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1
Topics in Chapter
2
Common Stock: Owners, Directors,
and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.
3
Equity securities
5
Preferred stock
10
Tracking Stock
11
Liquidation & Market Value
12
Difference b/w book, liquidation
and market value
13
Return / Expected Return
14
Return on common stock
1. Cash dividends
2. Capital gain
15
Return on common stock
16
Question (Expected Return)
17
Question (Expected Return)
18
Question (Price Today)
19
Question (Price Today)
20
Different Approaches for Valuing
Common Stock
21
Dividend Discount Model
22
Stock value = PV of dividends
discounted at required return
^ D1 D2 D3 D∞
P0 = + + +…+
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞
23
Stock value = PV of dividends
discounted at required return
^ D1 D2 D3 D∞
P0 = + + +…+
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞
24
Investors with Different Investment
Horizons
25
Investors with Different Investment
Horizons (Cont.)
26
Investors with Different Investment
Horizons (Cont.)
27
Investors with Different Investment
Horizons (Cont.)
28
Investors with Different Investment
Horizons (Example)
29
Investors with Different Investment
Horizons (Example)
A
B
C
30
Present Value for A
31
Present Value for A
32
Present Value for B
33
Present Value for B
34
Present Value for C
35
Present Value for C
36
Basic Principle
37
Case
38
Case (Cont.)
39
Case (Cont.)
40
Question
41
Question (Cont.)
P0 = EPS1 / r = $25/0.20
= $125
42
Suppose dividends are expected to grow at a
constant rate, g, forever.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
43
Present Value of a Constant Growth Dividend
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Present Value of a Constant Growth Dividend
45
Present Value of a Constant Growth Dividend
Growing Perpetuity:
46
Question (Dividend Yield)
47
Question (Dividend Yield)
48
Question (Preferred Stock)
49
Question (Dividend Yield)
50
Question (Rate of Return)
52
Question (Rate of Return-2)
53
Nonconstant Growth Stock
(Continued) 55
Steps to Estimate Current Stock Price (Continued)
56
Example of Estimating Current Stock
Value (D0 = $2.00, rs = 13%)
↓
$2.301 ← $2.600/(1+rs)1
PVs of divs. ← $3.250/(1+rs)2
$2.545
$2.590 ← $3.7375/(1+rs)3 ↓
$39.224 $56.596/(1+rs)3 ←
$46.661
57
Payout and Plowback Ratio
58
Questions (1)
59
Questions (1)
60
Questions (2)
61
Questions (2-a)
63
Questions (2-c)
64
Questions (2-d)
If you buy the stock and plan to hold it for 3 years, what
payments will you receive? What is the present value of
those payments? Compare your answer to (b).
Present Value = DIV1 + DIV2 + DIV3 + P3
(1+r) (1+r)^2 (1+r)^3
= 1.04 + 1.0816 + 1.125 +14.625
(1+0.12) (1+0.12)^2 (1+0.12)^3
= 0.9285 + 0.8622 + 11.2105
= $13
65
Common stock valuation
-Relative measures
P/E ratios
An alternative to DDM is relative valuation
Measures such as P/E value stocks in comparison
to some bench mark such as the market, industry
or stocks own history over time
P/E ratios or Earning multiplier
It is commonly used technique among
practitioners, stock traders, and analysts
It always appears in report from a stock advisor
P/E ratio means how much price investors are
willing to pay for one rupee of earning
PSO had earnings of Rs.80 per share in 2007, it
market price was Rs.400, how do you interpret it
in P/E terminology
PSO P/E ratio is = 400/80 = 5
It means for one rupee earnings investors are
willing to pay Rs.5 for buying one share of PSO
Suppose POL’s P/E ratio is = 8
Determinants of P/E ratio
To understand the determinants of P/E
ratio, consider a constant growth model
of DDM P
D1
kg
So buy or not?
The investment decision
The investment decision is either made on
the basis of P/E in relations to:
The company own current earning
Or in relation to industry P/E
In the previous example, what should be
the price of PSO based on its own P/E?
In relation to company owns earnings