a one-year investment in the stock
• Therefore, the stock’s total return should equal the equity of capital (
 Dividend Valuation
models
Example: Stock prices and returns (1 year)

Suppose you expect Walgreens Boots Alliance (a drugstore chain) to pay dividends of $1.60 per share and
trade for $70 per share at the end of the year. If investments with equivalent risk to Walgreen’s stock have
an expected return of 8.5%, what is the most you would pay today for Walgreen’s stock? What dividend
yield and capital gain rate would you expect at this price?

Using the equation

𝐷𝑖 𝑣 1 + 𝑃 1 1.60 +70.00
𝑃0= = = $ 65.99
1+𝑟 𝐸 1+ 0.085

At this price, Walgreen’s dividend yield is . The expected capital gain is $70.00 - $65.99 = $4.01 per share,
for a gain rate of 4.01/65.99 = 6.08% Therefore at this price, Walgreen’s expected total return is 2.42% +
6.08% = 8.5%, which is equal to its equity cost of capital.
Question

According to a recent report by OECD (2022), The war in

Ukraine was a massive and historic energy shock” to the
market. The “shock” of the war heavily impacted the steel, oil
and energy markets.

Could the companies’ share price in these sectors potentially fall into
negative terrority as its liabilities surpass its assets?
- If liabilities > assets  leads to insolvency or bankruptcy
- Company’s performance affects share price  poor performance  falling share price
- A company’s share price cannot fall into the negative territory
- The lowest a share price could fall is zero  company is worthless
Dividend Valuation
models Valuation methods

Dividend valuation
methods

1. Dividend Discount 2. Zero growth 3. Constant growth 4. Two stage dividend

Model (DDM) dividend model model growth model
Dividend Valuation
models
1. Dividend Discount Model (DDM)

 Cash flows from owning a share of stock comes in the form of future dividends
• DDM estimates the value of a stock as the present value of all expected future
dividend payments

𝐹𝑉
𝑃𝑉 = 𝑛
(1+ 𝑖)

+ ...
Dividend Valuation
models
(1) Dividend Discount Model (DDM)

Wakanda Corp expects to pay dividends of $12/share, $13/share, $14/share,

$16/share in the following 4 years. What is the present value of the stock? Discount
rate is 14%.

= 14%

= $39.45/share
Dividend Valuation
models 2. Zero Growth Dividend Model

• Stocks with dividends with zero growth

• Assumes that the dividend will stay the same

• Adverse economic conditions may force companies to stop increasing dividends. Other
factors like weak global growth, political uncertainty have an impact on company’s
profitability
• Case-in-point: Covid-19 Pandemic

•It is the constant dividend payout amount (D) divided by the required rate of return (r)

𝑫𝒊𝒗
𝑷 𝒐=
𝒓𝒆
Dividend Valuation
models 3. Constant Dividend Growth

• Also known as Gordon Growth Model

• Assumes a stable dividend growth in dividends year after year

𝐷𝑖 𝑣 1
𝑃𝑜=
𝑟 𝑒 −,growth
𝑔 denoted with g

𝐷𝑖 𝑣 1
𝑟𝑒= +𝑔
𝑃0

The value of the firm depends on the current dividend level, cost of equity and the growth
rate

The expected dividends are a constant growth, perpetuity. Dividend grow at a constant rate
g, forever
Dividend Valuation
models
3. Constant dividend growth

Starbucks plans to pay $0.46 per share in dividends in the coming years. It's cost of
equity is 9%. Its dividends are expected to grow by 7% per year in the future. Estimate
the value of Starbucks’ stock

=$23
Dividend Valuation
models What happens when growth rates are not constant?

• Comprises of two parts and assumes that dividends will go through two stages of
growth
• First stage – Dividends grows by a constant rate for a set amount of time
• Second stage – Dividend is assumed to grow at a different rate for the remainder
of the company’s life

•Measures intrinsic value of a company undergoing rapid expansion

• E.g., newer companies
• First stage is generally more aggressive, characterized with a higher growth rate
• Second stage assumes a lower, stable rate of dividend growth
•Also known as Two-stage dividend growth model (change in growth rates)
 Dividend Valuation
models Two stage dividend growth model

• The two-stage dividend growth model assumes firm will initially grow at a rate
for T years, then it will grow at a rate < during a second stage of growth into
perpetuity

