2000, Prentice Hall, Inc.

Security Valuation

In general, the In general, the intrinsic valueintrinsic value of of an asset = the an asset = the present valuepresent value of the of the stream of expected cash flows stream of expected cash flows discounted at an appropriate discounted at an appropriate required rate of returnrequired rate of return..

Preferred Stock

A hybrid securityA hybrid security:: it’s like common stock - no fixed it’s like common stock - no fixed maturity.maturity.

Preferred Stock

A hybrid securityA hybrid security:: it’s like common stock - no fixed it’s like common stock - no fixed maturity.maturity.

technically, it’s part of technically, it’s part of equity capitalequity capital..

Preferred Stock

A hybrid securityA hybrid security:: it’s like common stock - no fixed it’s like common stock - no fixed maturity.maturity.

technically, it’s part of equity capital.technically, it’s part of equity capital.

it’s like debt - preferred dividends are it’s like debt - preferred dividends are

fixed.fixed.

Preferred Stock

A hybrid securityA hybrid security:: it’s like common stock - no fixed it’s like common stock - no fixed maturity.maturity.

technically, it’s part of equity capital.technically, it’s part of equity capital.

it’s like debt - preferred dividends are it’s like debt - preferred dividends are

fixed.fixed. missing a preferred dividend does not missing a preferred dividend does not

constitute default, but preferred dividends are constitute default, but preferred dividends are cumulativecumulative..

Usually sold for $25, $50, or $100 per Usually sold for $25, $50, or $100 per share.share.

Dividends are often quoted as a Dividends are often quoted as a percentage of par.percentage of par.

Preferred StockPreferred Stock

Usually sold for $25, $50, or $100 per Usually sold for $25, $50, or $100 per share.share.

Dividends are often quoted as a Dividends are often quoted as a percentage of par.percentage of par. Example:Example: In 1988, Xerox issued $75 In 1988, Xerox issued $75

million of 8.25% preferred stock at $50 million of 8.25% preferred stock at $50 per share.per share.

Preferred StockPreferred Stock

Usually sold for $25, $50, or $100 per Usually sold for $25, $50, or $100 per share.share.

Dividends are often quoted as a Dividends are often quoted as a percentage of par.percentage of par. Example:Example: In 1988, Xerox issued $75 In 1988, Xerox issued $75

million of 8.25% preferred stock at $50 million of 8.25% preferred stock at $50 per share.per share.

$4.125 is the fixed, annual dividend per $4.125 is the fixed, annual dividend per share.share.

Preferred StockPreferred Stock

May be May be callablecallable and and convertibleconvertible.. Is usually Is usually non-votingnon-voting.. PriorityPriority: lower than debt, higher than : lower than debt, higher than

common stock.common stock. Usually includes Usually includes protective provisionsprotective provisions.. May include a May include a sinking fundsinking fund provision. provision.

Preferred StockPreferred Stock

Preferred Stock Valuation

A preferred stock can usually be A preferred stock can usually be valued like a perpetuity:valued like a perpetuity:

Preferred Stock Valuation

A preferred stock can usually be A preferred stock can usually be valued like a perpetuity:valued like a perpetuity:

V =Dk

psps

Example:

Xerox preferred pays an Xerox preferred pays an 8.25%8.25% dividend on a dividend on a $50$50 par value. par value.

Suppose our required rate of Suppose our required rate of return on Xerox preferred is return on Xerox preferred is 9.5%9.5%..

Example:

Xerox preferred pays an Xerox preferred pays an 8.25%8.25% dividend on a dividend on a $50$50 par value. par value.

Suppose our required rate of Suppose our required rate of return on Xerox preferred is return on Xerox preferred is 9.5%9.5%..

VVpsps ==4.1254.125

.095.095==

Example:

Xerox preferred pays an Xerox preferred pays an 8.25%8.25% dividend on a dividend on a $50$50 par value. par value.

Suppose our required rate of Suppose our required rate of return on Xerox preferred is return on Xerox preferred is 9.5%9.5%..

