November 26, 2014

Chapter 9. Valuation of Common Stock and Preferred Stock

Chapter 9 -- Stock Valuation

. Characteristics of common stock
. Common stock valuation
. Valuing a corporation
. Preferred stock

Finance managers have to understand how their company stock will be valued by various people in the financial market or more specifically stock market.

. Characteristics of common stock

 Ownership in a corporation: control of the firm

 Claim on income: residual claim on income

 Claim on assets: residual claim on assets

Commonly used terms: voting rights, proxy, proxy fight, takeover, preemptive

right, classified stock, and limited liability

. Common stock valuation

Intrinsic value is a term used to denote the value arrived at by using a valuation method.

Market valuation refers to the stock price at which shares are traded on a day on the stock exchange.

Growth rate in dividends is an important input in valuation formulas.

Growth rate g: expected rate of growth in dividends

g = ROE * retention ratio

Retention ratio = 1 - dividend payout ratio

 The growth rate, g plays an important role in stock valuation

 The general dividend discount model: .

The intrinsic value of a share is present value of all dividends expected from holding the share in the future.

Why one has to calculate intrinsic value?

 Rationale: estimate the intrinsic value for the stock and compare it with the
market price to determine if the stock in the market is over-priced or under-priced.

Underpriced shares can be bought with the expectation of higher than market return. Overpriced shares are sold by traders or speculators in the hope of buying them back at lower rates.

(1) Zero growth model (the dividend growth rate, g = 0)

I.V. =  D/r

D = dividend
r = rate of return required (can be calculated from the CAPM)

 (2) Constant growth model (the dividend growth rate, g = constant)

Common stock valuation: The expected rate of return can be estimated given the market

price for a constant growth stock

Expected return = expected dividend yield + expected capital gains yield


What would be the expected dividend yield and capital gains yield under the zero

growth model?

Expected capital gains yield, g = 0 (price will remain constant)

Expected dividend yield = D/P0

(3) Non-constant growth model: part of the firm’s cycle in which it grows much

faster for the first N years and gradually return to a constant growth rate

Apply the constant growth model at the end of year N and then discount all
expected future cash flows to the present

 Non-constant growth, gs Constant growth, gn

. Valuing a corporation

 It is similar to valuing a stock

 V = present value of expected future free cash flows

 FCF = EBIT*(1-T) + depreciation and amortization – (capital expenditures +in
net working capital)

 The discount rate should be the WACC (weighted average cost of capital)

. Preferred stock

 A hybrid security because it has both common stock and bond features

Claim on assets and income: has priority over common stocks but after bonds

Cumulative feature: all past unpaid dividends should be paid before any dividend
can be paid to common stock shareholders

Valuation of preferred stock

Intrinsic value = Vp = Dp / rp

MBA Core Management Knowledge - One Year Revision Schedule

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