Where,
Dividend Valuation
models Two stage dividend growth model

Sneezy Sneakers Inc. will pay an annual dividend of $0.65 one year from now. Analyst
expect this dividend to grow at 12% per year thereafter until the fifth year. After that, the
growth will level off at 2% per year. According to the dividend discount model, what is the
value of Sneezy’s stock if the firm’s equity cost of capital is 8%

$0.6
51 2
0 3 4 5 6 ……

𝒈𝟏 𝒈𝟐
Dividend Valuation 𝑫𝒊 𝒗 𝟏=$ 𝟎 . 𝟔𝟓∨𝒓 𝒆 =𝟖 % ∨ 𝐠𝟏 =𝟏𝟐 % ∨ 𝐠𝟐 =𝟐 %
models

In order to calculate the fair value of the security, we

5 yearsusing the formula given below

Step 1: Calculate the value of dividends paid at the end of ____

𝑭𝑽 ( 𝑺𝒊𝒏𝒈𝒍𝒆 𝑪𝑭 )=𝑪 (𝟏+ 𝒓 )𝒏

Dividend Valuation
models

Step 2: Calculate the value of the security at𝑃

using
5 the formula given below:

Calculate
Dividend Valuation
models

Step 3: Lastly, we calculate the value of the security using the following formula given below:

Stage Stage
1 2

Therefore, the value of Sneezy’s security is _

 Retained Earnings:
Dividend vs Investment
& Growth Dividends versus Investment and Growth

A company frequently asks important questions on the use of its retained

earnings

Should the company payout dividends to shareholders OR should

they hold on to the earnings for investments and growth expansion?

If a firm wants to increase share price, it should consider reducing its dividend
payout and reinvest in firms’ investment (only if the project generates positive
cash flows)
 Retained Earnings:
Dividend vs Investment
Dividend versus Investment & Growth: The
& Growth trade off

 To maximize firm share price, firms would like to increase both current dividend level and the
expected growth rate,
 However, firms often face a trade-off: Increasing growth may require investments, and money spent
on investments cannot be used to pay dividends

What determines the growth rate of a firm’s dividends?

• The dividend each year is equals to the firm’s earnings per share (EPS) multiplied by its dividend
payout rate

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑠𝑡
𝐷𝑖 𝑣 𝑡 = × 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡 𝑒 𝑡
𝑆h𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛 𝑔𝑡

𝐸𝑃 𝑆𝑡
 Retained Earnings:
Dividend vs Investment Dividend versus Investment & growth
& Growth

Assuming the number of shares outstanding remains constant, the firm can increase its
dividends in three ways:
(1) It can increase its earnings
(2) It can increase its dividend payout rate
(3) It can decrease its share outstanding

A firm can do one of two things with its earnings

(4) It can give them out to investors
(5) Firm can retain the earnings and reinvest them

𝑔=𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛𝑟𝑎𝑡𝑒 × 𝑟𝑒𝑡𝑢𝑟𝑛𝑜𝑛 𝑛𝑒𝑤𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠

 Retained Earnings:
Dividend vs Investment Dividend versus Investment Growth (con’t)
& Growth

If a firm wants to increase its share price, should it-

(1) reduce its dividend payout and invest more? or.,
(2) Should it cut investment and increase its dividend?

The decision depends on the profitability of the firm’s investments.

 Cutting the firm’s dividend to increase investment will raise the stock price if, and
only if, the new investment have a positive NPV
 Retained Earnings:
Dividend vs Investment
Example: Dividend versus Investment
& Growth Growth

Karuna Inc. is considering expanding into developing a new product line of Tasty Spices. Earnings per share was
$3 this year and is expected to grow annually at 4% without this new product line.

However, growth is anticipated to increase to 6% if the Tasty Spices were introduced. To finance this expansion,
Karuna would need to cut its dividend payout from 75% to 35%. If Karuna’s equity cost of capital is 14%, what
would be the impact on Karuna’s stock price if they introduce the new product?
𝒈 =𝟒 % 𝒈 =𝟔 %
Formula Without new product With new product line
line
𝐸𝑃 𝑆0 (1+ 𝑔) $ 3 ×1.04=$ 3.12 $3 × 1.06=$3.18
𝐸𝑃 𝑆1 × 𝐷𝑃𝑂 $ 3.12 ×0.75=$ 2.34$ 3.18 × 0.35=$ 1.11
𝐷1 $ 2.34 $ 1.11
𝑃0= =$ 23.4 = $ 13.88
𝑟 𝑒− 𝑔 0.14 − 0.04 0.14 − 0.06
 Question Dividend versus Investment Growth

Should Karuna Inc. pursue this investment? Explain why.