VVpsps ==4.1254.125

.095.095== $43.42$43.42

Expected Rate of Return on Preferred

Just adjust the valuation model:Just adjust the valuation model:

Expected Rate of Return on Preferred

Just adjust the valuation model:Just adjust the valuation model:

D

Po

kps =

Example

If we know the preferred stock price If we know the preferred stock price is is $40$40, and the preferred dividend is , and the preferred dividend is $4.125$4.125, the expected return is:, the expected return is:

Example

If we know the preferred stock price If we know the preferred stock price is is $40$40, and the preferred dividend is , and the preferred dividend is $4.125$4.125, the expected return is:, the expected return is:

D

Po

kps = = = 4.125

40

Example

If we know the preferred stock price If we know the preferred stock price is is $40$40, and the preferred dividend is , and the preferred dividend is $4.125$4.125, the expected return is:, the expected return is:

D

Po

kps = = = .10314.125

40

The Financial Pages:Preferred Stocks

52 weeks 52 weeks Yld Yld Vol Vol

Hi Lo Sym Hi Lo Sym Div % PE 100s Close Div % PE 100s Close

292933//88 25 2511//88 GenMotor pfG 2.28 8.8 … 27 25 GenMotor pfG 2.28 8.8 … 27 25 77//88

Dividend:Dividend: $2.28 on $25 par value $2.28 on $25 par value

= 9.12% dividend rate.= 9.12% dividend rate.

Expected return:Expected return: 2.28 / 25.875 = 2.28 / 25.875 = 8.8%.8.8%.

Common Stock

is a is a variable-incomevariable-income security. security. dividends may be increased or dividends may be increased or

decreased, depending on earnings.decreased, depending on earnings. represents represents equity equity or ownership.or ownership. includes includes voting rightsvoting rights.. PriorityPriority: lower than debt and : lower than debt and

preferred. preferred.

Common Stock Characteristics

Claim on IncomeClaim on Income - a stockholder has a - a stockholder has a claim on the firm’s residual income.claim on the firm’s residual income.

Claim on AssetsClaim on Assets - a stockholder has a - a stockholder has a residual claim on the firm’s assets in case residual claim on the firm’s assets in case of liquidation.of liquidation.

Preemptive RightsPreemptive Rights - stockholders may - stockholders may share proportionally in any new stock share proportionally in any new stock issues. issues.

Voting RightsVoting Rights - right to vote for the firm’s - right to vote for the firm’s board of directors.board of directors.

You expect XYZ stock to pay a You expect XYZ stock to pay a $5.50$5.50 dividend at the end of the year. The stock dividend at the end of the year. The stock price is expected to be price is expected to be $120$120 at that time. at that time.

If you require a If you require a 15%15% rate of return, what rate of return, what would you pay for the stock now?would you pay for the stock now?

Common Stock Valuation(Single Holding Period)

You expect XYZ stock to pay a You expect XYZ stock to pay a $5.50$5.50 dividend at the end of the year. The stock dividend at the end of the year. The stock price is expected to be price is expected to be $120$120 at that time. at that time.

If you require a If you require a 15%15% rate of return, what rate of return, what would you pay for the stock now?would you pay for the stock now?

Common Stock Valuation(Single Holding Period)

0 1

? 5.50 + 120

Common Stock Valuation(Single Holding Period)

Financial Calculator solution:Financial Calculator solution:

P/Y =1, I = 15, n=1, FV= 125.50P/Y =1, I = 15, n=1, FV= 125.50

solve:solve: PV = -109.13 PV = -109.13

or:or:

P/Y =1, I = 15, n=1, FV= 120, P/Y =1, I = 15, n=1, FV= 120,

PMT = 5.50PMT = 5.50

solve:solve: PV = -109.13 PV = -109.13

The Financial Pages:Common Stocks

52 weeks 52 weeks Yld Yld Vol Vol NetNet

Hi Lo Sym Div % PE 100s Hi Lo Close ChgHi Lo Sym Div % PE 100s Hi Lo Close Chg

139 81 IBM .48 .5 26 56598 108 106 106139 81 IBM .48 .5 26 56598 108 106 10655//88 -2 -2

119 75 MSFT … 60 254888 96 93 95119 75 MSFT … 60 254888 96 93 9533//88 + +11//44

Common Stock Valuation(Multiple Holding Periods)

Constant Growth ModelConstant Growth Model Assumes common stock dividends Assumes common stock dividends

will grow at a constant rate into will grow at a constant rate into the future.the future.

Common Stock Valuation(Multiple Holding Periods)

Constant Growth ModelConstant Growth Model Assumes common stock dividends Assumes common stock dividends

will grow at a constant rate into will grow at a constant rate into the future.the future.

Vcs =D1

kcs - g

Constant Growth ModelConstant Growth Model Assumes common stock dividends will grow Assumes common stock dividends will grow

at a constant rate into the future. at a constant rate into the future.

