Activity 3 - Financial Management

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STOCK VALUATION

CHAPTER 8

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7.1

Explain how stock prices depend on future dividends and dividend growth

Show how to value stocks using multiples

Lay out the different ways corporate directors are elected to office

Define how the stock markets work

Key Concepts and Skills

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Common Stock Valuation

Some Features of Common and Preferred Stocks

The Stock Markets

Chapter Outline

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If you buy a share of stock, you can receive cash in two ways:

The company pays dividends.

You sell your shares, either to another investor in the market or back to the company.

As with bonds, the price of the stock is the present value of these expected cash flows.

Cash Flows for Stockholders

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7.4

Section 8.1 (A)

As the text points out, a stock that currently pays no dividends may or may not have value; a stock that will NEVER pay a dividend cannot have any value as long as investors are rational. For a stock that currently pays no dividend, market value derives from (a) the hope of future dividends and/or (b) the expectation of a liquidating dividend.

Suppose you are thinking of purchasing the stock of Moore Oil, Inc.

You expect it to pay a $2 dividend in one year, and you believe that you can sell the stock for $14 at that time.

If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay?

Compute the PV of the expected cash flows.

Price = (14 + 2) / (1.2) = $13.33

Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

One-Period Example

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7.5

Section 8.1 (A)

Note, the calculation can also be done as:

FV = 14; PMT = 2; I/Y = 20; N = 1; CPT PV = -13.33

Now, what if you decide to hold the stock for two years?

In addition to the dividend in one year, you expect a dividend of $2.10 in two years and a stock price of $14.70 at the end of year 2.

Now how much would you be willing to pay?

PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

Two-Period Example

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7.6

Section 8.1 (A)

If you have taught students how to use uneven cash flow keys, then you can show them how to do this on the calculator. The notation below is for the TI BA-II+.

Calculator: CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; NPV; I = 20; CPT NPV = 13.33

Finally, what if you decide to hold the stock for three years?

In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and the stock price is expected to be $15.435.

Now how much would you be willing to pay?

PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33

Three-Period Example

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7.7

Section 8.1 (A)

Calculator: CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33

You could continue to push back the year in which you will sell the stock.

You would find that the price of the stock is really just the present value of all expected future dividends.

So, how can we estimate all future dividend payments?

Developing The Model

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7.8

Section 8.1 (A)

In equilibrium, the required return, R, is the same as the “expected return.”

Constant dividend (i.e., zero growth)

The firm will pay a constant dividend forever.

This is like preferred stock.

The price is computed using the perpetuity formula.

Constant dividend growth

The firm will increase the dividend by a constant percent every period.

The price is computed using the growing perpetuity model.

Supernormal growth

Dividend growth is not consistent initially, but settles down to constant growth eventually.

The price is computed using a multistage model.

Estimating Dividends: Special Cases

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Section 8.1 (B)

7.9

If dividends are expected at regular intervals forever, then this is a perpetuity, and the present value of expected future dividends can be found using the perpetuity formula.

P0 = D / R

Suppose a stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

P0 = .50 / (.1 / 4) = $20

Zero Growth

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7.10

Section 8.1 (B)

Remind the students that if dividends are paid quarterly, then the discount rate must be a quarterly rate.

Also, if students have been using a financial calculator for most of their calculations, they often forget to convert the interest rate and they leave it as a percent, i.e., P = .5 / (10/4) = .2. Ask them if this is a reasonable answer – “Would you only be willing to pay $0.20 for an asset that will pay you $0.50 every quarter forever?”

Dividends are expected to grow at a constant percent per period.

P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …

P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + …

With a little algebra and some series work, this reduces to:

Dividend Growth Model

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7.11

Section 8.1 (B)

g is the growth rate in dividends; the subscripts denote the period in which the dividend is paid. This is the formula for a growing perpetuity that was developed in chapter 6.

Lecture Tip: The newly instituted tax cuts, all else equal, should increase margins and cash flow. Companies can increase dividends or reinvest more in the firm, which would increase the growth rate. In either case, stock values should increase, which is what has happened to the market – beginning even before the cuts were officially announced.

Suppose Big D, Inc., just paid a dividend of $0.50 per share.

It is expected to increase its dividend by 2% per year.

If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?

