Topic 8

Valuation of Common Stocks

and Preferred Stocks
Common Stock Preferred Stock
 Common Stock
 Represents the true residual ownership of the
firm.
 Claims of common stockholders on the firm’s
earnings and assets are considered only AFTER all
other claims have been paid.

 Stockholders bear most of the risk of the firm.

 Therefore, common stockholders have the potential
to earn very high returns (no limits)
 Rights of Common Stockholders
1. Dividend rights
-Have the right to share equally on a per-
share basis in dividend distribution
2. Asset rights
-In liquidation, stockholders have the right
to receive assets that remain after the
obligations to government (taxes),
employees, debt holders and creditors have
been satisfied.
 Rights of Common Stockholders
(Cont…)
3. Preemptive rights
-Right to share proportionately in any new
stock sold.(first priority to the existing
stockholders before offering it to the
general public)

4. Voting rights
-Right to vote on matters such as selection
of Board of Directors.
Voting for the Board of Directors
 Normally occurs at annual stockholders’
meeting.
 Prior to the meeting, firms will mail proxy
statement to shareholders which contains
information regarding matters to be voted.
 Shareholders may authorise management or
someone else to vote on their behalf – Vote by
Proxy
 Proxy - signing over your voting rights to someone
else
 Estimating Dividends: Special
Cases
 Constant dividend
 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
 Supernormal growth
 Dividend growth is not consistent initially,
but settles down to constant growth eventually
 One-Period Model
 An investor who purchased a stock and hold it for one
period expects to receive a cash dividend, D1 and sell
the stock for P1.
0 1

RM D1 + RM P1


D1 P1
P0 = +
(1 + ke) 1
(1 + ke)1
D1  Future Dividend
k e  required rate of return
 One-Period Model
 Example:
Diversified common stock is expected to pay RM1 dividend
and sell for RM27.50 at the end of the period, what is the
value of this stock to an investor who requires 14% rate of
return?

RM 1.00 RM 27.50
P0  
(1  0.14) (1  0.14)
1 1

P0  RM 0.88  RM 24.12
P0  RM 25.00
 n (Few)-Period Model
D1 D2 D3 Dn Pn
P0     ...  
(1  ke ) (1  ke ) (1  ke )
1 2 3
(1  ke ) n
(1  ke ) n

Example:
•Continue from previous example, Diversified Corp.
stock expects to pay dividends of RM1, RM1 and
RM1.50 in years 1, 2 and 3.
Assume the stock can be sold for RM33.10 at the end
•

of year 3.
What is the value of the stock today, for an investor
•

whose required rate of return is 14%?

 n-Period Model
 Solution:

RM 1 RM 1 RM 1.50 RM 33.10
P0    
(1  0.14) (1  0.14) (1  0.14) (1  0.14) 3
1 2 3

P0  RM 0.88  RM 0.77  RM 1.01  RM 22.34

P0  RM 25.00
 Constant Growth Dividend
Valuation Model
When dividends grow at a constant rate, g, forever:
Dt  D0 1  g 
t

D1  D0 1  g 
1

D2  D1 1  g   D0 1  g 
2

Since future CFs grow at a constant rate forever, the

value of a constant growth stock is the PV of a
growing perpetuity.
D1 Assumption
P0 
ke  g ke > g
 How to differentiate between D0 and D1

D0 D1
 Just paid a dividend  Going to pay a
 Previous dividend dividend
 Current dividend  Next dividend
 Last dividend  Expected dividend
 Will pay a dividend
 Constant Growth Dividend
Valuation Model
 Example:
 You are trying to value the common stock of Lily

and Co. at the beginning of 2005.

 Dividends are expected to be RM1.34 per share in

the coming year, D1 (2005).

 Dividends are also expected to grow at 8.5%

annually.
 What is the value of the stock to an investor who

requires an 11% rate of return?

 Constant Growth Dividend
Valuation Model
 Solution:

RM 1.34
P0 
0.11  0.085
P0  RM 53.60
 Lecture Exercises
1. Ranney Inc. will pay RM3.50 per share
dividend next year. The company pledges to
increase its dividend by 5% per year,
indefinitely. If you require a 13percent return
on your investment, how much will you pay
for the company’s stock today?
Answer
 Lecture Exercise
2. Granic Berhad, just paid a dividend of RM8
per share on its stock. The dividends are
expected to grow at a constant rate of 7% per
year, indefinitely. If investors require a 13%
return on Granic Berhad stock, what is the
current price? What will the price be in 3 years?
In 15 years?
Answer
 Nonconstant Growth Problem
Statement
 Example
 Suppose a firm is expected to increase
dividends by 20% in first year and by 15% in
second 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?
 Nonconstant Growth – Example
Solution
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 / (ke – 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
 Lecture Exercise
1. Massey Ltd. is growing quickly.
Dividends are expected to grow at a 25%
rate for the next 3 years, with the growth
rate falling off to a constant 7% thereafter.
If the required return is 13% and the
company just paid an RM13.40 dividend,
what is the current share price?
Answer
 Lecture Exercise
2. Develop a current stock value for a firm that is
expected to have extraordinary growth of 25%
for four years, after which it will face more
competition and slip into a constant growth
rate of 5%. Its required return is 14% and next
year’s dividend is expected to be RM5.00.
Answer
 Required rate of return

 ke 
 
(1) k e  r f    rm  r f 
 

rf
 D1
(2) 
ke  g
rm P0
(rm  rf )
 Estimation Inputs (Cont…)
 Example:
 Let’s assume that risk free rate is 5%, the beta of

Lily’s stock was 0.85, and market risk premium

  

was 7%. r
 m  r f 
 
 Using these values in SML equation, we have:

ke = 5 + 0.85(7)
ke = 11%
 Recall, 11% is the value used for ke to determine

constant dividend growth rate value for Lily stock.

 Lecture Exercise
The next dividend payment by BDJ Sdn. Bhd.,
will be RM5.70 per share. The dividends are
anticipated to maintain a 6% growth rate,
indefinitely. What is the required return if
BDJ’s stock currently sells for RM68 per
share?
Answer:
 What Factors Influence Stock
Prices?
 Divided next period, D1
 The higher the next period dividend, the higher the current
stock price.

 Required rate of return, ke

 The higher the rate of return required by investors, the lower
the current stock price is.

 Growth rate in dividends

 Increase in growth rate of dividends, g; will increases the
stock price.
 Limitations of Model
 Some stocks do not pay a dividend.

 Some dividends do not grow at a constant rate.

 Required rate of return, ke, must exceed the expected

growth rate in dividends, g; otherwise the resulting
stock price is infinite.
 Preferred Stock
 Has preference or priority over common
stock with regard to the company’s dividends
and assets.

 Dividends cannot be paid on common stock

unless the preferred dividend for the period
has been paid.
 Preferred Stock (Cont…)
 Is a hybrid security sharing certain
characteristics of debt and common stock.
 Like common stock, preferred stock is part of
stockholders’ equity. However, it does not
have the voting rights.
 Like long term debt, preferred stock is a fixed
income security which receives dividends
instead of interest payments.

 Dividends on preferred stocks are not tax

deductible
 Features of Preferred Stock
 Preferred dividends
 Usually stated as ringgit amount but
sometimes stated as a percentage of par value.

 Cumulative feature
 If a firm fails to pay its preferred dividend, it
cannot pay dividend to common stock until it
satisfy all preferred stock in arrears.
Features of Preferred Stock (Cont…)
 Maturity
 Some firms issue preferred stock that is
intended to be perpetual (having no specific
maturity date).
 Voting rights
Preferred stockholders are not entitled to vote
for the company’s board of directors.
However, special voting procedures take effect
if the company omits its preferred dividends or
incurs losses for a period of time.
 Valuation of Preferred Stock
Consider the case of preferred stock that pays
regular, fixed dividends, and has no maturity
date.

Valuation of preferred stock should be as

follows:
Dp
P0 
kp
 Valuation of Preferred Stock
Example:
Great Plains Energy 3.8% preferred stock with a
RM100 par value per share.
What is the value of this stock to an investor who
requires a 7% annual rate of return?
Dividend = 0.038 x RM100 = RM3.80

Po=RM3.80/0.07
Po=RM54.29
 Lecture Exercise
1. What is the required rate of return to the
investor who is willing to purchase a Duke
Power preferred stock with a RM8.70
dividend, a par value of RM100, and a current
market price of RM87?
Answer:
 Lecture Exercise
2. Macau Pets just issued some new preferred
sock. The issue will pay an annual dividend of
RM6. If the market requires a 7 percent return
on this investment, how much does a share of
preferred stock cost today?
Answer:
 Lecture Exercise
Sam Yu Corporation’s preferred stock is
currently selling for RM32 per share. The
preferred dividend amounts to RM2.50 per
share. If you require a return of 9%, should
you invest in this stock?
Answer:
"I hear and I forget.
I see and I remember.
I do and I understand."
-- Confucius