Stocks and Their Valuation

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 Definition of Common Stock

The smallest equal portion of Common

Equity which represent the single
ownership of the firm is called Single Stock
(Common Stock).

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Features/Right of Common Stock
 Right to Income
 Right on Asset
 Right to Control
 Voting Right
 Pre-emptive Right
 Limited Liability
 Maturity Period
 Ownership

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 Advantages of Common Stock
 Permanent Capital
 Dividend Payment
 Borrowing Base
 No Maturity
 Creditworthiness
 Unsecured
 Lower Risk

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Disadvantages of Common Stock
 High Cost
 Tax Deductible (not)
 High Flotation Cost
 Ownership Dilution
 Earning Dilution
 Dilution of Control

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Valuation of Common Stock

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 Stock and Their Valuation

To determine whether a stock is fairly priced,

you first need to estimate the stock’s true
value, or “intrinsic value,”

VALUATION IS SUBJECTIVE

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 Stock and Their Valuation
Bond: Cashflows are set by contract.

Stock: Cashflows (Common stock returns)

are not contractual. Depends on many
random factors.

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 Models of Equity Valuation
Models:
The Discounted Dividend Model
The Corporate Valuation Model
Relative Valuation / Comparative Valuation

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The Discounted Dividend Model
(DDM)

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 DDM: Growth of Stock

 Constant Growth Stock (Gordon model)

 Zero Constant Stock
 Non Constant Growth Stock.

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DDM: Constant Growth

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 Problem on Common Stock
Thomas Brothers is expected to pay a
$0.50 per share dividend at the end of the
year (that is, D1 = $0.50). The dividend is
expected to grow at a constant rate of 7%
a year. The required rate of return on the
stock, rs, is 15%. What is the stock’s
current value per share?

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Stock Value: Zero Growth

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 Stock Value: Non-constant growth

Terminal (Horizon) Date:

The date when the growth rate becomes
constant. At this date, it is no longer
necessary to forecast the individual
dividend.

Horizon (Terminal) Value:

The value at the horizon date of all
dividends expected thereafter.
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Stock Value: Non-constant growth

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 Problem on Common Stock
Hart Enterprises recently paid a dividend, D0, of
$1.25. It expects to have non-constant growth of
20% for 2 years followed by a constant rate of 5%
thereafter. The firm’s required return is 10%.
a. How far away is the terminal, or horizon, date?
b. What is the firm’s horizon, or terminal, value?
c. What is the firm’s intrinsic value today, P0?

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Preferred Stock

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 Preferred Stock
Preferred stock is Hybrid security.

Similarity of Bond:
 It carries a fixed rate of dividend.
 It ranks higher claim to income/assets than
Common Stock.
 It does not have a share in residual earning/Assets.

Similarity to common stock:

 Non payment of dividend does not force the
company to insolvency.
 In some cases, it has no fixed maturity date.
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 Features of Preferred Stock
 Claims on Income and Asset.
 Fixed Dividend.
 Cumulative dividend.
 Sinking fund.
 Convertibility.
 Par value.

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 Advantages of Preferred Stock
 Risk less financing.
 Dividend Postpone.
 Fixed Dividend.
 Lower Cost.
 Obligation.

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Disadvantages of Preferred Stock

 Not Tax Deductibility.

 Cumulative dividend.
 Not Popular sources.

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Problems on Preferred Stock

What will be the nominal rate of return on

a perpetual preferred stock with a $100
par value, a stated dividend of 8% of par,
and a current market price of (a) $60, (b)
$80, (c) $100, and (d) $140?

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Problems on Preferred Stock
Ezzell Corporation issued perpetual
preferred stock with a 10% annual
dividend. The stock currently yields 8%,
and its par value is $100.

a. What is the stock’s value?

b. Suppose interest rates rise and pull the
preferred stock’s yield up to 12%. What is
its new market value?
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The Corporate Valuation Model
A valuation model used as an alternative to
the discounted dividend model to determine
a firm’s value, especially one with no history
of dividends, or the value of a division of a
larger firm.

The corporate model first calculates the

firm’s free cash flows, then finds their
present values to determine the firm’s value.

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The Corporate Valuation Model
Market Value of a firm can be expressed as
follows:

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 Assignment

Problem: 9-1 to 9-14

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Class Summary

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