P0 = .50(1+.02) / (.15 - .02) = $3.92

DGM – Example 1

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7.12

Section 8.1 (B)

The biggest mistake that students make with the DGM is using the wrong dividend. Be sure to emphasize that we are finding a present value, so the dividend needed is the one that will be paid NEXT period, not the one that has already been paid.

Suppose TB Pirates, 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) = $13.33

Why isn’t the $2 in the numerator multiplied by (1.05) in this example?

DGM – Example 2

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7.13

Section 8.1 (B)

Does this result look familiar? The examples used to develop the earlier model were based on a 5% growth rate in dividends.

Stock Price Sensitivity to Dividend Growth, g

D1 = $2; R = 20%

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7.14

Section 8.1 (B)

As the growth rate approaches the required return, the stock price increases dramatically.

Price 0.01 0.02 0.03 0.04 0.05 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 10.53 11.11 11.76 12.5 13.33 14.29 15.38 16.670000000000002 18.18 20 22.22 25 28.57 33.33 40 50 66.67 100 200 0.01 0.02 0.03 0.04 0.05 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 0.01 0.02 0.03 0.04 0.05 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 0.01 0.02 0.03 0.04 0.05 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19

Growth Rate

Stock Price

Stock Price Sensitivity to Required Return, R

D1 = $2; g = 5%

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7.15

Section 8.1 (B)

As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.

Lecture Tip: The newly instituted tax cuts, all else equal, should increase margins and cash flow. Companies can increase dividends or reinvest more in the firm, which would increase the growth rate. In either case, stock values should increase, which is what has happened to the market – beginning even before the cuts were officially announced.

Price 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 200 100 66.67 50 40 33.33 28.57 25 22.22 20 18.18 16.670000000000002 15.38 14.29 13.33 12.5 11.76 11.11 10.53 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.06 7.0000000000000007E-2 0.08 0.09 0.1 0.11 0.12 0.13 0.14000000000000001 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24

Growth Rate

Stock Price

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 price?

P0 = 4 / (.16 - .06) = $40

Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g.

Example 8.3: Gordon Growth Company - I

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7.16

Section 8.1 (B)

What is the price expected to be in year 4?

P4 = D4(1 + g) / (R – g) = D5 / (R – g)

P4 = 4(1+.06)4 / (.16 - .06) = 50.50

What is the implied return given the change in price during the four year period?

50.50 = 40(1+return)4; return = 6%

PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%

The price is assumed to grow at the same rate as the dividends.

Example 8.3: Gordon Growth Company - II

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7.17

Section 8.1 (B)

Point out that the formula is completely general. The dividend in the numerator is always for one period later than the price we are computing. This is because we are computing a Present Value, so we have to start with a future cash flow. This is very important when discussing supernormal growth.

We know the dividend in one year is expected to be $4 and it will grow at 6% per year for four more years. So, D5 = 4(1.06)(1.06)(1.06)(1.06) = 4(1.06)4

Lecture Tip: In his book, A Random Walk Down Wall Street, pp. 82 – 89, (1985, W.W. Norton & Company, New York), Burton Malkiel gives four “fundamental” rules of stock prices. Loosely paraphrased, the rules are as follows. Other things equal:

-Investors pay a higher price, the larger the dividend growth rate

-Investors pay a higher price, the larger the proportion of earnings paid out as dividends

-Investors pay a higher price, the less risky the company’s stock

-Investors pay a higher price, the lower the level of interest rates

Suppose 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 price of the stock?

Remember that we have to find the PV of all expected future dividends.

Nonconstant Growth Example - I

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Section 8.1 (B)

7.18

Compute the dividends until growth levels off.

D1 = 1(1.2) = $1.20

D2 = 1.20(1.15) = $1.38

D3 = 1.38(1.05) = $1.449

Find the expected future price.

P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66

Find the present value of the expected future cash flows.

P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

Nonconstant Growth Example - II

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7.19

Section 8.1 (B)

Point out that P2 is the value, at year 2, of all expected dividends year 3 on.

The final step is exactly the same as the 2-period example at the beginning of the chapter. We can look at it as if we buy the stock today and receive the $1.20 dividend in 1 year, receive the $1.38 dividend in 2 years and then immediately sell it for $9.66.

