Chapter 8: Stock Valuation Flashcards
In practice, it is more difficult to value a share of common stock than a bond for at least _______ reasons
three (3)
3 reasons as to why it is harder to value common stock than bonds
First, not even the promised cash flows are known in advance.
Second, the life of the investment is essentially forever because common stock has no maturity.
Third, there is no way to easily observe the rate of return that the market requires
Calculating the value of a share today
P0 = (D1 + P1) / (1 + r)
P0 = Current price of stock P1 = Price in one period D1 = Cash dividend paid at the end of the period r = Required return in the market
Importantly, no matter what the stock price is, the present value is essentially _____ if we push it far enough away
zero
We have illustrated here that the price of the stock today is equal to the present value of all the future dividends. How many future dividends are there? discount them all
In principle, there can be an infinite number. This means we still can’t compute a value for the stock because we would have to forecast an infinite number of dividends and then
Assuming there will be future dividends, there are three cases to consider regarding their patterns, what are they?
(1) the dividend has a zero-growth rate,
(2) the dividend grows at a constant rate, and (3) the dividend grows at a constant rate after some length of time.
Zero Growth
Since the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period
A share of common stock in a company with a constant dividend is much like a share of _________ stock
preferred
Zero Growth Stock Formula (equation)
P0 = D / r
D = Dividend (which is always the same, aka perpetuity)
r = Required return
Constant Growth
a
Why would the dividend grow at a constant rate?
The reason is that, for many companies steady growth in dividends is an explicit goal
Dividend aristocrats
Such companies with a policy of consistently increasing dividends every year for a specific period of time
**In Canada, the time frame to attain dividend aristocrat status is five consecutive years of dividend increases
Dividend Growth Model
A model that determines the current price of a stock as its dividend next period, divided by the discount rate, less the dividend growth rate.
We can actually use the dividend growth model to get the stock price at any point in time, not just today. In general, the price of the stock as of time t is:
(equation)
Pt = (D1 x (1 + g) / r - g) = (Dt + 1) / (r - g)
If growth rate, ‘g’, is larger than the discount rate, ‘r’
You do not get a negative stock price!
Rather, is g>r than the stock price is infinitely large
Therefore, the dividend growth model should not be used unless the growth rate is less than the discount rate (g < r)
Non-Constant Growth
The main reason to consider this is to allow for supernormal growth rates over some finite length of time
To avoid the problem of having to forecast and discount an infinite number of dividends, we assume that the dividends start growing at a constant rate sometime in the future
Critics raise two points about the dividend growth model
First, in the late 1990s, the level of the market, and especially tech stocks, was far higher than the present value of expected dividends.
Second, market prices are far more volatile than the present value of dividends
Rearranging P0 = D1 / r - g to solve for r (equation)
r - g = D1 / P0
ORRRR
r = (D1 / P0) + g
Dividend Yield
A stock’s cash dividend divided by its current price. (D1 / P0)
Capital Gains Yield
The dividend growth rate or the rate at which the value of an investment grows.
So variable ‘g’
Dividend Growth Model Calculates Total Return as
r = Dividend Yield + Capital Gains Yield
or, in Math Formate
r = (D1 / P0) + g
Reference P/E ratio / Benchmark
Pt = Benchmark P/E Ratio x EPSt
Pt = Price at a time EPS = Earning per share
“forward” P/E ratio
A P/E ratio that is based on estimated future earnings
For example, suppose you felt that Aphria’s earnings for the coming year were going to be $0.79, reflecting its growing customer base.
In this case, if the current stock price is $15.05, the forward P/E ratio is $15.05 / $ 0.79 = 19
Preferred stock
- Stock with dividend priority over common stock,
- Normally with a fixed dividend rate
- Often without voting rights, no voting options, but can
- If company is liquidated, preferred stock gets the share of the assets first over common stock (still placed behind all creditors)
- Is a form of Equity from a legal, tax and regulatory standpoint
Stated Value
Preferred shares have a stated liquidating value. The cash dividend is described in dollars per share or as a percentage of the stated value
For example, Bank of Montreal’s fixed quarterly dividend of “$0.275” translates easily into an annual dividend yield of 4.4% of the $25 stated share value.
Dividends payable on preferred stock are either ________________________
cumulative or non-cumulative
**But most are cumulative
Arrearage
A legal term for the part of a debt that is overdue after missing one or more required payments.
What does it mean is the preferred stock are cumulative?
If a company is to not pay dividends one year, than it will carry over to the next year to be paid (known as arrearage)! Therefore, there is always dividends to be paid.
Usually both the cumulated (past) preferred dividends plus the current preferred dividends must be paid before the common shareholders can receive anything.
Directors elected by the common shareholders can defer preferred dividends indefinitely. However, in such cases:
1) Common shareholders must also forgo dividends.
2) Holders of preferred shares are often granted voting and other rights if preferred dividends have not been paid for some time.
