1 Chapter 9: Valuation of Common Stocks Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc. Objective Explain equity evaluation using discounting Dividend policy and wealth
Dec 17, 2015
1
Chapter 9: Valuation of Common Stocks
Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc.
ObjectiveExplain equity evaluation
using discounting
Dividend policy and wealth
2
Chapter 9 Contents
1. Reading stock listings2. The discounted dividend model3. Earning and investment
opportunity4. A reconsideration of the price
multiple approach5. Does dividend policy affect
shareholder wealth?
3
Reading Stock Listings
Yr Hi Yr Lo Stock Sym
123 1/8 93 1/8 IBM IBM
Div Yld % PE Vol 100
4.84 4.2 16 14591
Day Hi Day Lo Close Net Chg
115 113 114 3/4 +1 3/8
4
Reading Stock Listings
Dividend yield: the annualized dollar dividend divided by the stock’s price
Price/earnings ratio: the ratio of the current stock price to earnings during the most recent four quarters
Round lots of 100 shares Odd lots requires higher commissions
5
Discounted Dividend Model
Computes the value of a share of stock as the present value of its expected future cash dividends.
Any investor in common stock expects a return consisting of cash dividends and the change in price.
Risk adjusted discount rate: the expected rate of return that investors require in order to be willing to invest in the stock.
6
DDM Model
Thus
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1
110
7
DDM Model
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t
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8
The Constant-Growth-Rate DDM
When the dividends grow at a constant rate g:
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k
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DP
gDDt
t
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1
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9
The Constant-Growth-Rate DDM
Stock price is expected to grow at the same rate as dividends:
gP
PP
gPgk
gD
gk
DP
0
01
012
1 )1()1(
10
Future Dividends and Price
Year Price start of Year
Expected Dividend
Exp. Dividend Yield
Exp. Rate of Price Increase
1 $100 $5.00 5% 10%
2 $110 $5.50 5% 10%
3 $121 $6.05 5% 10%
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Dividend Policy
A corporation’s policy regarding paying out cash to its shareholders holding constant its investment and
borrowing decisions
24
Dividend Policy
Cash dividend All shareholders receive cash in
amounts proportional to the number of shares they own
We assume that when cash is distributed, all else the same, the share price declines immediately by the amount of the dividend
25
Dividend Policy
Share repurchase The company pays cash to buy
shares of its stock in the stock market
Only those shareholders who choose to sell some of their shares will receive cash
Assumption: all else the same, the share price remains unchanged
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Dividend Policy
Original Balance Sheet
Assets Liab\ Equ Cash 2 Debt 2 Other 10 Equity 10 Total 12 Total 12
Number of shares outstanding=500,000 Price per share=$20
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Dividend Policy, Cash Dividend
After Payment of Cash Dividends
Assets Liab\ Equ Cash 1 Debt 2 Other 10 Equity 9 Total 11 Total 11
Number of shares outstanding=500,000 Price per share=$18
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Dividend Policy, Share Repurchase
After Share Repurchase
Assets Liab\ Equ Cash 1 Debt 2 Other 10 Equity 9 Total 11 Total 11
Number of shares outstanding=450,000 Price per share=$20
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Dividend Policy
Stock splits A two-for-one stock split means that
each old share will counted as two shares
The market price of a share will immediately drop to half
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Dividend Policy
Stock dividend The corporation distributes additional
shares of stock to each stockholder Can be seen as distributing a cash
dividend to existing shareholders, and then requiring them to immediately use the cash to buy additional shares
No tax effect
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Dividend Policy
Original Balance Sheet
Assets Liab\ Equ Cash 2 Debt 2 Other 10 Equity 10 Total 12 Total 12
Number of shares outstanding=500,000 Price per share=$20
32
Dividend Policy, Cash Dividend
After Payment of Cash Dividends
Assets Liab\ Equ Cash 1 Debt 2 Other 10 Equity 9 Total 11 Total 11
Number of shares outstanding=500,000 Price per share=$18
33
Dividend Policy, Stock Dividend
After Stock Dividends
Assets Liab\ Equ Cash 2 Debt 2 Other 10 Equity 10 Total 12 Total 12
Number of shares outstanding=550,000 Price per share=$18.18
34
Dividend Policy in Frictionless Environment (M&M)
M&M 1961: In a frictionless environment, in which there are no taxes and no costs of issuing new shares or repurchasing existing shares, a firm’s dividend policy can have no effect on the wealth of its current shareholders
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Dividend Policy in a Frictionless Environment (M&M)
Example(paying cash dividend or not?) the Cashrich company decide not to
pay out the $2 million in cash, but invest it in a project that leaves the total market value of the firm unchanged. A shareholder who owns 100 shares and would have preferred a cash dividend of $2 per share, can sell 10 shares, then he winds up with stock worth $1800 and cash $200.
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Dividend Policy in a Frictionless Environment (M&M)
o Suppose Cashrich pays out a cash dividend of $2 per share, and the shareholder does not want the cash. After the payment of the dividend, he has $200 in cash and $1800 in stock. He can reestablish his position by using the $200 in cash to buy more shares at the price of $18.
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Dividend Policy in the Real World
Taxes Regulations The costs of external financing Informational content of dividend
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Tax
If a corporation distributes cash by paying dividends, it forces all of its shareholders to pay taxes. If instead the firm distributes the cash by repurchasing shares, it does not create a tax liability for all of its shareholders.
39
Regulations
In US there are laws that prevent corporations from using share repurchase as an alternative to dividends as a regular mechanism.
There are also laws that prevent corporations from retaining cash in the business that is not needed to run.
40
Cost of External Financing
Favoring the nonpayment of cash to shareholders, either in the form of cash or repurchase of shares.
The investment bankers who intermediate the sale of new shares to outside investors have to be paid, and the current shareholders bear the cost.
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Cost arising from asymmetry of information
Differences in information that is available to the firm’s management (insiders) and the potential buyers of new stock issued by the firm (outsiders)
The outsiders may be skeptical about the reasons for issuing new stock, therefore, have to be offered a bargain price to induce them to buy new shares.
42
The Informational Content of Dividends
Outside investors may interpret an increase in a corporation’s cash dividend as a positive sign and, therefore, a dividend increase might cause a rise in the stock’s price, and conversely.
Corporate management is cautious about making changes in dividend payouts and usually offers an explanations to the investing public.