Calculator: CF0 = 0; C01 = 1.20; F01 = 1; C02 = 11.04; F02 = 1; NPV; I = 20; CPT NPV = 8.67

What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?

What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15%.

Quick Quiz – Part I

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7.20

Section 8.1 (B)

Zero growth: 2 / .15 = 13.33

Constant growth: 2(1.03) / (.15 - .03) = $17.17

Start with the DGM:

Using the DGM to Find R

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7.21

Section 8.1 (C)

Point out that D1 / P0 is the dividend yield and g is the capital gains yield.

Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend, and dividends are expected to grow at 5% per year. What is the required return?

R = [1(1.05)/10.50] + .05 = 15%

What is the dividend yield?

1(1.05) / 10.50 = 10%

What is the capital gains yield?

g = 5%

Example: Finding the Required Return

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Section 8.1 (C)

7.22

Another common valuation approach is to multiply a benchmark PE ratio by earnings per share (EPS) to come up with a stock price.

Pt = Benchmark PE ratio × EPSt

The benchmark PE ratio is often an industry average or based on a company’s own historical values.

The price-sales ratio can also be used.

Stock Valuation Using Multiples

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Section 8.1 (D)

The price-sales ratio is often used to value newer companies that do not pay dividends and are not yet profitable (meaning that earnings are negative).

7.23

Suppose a company had earnings per share of $3 over the past year. The industry average PE ratio is 12.

Use this information to value this company’s stock price.

Pt = 12 × $3 = $36 per share

Example: Stock Valuation Using Multiples

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Section 8.1 (D)

7.24

Table 8.1 – Stock Valuation Summary (1)

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Section 8.1

7.25

Table 8.1 – Stock Valuation Summary (2)

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Section 8.1

7.26

Voting Rights

Proxy voting

Classes of stock

Other Rights

Share proportionally in declared dividends

Share proportionally in remaining assets during liquidation

Preemptive right – first shot at new stock issue to maintain proportional ownership if desired

Features of Common Stock

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7.27

Section 8.2 (A)

Shareholders have the right to vote for the board of directors and other important issues.

Cumulative voting increases the likelihood of minority shareholders getting a seat on the board.

Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for a vote.

Different classes of stock can have different rights. Owners may want to issue a nonvoting class of stock if they want to make sure that they maintain control of the firm.

Lecture Tip: Large institutions, such as mutual funds and pension funds, used to remain on the sidelines when it came to corporate control. However, several institutions have become much more active in recent years and have worked to force companies to operate in the shareholders’ best interests. CalPERS, the pension plan for California public employees, has been at the forefront of the corporate governance movement. For more information, see http://www.calpers-governance.org/principles/home.

Dividends are not a liability of the firm until a dividend has been declared by the Board.

Consequently, a firm cannot go bankrupt for not declaring dividends.

Dividends and Taxes

Dividend payments are not considered a business expense; therefore, they are not tax deductible.

The taxation of dividends received by individuals depends on the holding period.

Dividends received by corporations have a minimum 70% exclusion from taxable income.

Dividend Characteristics

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7.28

Slide 8.2 (A)

Dividend exclusion: If corporation A owns less than 20% of corporation B stock, then 30% of the dividends received from corporation B are taxable. If A owns between 20% and 80% of B, then 20% of the dividends received are taxable. If A owns more than 80%, a consolidated statement can be filed and dividends received from B are essentially untaxed.

Dividends

Stated dividend that must be paid before dividends can be paid to common stockholders

Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely.

Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid.

Preferred stock generally does not carry voting rights.

Features of Preferred Stock

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7.29

Section 8.2 (B)

Point out that there are a lot of features of preferred stock that are similar to debt. In fact, many new issues have sinking funds that effectively convert what was a perpetual security into an equity security with a definite maturity. However, for tax purposes, preferred stock is equity and dividends are not a tax deductible expense, unless they meet specific characteristics as discussed in the text.

Corporations that own stock in other corporations are permitted to exclude 50 percent of the dividend amounts they receive and are taxed on only the remaining 50 percent (the 50 percent exclusion was reduced from 70 percent by the Tax Cuts and Jobs Act of 2017).