Constant Growth ModelConstant Growth Model Assumes common stock dividends will grow Assumes common stock dividends will grow

at a constant rate into the future.at a constant rate into the future.

Vcs =D1

kcs - g

Constant Growth ModelConstant Growth Model Assumes common stock dividends will grow Assumes common stock dividends will grow

at a constant rate into the future.at a constant rate into the future.

DD11 = the dividend at the end of period 1. = the dividend at the end of period 1. kkcscs = the required return on the common = the required return on the common

stock.stock. gg = the constant, annual dividend growth = the constant, annual dividend growth

rate.rate.

Vcs =D1

kcs - g

Example

XYZ stock XYZ stock recentlyrecently paid a paid a $5.00$5.00 dividend. The dividend is expected to dividend. The dividend is expected to grow at grow at 10%10% per year indefinitely. per year indefinitely. What would we be willing to pay if our What would we be willing to pay if our required return on XYZ stock is required return on XYZ stock is 15%15%??

Example

XYZ stock XYZ stock recentlyrecently paid a paid a $5.00$5.00 dividend. The dividend is expected to dividend. The dividend is expected to grow at grow at 10%10% per year indefinitely. per year indefinitely. What would we be willing to pay if our What would we be willing to pay if our required return on XYZ stock is required return on XYZ stock is 15%15%??

D0 = $5, so D1 = 5 (1.10) = $5.50

Example

XYZ stock XYZ stock recentlyrecently paid a paid a $5.00$5.00 dividend. The dividend is expected to dividend. The dividend is expected to grow at grow at 10%10% per year indefinitely. per year indefinitely. What would we be willing to pay if our What would we be willing to pay if our required return on XYZ stock is required return on XYZ stock is 15%15%??

Vcs =

Example

XYZ stock XYZ stock recentlyrecently paid a paid a $5.00$5.00 dividend. The dividend is expected to dividend. The dividend is expected to grow at grow at 10%10% per year indefinitely. per year indefinitely. What would we be willing to pay if our What would we be willing to pay if our required return on XYZ stock is required return on XYZ stock is 15%15%??

Vcs = = D1

kcs - g

Example

XYZ stock XYZ stock recentlyrecently paid a paid a $5.00$5.00 dividend. The dividend is expected to dividend. The dividend is expected to grow at grow at 10%10% per year indefinitely. per year indefinitely. What would we be willing to pay if our What would we be willing to pay if our required return on XYZ stock is required return on XYZ stock is 15%15%??

Vcs = = = D1 5.50

kcs - g .15 - .10

Example

XYZ stock XYZ stock recentlyrecently paid a paid a $5.00$5.00 dividend. The dividend is expected to dividend. The dividend is expected to grow at grow at 10%10% per year indefinitely. per year indefinitely. What would we be willing to pay if our What would we be willing to pay if our required return on XYZ stock is required return on XYZ stock is 15%15%??

Vcs = = = $110 D1 5.50

kcs - g .15 - .10

Expected Return on Common Stock

Just adjust the valuation modelJust adjust the valuation model

Expected Return on Common Stock

Just adjust the valuation modelJust adjust the valuation model

Vcs =D

kcs - g

Expected Return on Common Stock

Just adjust the valuation modelJust adjust the valuation model

Vcs =D

kcs - g

k = ( ) + gD1

Vcs

Expected Return on Common Stock

Just adjust the valuation modelJust adjust the valuation model

Vcs =D

kcs - g

k = ( ) + gD1

Po

Example We know a stock will pay a We know a stock will pay a $3.00$3.00

dividend at time 1, has a price of dividend at time 1, has a price of $27$27 and an expected growth rate of and an expected growth rate of 5%5%..

Example We know a stock will pay a We know a stock will pay a $3.00$3.00

dividend at time 1, has a price of dividend at time 1, has a price of $27$27 and an expected growth rate of and an expected growth rate of 5%5%..

kcs = ( ) + gD1

Po

Example We know a stock will pay a We know a stock will pay a $3.00$3.00

dividend at time 1, has a price of dividend at time 1, has a price of $27$27 and an expected growth rate of and an expected growth rate of 5%5%..

kcs = ( ) + gD1

Po

kcs = ( ) + .05 =3.00

27

Example We know a stock will pay a We know a stock will pay a $3.00$3.00

dividend at time 1, has a price of dividend at time 1, has a price of $27$27 and an expected growth rate of and an expected growth rate of 5%5%..

kcs = ( ) + gD1

Po

kcs = ( ) + .05 = 16.11%3.00

27