COMMON STOCK VALUATION

(1) A Single Period Valuation Model:

d1
P0 =
Ks - g
where P0 = price per share at t=0
d1 = dividend income to be paid at t=1
Ks = cost of equity capital
g = constant growth rate of dividend (and/or price per share)
Ks > g

0 1

Proof: where P1 = price per share at

t=1.
P0 P1
d1

P0 = (P1 + d1)/(1+Ks) = [d1 + P0(1+g)]/(1+Ks)

It follows:

P0(1+Ks)-Po(1+g) = d1

Therefore, P0 = d1/(Ks - g)

(2) A Multi-Period Valuation Model:

P0 = d1/(Ks - g) (Ks>g is assumed)

We had a simple proof for this in class using the PV formula for growth income
streams.

Example 1:

The ABC Corporation is expected to grow at a rate of about 18 percent for the next
four years, then at 12 percent for another three years, and finally settle down to a
growth rate of 6 percent for the indefinite future. Its common stock currently pays a
$0.60 dividend, but dividends are expected to increase in proportion to the growth
of the firm.

a. What values would you place on the common stock if you require a 12
percent return on your investment?
 b. What would be the price per share at t=5?

Example 2:

Kathy Kobb plans to invest in common stocks for a period of 12 years, after which
she will sell out, buy a lifetime room-and-board membership in a retirement home,
and retire. She feels that Ogden Mines' common stock is currently, but temporarily,
undervalued by the market. Kobb expects Ogden Mines' current earnings and
dividend to double in the next 12 years. Ogden Mines' last dividend was $2.00,
and its stock currently sells for $45.00 a share.

a. If Kobb requires a 10 percent return on her investment, will Ogden Mines be

a good buy for her?

b. What is the maximum that Kobb could pay for Ogden Mines and still earn
her required 10 percent?

c. What might be the cause of such a market undervaluation?

d. Given Kobb's assumptions, what market capitalization rate for Ogden Mines
does the current price imply?

DIVIDEND POLICY

(1) The Impact of Dividend Policy on Stock Price Per Share.

a. P0 = d1/(Ks-g) = e1(1-b)/(Ks-br)

where b = retention ratio

e1 = earnings per share at t=1
r = rate of return on retained earnings

Growth Firm Declining Firm Normal Firm

(r > Ks) (r < Ks) (r = Ks)

r = 15% r = 5% t = 10%

Ks = 10% Ks = 10% Ks = 10%

e1 = $5 e1 = $5 e1 = $5

If b = 60%, then If b = 60%, then If b = 60%, then

 P0 = P0 = P0 =

If b = 20%, then If b = 20%, then If b = 20%, then

P0 = P0 = P0 =

b. dP0/db = e1(r-Ks)/(Ks-br)2 0 if r Ks

(2) The Dividend Payment Procedures

a. Cash Dividend vs. Stock Dividend (or Stock Split)

Regular Dividend
i. Cash Dividend
Extra Dividend

ii. Payment Procedures

4 business days

Announcement Ex-Dividend Record Date Payment Date

Date October 19 October 25 November 26
September 27 (Tuesday) (Monday)

Dividends of 50 cents/share will be payable to all stockholders of record on

October 25, 1999, payment being made on November 26, 1999.

1. If the firm were informed of a transfer of shares on October 19 or before,

then the new owner receives dividend. If not, the old owner receives
dividend.

2. Recognizing the time lag from the date of transaction to the date the firm is
informed of the transaction, the practice in the brokerage industry is that the
right to the dividend goes with the stock up to, but not including, four
business days before the record date.

iii. Stock Dividend (or Stock Split)

1. Defined as a dividend payment in the form of additional shares of stock

instead of cash. Stock split is essentially the same as stock dividend (see
 below).

Stock Stock
Dividend Meaning Split

5% 1 share per every 20 shares owned 21-for-20

10% 1 share per every 10 shares owned 11-for-10
25% 1 share per every 4 shares owned
50% 1 share per every 2 shares owned 3-for-2
100% 1 share per every 1 share owned
200% 1 share per every 1/2 share owned 3-for-1

2. After stock dividend (or stock split), there would be no change in the firm's
assets, liabilities, or shareholders' equity. But earnings per share, book
value per share, and market price per share would decline.

3. Calculation of Rates of Return to Stockholders

Year Raw Data Adjusted Rate of Change Dividend Rates of

Month Price* Cash Div. Stock Div. Price Cash Div. in prices (1) Yield (2) Return(%)
1998/5 $10 $5
6 11 .20 5.5 .10 10.00% 2.00% 12.00%
7 12 100% 6 9.09 9.09
8 7 7 16.67 16.67
9 8 8 14.29 14.49
10 6 6 -25.00 -25.00

*Price represents the closing price of the last date of each month.

(3) Tax-Induced Dividend Clientele Effect.

a. The lower a firm's dividend yield, the smaller the percentage of return a
stockholder expects to receive in the form of dividend and the larger the
percentage he expects to receive in the form of capital gain. Thus, those
firms with high dividend yields should attract stockholders in the lower tax
brackets and vice versa.

b. The higher the payout ratio, the slower the growth rate of the firm. Thus,
firms with high payout ratios should attract stockholders in the lower tax
brackets and vice versa.

c. t=-30 t=-1 t=0 (Ex-Dividend Date)

PC PB PA
PB - tg(PB - PC) = PA - tg(PA - PC) + d(1-to)

After-tax cash flow

when you sell on the day
before it goes ex-dividend

(PB - PA)/d = (1-to)/1-tg)

where to = ordinary income tax rate.

tg = capital gain tax rate.

d. d/p (pB - pA)/d Implied Tax Rate

.0125 .6690 .4974

.0216 .4873 .6145

.0276 .5447 .5915

.0328 .6246 .5315

.0376 .7953 .3398

.
.
.

.0496 .9054 .1747

e. 1-b (pB - pA)/d Implied Tax Rate

.204 .677 .4883

.316 .674 .4945

.371 .756 .3889

.409 .730 .4254

.447 .741 .4108

.
.
.

.674 .925 .0806