No. The share price will fall if Karuna pursues this new investment.

Why?

• Fall in share price when a project is announced can reflect loss of investor
confidence and a drop in share price due to an increase in perceived business risk.
• For example, investors may perceive the project as too risky as it is not
in line with the company’s core competencies.
• If the company pursues this unprofitable venture, it will strain the company’s
financial resources to potentially undertake more profitable projects in the future.

• In this case, Karuna Inc. is better off paying the dividend than investing in this project.
Total Payout Model
Valuation with share Share repurchase
repurchase

 The Dividend Discount Model assumes that any cash paid out by the firm to shareholders
are in the form of a dividend.
 However, some firms replace dividend payouts with share repurchase

Implications of share repurchase for Dividend-Discount Model

 Share repurchase
 Firm uses excess free cash flow to purchase its own stock
 Reasons to do so: To reduce the amount of shares outstanding, which increases its
earnings per share and dividend per share
 The more cash the firm uses to repurchase shares, the less it has available to pay
dividends
Total Payout Model
Valuation with share Total Payout: An alternative method
repurchase

 A more reliable method to consider when a firm repurchase shares is the total
payout model
 Values all of the firm’s equity, rather than a single share

To do so, we can discount the total payouts that the firm makes to shareholders,
which is the total amount spent on both dividends and share repurchase. Then we
divide by the current number of shares outstanding to determine the share price

𝑃𝑉 ( 𝐹𝑢𝑡𝑢𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐h𝑎𝑠𝑒)

𝑃0=
𝑆h𝑎𝑟𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛 𝑔0

• This method is more reliable and easier to apply when firms use share repurchases
Total Payout Model
Valuation with share Example: Total payout model
repurchase

Valuation with Share Repurchase

 Titan Industries has 217 million shares outstanding and expects

earnings at the end of this year of $860 million. Titan plans to pay out
50% of its earnings in total, paying 30% as a dividend and using 20%
to repurchase shares. If Titan’s earnings are expected to grow by 7.5%
per year and these payout rates remain constant, determine Titan’s
share price assuming an equity cost of capital of 10%.
 Total Payout Model
Valuation with share
repurchase

Titan will have a total payout this year of . Based on the equity cost of capital 10% and expected earnings growth of ,
the present value of Titan’s future payouts can be computed as a constant growth perpetuity

$ 430 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑃𝑉 ( 𝐹𝑢𝑡𝑢𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐h𝑎𝑠𝑒 )0.10
=¿ −0.075 =$ 17.2𝑏𝑖𝑙𝑙𝑖𝑜𝑛

This value represents the total value of Titan’s equity ([Link] capitalization). To compute the share
price, we divide the current number of shares outstanding:

$ 17.2 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
𝑃0= = $ 79.26 𝑝𝑒𝑟 𝑠h𝑎𝑟𝑒
217 𝑚 𝑠h𝑎𝑟𝑒𝑠

Using the total payout method, we did not need to know the firm split between dividends and share
repurchase.
So, what decision should
the company make? Value creation is the no.1 priority

 Firm’s goal is to maximize firm and shareholder value

 Firm value is tied to NPV positive investments
 The NPV of any individual project represents its contribution to the firm’s value. To maximize
the firm’s share price, we should accept projects that have a positive NPV
 If the firm has a choice to (1) payout dividends (2) repurchase shares (3) reinvestments
 Managers should always choose to reinvest when the opportunity arises (opportunity
meaning NPV positive projects)
 If a firm wants to increase share price, it should consider reducing its dividend payout and
reinvest in firms’ investment (ONLY if the project generates positive cash flows)
 Question Value creation is the no.1 priority

Explain why dividend payouts and share buybacks are

considered a ‘value neutral’ activity?

- Dividend payouts leaves the firm  goes into the shareholder’s pocket
- Share buyback is an activity where the firm uses cash to buy back for a variety reasons
–e.g., improve financial ratios to appear ‘profitable’, share price support, optimize capital
structure etc.

-These activities neither contributes to value creation nor destruction.

-However, they are still important aspects of financial management as they part of
planning, organizing and distributing resources in order to maximize firm value.
End