Real-World Tip: Here’s a gruesome-sounding security – the “death spiral.” Actually, the name refers to convertible preferred shares that have a floating conversion ratio. That is, the conversion ratio varies with the price of the firm’s common stock. Also known as “toxic convertibles,” The Wall Street Journal reports that, when the issuer’s common stock falls, more shares must be issued to redeem the convertible securities, so this dilution pushes the common stock price down further. Hence, the “death spiral” appellation.

Dealers vs. Brokers

New York Stock Exchange (NYSE)

Largest stock market in the world

License holders (1,366)

Designated market makers (DMMs)

Floor brokers

Supplemental liquidity providers (SLPs)

Operations

Floor activity

Stock Market

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7.30

Section 8.3 (A) and (B)

DMMs, formerly known as “specialists,” act as dealers in particular stocks. A DMM maintains an inventory and stands ready to trade at quoted bid (DMM posts the price at which they will buy) and ask (DMM posts the price at which they will sell) prices. They make their profit from the difference between the bid and ask prices, called the bid-ask spread. The smaller the spread, the more competition and the more liquid the stock. The move to decimalization allows for a smaller bid-ask spread. There will be more discussion of this later.

Floor broker: a broker matches buyers and sellers. They perform the search function for a fee (commission). They do not hold an inventory of securities.

SLPs: investment firms that agree to be active participants in stocks assigned to them. They trade purely for their own accounts. Unlike DMMs and floor brokers, SLPs do not operate on the floor of the stock exchange.

Lecture Tip: Some students find it hard to grasp the relative importance of primary and secondary market transactions. Suggest that they consider automobile sales rather than stocks. New automobiles are sold through a network of dealers and salesman (brokers) to the public. In any given year, however, the majority of transactions are between people buying and selling existing automobiles, i.e., the secondary (used) car market. As with secondary market transactions in stocks, used car purchases do not directly benefit the issuer/manufacturer. You can also introduce the notion of information asymmetry and signaling at this point, see the classic article by George Akerlof titled “Market for Lemons.”

www: Check out the NYSE by clicking on the embedded link. Students are often amazed at all of the information that is available.

Not a physical exchange – computer-based quotation system

Multiple market makers

Electronic Communications Networks

Three levels of information

Level 1 – median quotes, registered representatives

Level 2 – view quotes, brokers, and dealers

Level 3 – view and update quotes, dealers only

Large portion of technology stocks

NASDAQ

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7.31

Section 8.3 (C)

Point out that the NASDAQ market site in Times Square is NOT an exchange. It is just offices and basically a place for reporters to report on what is happening with Nasdaq stocks.

Electronic Communications Networks provide trading in NASDAQ securities.

To see more detail, visit Instinet.

Work the Web Example

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Section 8.3 (C)

7.32

Reading Stock Quotes

What information is provided in the stock quote?

You can go to Bloomberg for current stock quotes.

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7.33

Section 8.3 (D)

This quote is the Costco quote from the text.

52 week high = 169.59

52 week low = 138.57

Company is Costco Wholesale

Annual dividend = $1.80 per share

Dividend yield = 1.12%

P/E ratio = 29.31

Most recent price = 160.63

Lecture Tip: A useful assignment is to require students to obtain a recent Wall Street Journal and examine the financial section. Have the students examine the dividend column for various stocks and point out the number of non-dividend paying stocks. Also have them identify the information available in each quote. This allows them to see more information at once than they would normally see with online quotes.

You observe a stock price of $18.75. You expect a dividend growth rate of 5%, and the most recent dividend was $1.50. What is the required return?

What are some of the major characteristics of common stock?

What are some of the major characteristics of preferred stock?

Quick Quiz – Part II

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7.34

Section 8.4

r = [1.5(1.05)/18.75] + .05 = 13.4%

The status of pension funding (i.e., over- vs. under-funded) depends heavily on the choice of a discount rate. When actuaries are choosing the appropriate rate, should they give greater priority to future pension recipients, management, or shareholders?

How has the increasing availability and use of the internet impacted the ability of stock traders to act unethically?

Ethics Issues

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7.35

XYZ 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?

If the required rate of return on this stock were 12%, what would the stock price be, and what would the dividend yield be?

Comprehensive Problem

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7.36

Section 8.4

Expected return = 2/50 + .06 = .10

Price = 2/ (.12 - .06) = $33.33

Dividend yield = 2 / 33.33 = 6%

End of Chapter

Chapter 8

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