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Financial Management

Arthur J. Keown J. William Petty John D. Martin David F. Scott, Jr.

Chapter 8
Stock Valuation

Chapter 8

Valuation and Characteristics of Stocks

Learning Objectives
Identify the basic characteristics and features of preferred stock. Value Preferred Stock. Identify the basic characteristics and features of common stock.
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Chapter 8

Valuation and Characteristics of Stocks

Learning Objectives
Value common stock.

Calculate a stocks expected rate of return.

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Chapter 8

Valuation and Characteristics of Stocks

Principles Used in this Chapter


Principle 1: The Risk-Return Trade-off We Wont Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. Principle 2: The Time Value of Money A Dollar Received Today is Worth More Than a Dollar Received in the Future Principle 3: Cash-Not Profits-Is King.
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Chapter 8

Valuation and Characteristics of Stocks

Stock
Two types:
Preferred and common

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Chapter 8

Valuation and Characteristics of Stocks

Preferred Stock
Preferred stock is often referred to as a hybrid security because it has many characteristics of both common stock and bonds. Like common stocks
No fixed maturity date Failure to pay dividends does not bring on bankruptcy Dividends are not deductible

Like Bonds
Dividends are for a limited time
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Valuation and Characteristics of Stocks

Features of Preferred Stocks


Multiple series of preferred stock Preferred stocks claim on assets and income Cumulative dividends Protective provisions Convertibility Retirement Features
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Valuation and Characteristics of Stocks

Claim on Assets and Income


Preferred stock has priority over common stock with regard to claim on assets in the case of bankruptcy. Honored before common stockholders, but after bonds. Must pay dividends to preferred stockholders before it pays common stockholder dividends.
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Valuation and Characteristics of Stocks

Cumulative Dividends
Cumulative features require 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 rights in the event of nonpayment of dividends, or they restrict the payment of common stock dividends if sinking-funds payments are not met or if the firm is in financial difficulty.
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Valuation and Characteristics of Stocks

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 issued today is convertible preferred. Reduces the cost of the preferred stock to the issue
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Valuation and Characteristics of Stocks

Retirement Features
Although preferred stock has no set maturity associated with it, issuing firms generally provide for some method of retiring the stock.

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Chapter 8

Valuation and Characteristics of Stocks

Callable Preferred
A call provision entitles a company to repurchase its preferred stock (or bonds) from their holders at stated prices over a given time period. Call feature usually involves an initial premium of 10% above par value Premium declines over time Allows the issuing firm to plan for the retirement of its preferred stock at predetermined prices.
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Valuation and Characteristics of Stocks

Sinking-Fund Provision
Sinking-fund provision requires the firm to set aside an amount of money periodically for the retirement of its preferred stock. Money used to purchase the preferred stock in the open market or to call the stock, whichever method is cheaper.
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Chapter 8

Valuation and Characteristics of Stocks

Valuing Preferred Stock


The value of a preferred stock is the present value of all future dividends. Calculate the value of preferred stock:
= Annual dividend / required rate of return
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Chapter 8

Valuation and Characteristics of Stocks

Valuing Preferred Stock


Vps= annual dividend =D required rate of return kps

Example: Xeroxs Series C preferred stock pays an annual dividend of $6.25 and the investors required rate of return is 5%.

Vps= D = $6.25 = $125.00

kps

0.05
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Chapter 8

Valuation and Characteristics of Stocks

Common Stock
Certificate that indicates ownership in a corporation Common stockholders are the true owners of the firm

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Chapter 8

Valuation and Characteristics of Stocks

Common Stock
Common stock is a certificate that indicates ownership in a corporation. Has no maturity date No upper limit on dividends Dividend payments must be declared each period (usually quarterly) by the firms board of directors. In the event of bankruptcy, common stockholders will not receive any payment until the creditors, including the bondholders and preferred stockholders, have been satisfied.
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Valuation and Characteristics of Stocks

Features of Common Stock


Claim on income Claim on assets Voting rights Preemptive rights Limited liability

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Valuation and Characteristics of Stocks

Claim on Income
Common shareholders have the right to residual income after bondholders and preferred stockholders have been paid. Can be in the form of dividends or retained earnings.

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Valuation and Characteristics of Stocks

Claim on Assets
Common stock has a residual claim on assets after claims of debt holders and preferred stockholders. If bankruptcy occurs, claims of the common shareholders generally go unsatisfied.
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Valuation and Characteristics of Stocks

Voting Rights
Common shareholders are entitled to elect the board of directors Most often are the only security holders with a vote Can approve any change in the corporate charter
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Valuation and Characteristics of Stocks

Voting Rights
Voting for directors and charter changes occur at the corporations annual meeting. A proxy gives a designated party the temporary power of attorney to vote for the signee at the corporations annual meeting. Proxy fights - battles between rival groups for proxy votes. Cumulative voting - each share of stock allows the stockholder a number of votes equal to the number of directors being elected.
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Valuation and Characteristics of Stocks

Preemptive Rights
Preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the firm. Rights - certificates issued to the shareholders giving them an option to purchase a stated number of new shares of stock at a specified price during a two- to ten-week period.
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Limited Liability Liability of the shareholder is limited to the amount of their investment. Limited liability feature aids the firm in raising funds.

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Valuation and Characteristics of Stocks

Valuing Common Stock Two Methods:


Present value of all future dividends Free cash flow method

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Valuation and Characteristics of Stocks

Present Value of Future Dividends

Growth factor
Infusion of capital
Financing, debt, common stock

Internal growth
Management retains some or all of the firms profits for reinvestment in the firm
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Valuation and Characteristics of Stocks

Internal Growth
g= ROE x r Where g = the growth rate of future earnings
and the growth in the common stockholders investment in the firm ROE = the return on equity (net income/common book value) r = the companys percentage of profits retained - profit retention rate
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Valuation and Characteristics of Stocks

Valuing of Common Stock Dividend Valuation Method:


Common stock value =
dividend in year 1 / (required rate of return growth rate)

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Chapter 8

Valuation and Characteristics of Stocks

Valuing Common Stock


Consider the valuation of a common stock that paid $2.00 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 the investors required rate of return is 15%.
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Valuation and Characteristics of Stocks

Valuing Common Stock


1. The dividend last year was $2. Compute the new dividend by: D1 = D0(1+g) = $2(1+.10)=$2.20 2. Vcs= D1/ (kcs g)

= $2.20/(.15-.10) = $44
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Valuation and Characteristics of Stocks

Valuing Common Stock


Free Cash Flow Method:
Shareholder value = firm value debt / number of shares outstanding
Where firm value is the present value of free cash flows discounted a the companys cost of capital
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Valuation and Characteristics of Stocks

Expected Rate of Return


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

Common Stock Expected Return


(Dividend in year 1 / market price) + dividend growth rate
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