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# Week 6: Chap 8: Stock Valuation FIN 331

Towson

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This 4 page Class Notes was uploaded by Nj on Tuesday October 13, 2015. The Class Notes belongs to FIN 331 at Towson University taught by Moon-Whoan Rhee in Summer 2015. Since its upload, it has received 32 views. For similar materials see Principles Financial Management in Finance at Towson University.

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Date Created: 10/13/15

Chapter 8 Stock Valuation A share of common stock is more difficult to value in practice than a bond for at least three reasons 0 The promised cash flows are not known in advance 0 The stock has no maturity the life of investment is essentially forever 0 There is no way to easily observe the rate of return that the market requires Cash Flows One period example 1 You are thinking of buying the stock of Moore Oil Inc you expect a 2 dividend in 1 year and you believe that you can sell the stock for 14 at time If you require a return of 20 on investments of this risk what is the maximum you would be willing to pay for this stock today PV 14212 1333 or FV 16 Y 20 N 1 CPT PV 1333 Two period example 2 What if you decide to hold the stock for 2 years In addition to the dividend 1 year you expect a dividend of 210 in 2 years and have a stock price of 1470 at the end of year 2 How much would you be willing to pay PV 212 210147012quot2 1333 Estimating dividends special cases Constant dividends the firm will pay a constant dividend forever same as preferred stock perpetuity formula to calculate the value PV DR Exponential growth compounded growth Constant dividend growth rate the firm will increase the dividend by a constant percent every period PV D1Rg If Do is given we have to determine D1 D0 x 1gRg Supernormal growth dividend growth is not consistent talk about that later Zero Growth This a perpertuity Suppose stock is expected to pay a 50 dividend every quarter and the required return is 10 with quarterly compounding What is the value PV 5014 20 Dividend Growth 1Suppose Big D nc just paid a dividend of 050share If the dividend is expected to grow at 5 per year and the required return is 20 PV D1Rg Po Do x 1gRg 50 1021502 312 2 Suppose Towson Inc is expected to pay a 2 dividend in one year If the dividend is expected to grow at 5 per year and the required return is 20 what is the price P0 2 2 05 1333 Inverse relationship between interest rate and PV if r increase PV decrease 3 Gordon Growth Company is expected to pay a dividend of 4 next period and dividends are expected to grow at 6 per year The required return is 16 What is the current value P0 4 16 06 40 What is the price expected to be in year 4 P4 041gR g DSR g P4 41064 16 06 5050 Non Constant Growth If a firm is expected to increase dividends by 20 in one year and by 15 in two years After that dividends will increase at a rate of 5 per year indefinitely If the last dividend was 1 and the required return is 20 what is the value of the stock Compute the dividends until growth levels off D1 112 120 I D2 120115 138 I D3 138105 1449 Find the expected future value at the end of period 2 I PV2 D3 R g 1449 2 05 966 Find the present value of the expected future cash flows 2 I PV 120 12 138 966 12 867 Find the required return Suppose a firm s stock is selling for 1050 It just paid a 1 dividend and dividends are expected to grow at 5 per year What is the required return I R 11051050 05 15 What is the dividend yield I 1105 1050 10 What is the capital gains yield I g5 Stock valuation using multiples Another common valuation approach is to multiply a benchmark PE ratio by projected EPS so V benchmark PE price per share and earning per share ratio x EPS Benchmark PE ratio often an industry average or based on a company s own historical values Ex if a company is expected to have a EPS of 3 over the past year The industry average PE ratio is 12 What is the value V 12x3 36 Dividend Characteristics o Dividends are not a liability of the firm until a dividend has been declared by the Board 0 Consequently a firm cannot go bankrupt for not declaring dividends Dividends and Taxes 0 Dividend payments are not considered a business expense therefore they are not tax deductible o Dividends received by corporations have a minimum 70 exclusion from taxable income QUiZ 1 You observe a stock price of 1875 You expect a dividend growth rate of 5 and the most recent dividend was 150 What is the required return R 151051875 05 134 2 ABC stock currently sells for 50 per share The next expected annual dividend is 2 and the growth rate is 6 What is the expected rate of return on this stock Expected return 250 06 10 If the required rate of return on this stock were 12 what would the stock value be Value 2 12 06 3333

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