Valuation of Financial Assets Stocks (Equity) : Business Finance 1

Valuation of Financial Assets
Stocks (Equity)
Business Finance 1
Muslim Reza Mooman

Capitalization-of-Income Method
• Financial asset: a security (e.g. a share of stock
or bond) that represents a claim against the
future income or assets of issuer
• Value of financial asset may be determined as
discounted present value of expected future
cash flows earned on that asset.
Capitalization-of-Income Method
• Two areas of concern
1. Determining appropriate earnings to be
capitalized
2. Determining appropriate capitalization rate
Selecting Appropriate Capitalization Rates
1. Given risk characteristics of a particular

investment opportunity or security, define
appropriate capitalization rate (K) as minimum
expected rate or return required to induce
investors to accept that investment
Preferred Stock Valuation
• Preferred stock has no maturity date.
• Value of share of preferred stock is present value of
dividend payment from date of purchase to infinity.
• Consider two factors when discounting out to
infinity:
1. There are corporations that have existed for 50 or more
years and can be expected to survive for another 50 or
more years.
2. “Economic infinity” for discounting purposes is not as far
away as the word infinity implies.
• Assuming that dividends are paid annually,
value of share of preferred stock is:
V = D/(1+K) + D/(1+K)2 + D/(1+K)3 + … + D/(1+K)∞
Where V = value of preferred stock

D = annual dividend payment
K = appropriate capitalization rate
∞ = infinity
• Since present value of each year’s dividend
decreases each year, preferred-stock-valuation
equation is infinite series of decreasing
numbers.
• Sum of preferred-stock-dividend series:
V = D/K
• Ex. If K is 12%, value of share of preferred
stock paying an $8.00 annual dividend is:
V = $8.00/0.12
V = $66.67
• At price of $66.67, share of preferred stock
paying $8.00 dividend provides annual yield of
12% from now to infinity.
• Preferred stocks are riskier investments than
bonds.
– Unlike bond-interest payments, preferred stock is
not guaranteed.
– Preferred stock is junior to debt in priority.
• However, market-capitalization rates for
preferred stock are often lower than bond-
capitalization rates. Why?
• Recall Ch. 2: 85% of stock dividends paid to corporation are
tax free.
– Dividends paid by corporations are subject to tax at long-term capital
gains rate, which is significantly lower than highest personal marginal
income tax rate.
– Bond interest is fully taxable at highest marginal rate.
• For corporation or individual investor, dollar’s worth of
preferred dividends is worth much more than dollar’s
worth of bond interest.
• Investors willing to accept lower pre-tax yield on preferred
stocks than on bonds.
• Market activities generally results in lower pre-tax
capitalization rates for preferred stocks than for bonds.
Common-Stock Valuation
• Two forms of expected cash flows from
common stocks:
1. Dividends received over investor’s stock holding
period
2. Price expected to be received when stock is
sold
• Two major concerns for valuation:
1. Earnings and dividends per share are expected to
increase over time.
• Cannot use annuity formulas for common-stock valuation
because calculating present vale of annuity requires that cash
flows be constant annual amount.
2. Uncertainty surrounding expected future dividend
payments and expected future stock price.
• Common-stock dividends are never guaranteed and stock prices
fluctuate.
• Account for uncertainty in valuation process by assigning higher
capitalization rate to common stocks than to bonds or preferred
stocks.
• Most models are based on premise that common-stock values
are function of expected future cash flows from dividends and
expected future value of stock.
• Widely accepted model views common-stock values as
dependent on dividend-paying capacity of corporation.
– Explanation: Price at end of any year is always equal to present value
of following year’s dividend and price.
– As price approaches economic infinity, present value of terminal price
(price in final year) becomes zero for valuation purposes.
– Any financial asset is equal to present value of future cash flows.
– Since stock may exist until economic infinity, only cash flows that will
be received from share of common stocks are dividends.
– Present value of share of common stock is equal to present value of
future expected dividends from now until infinity.
• Value of common stock is sum of infinite
series of growing dividends.
• Two assumptions must be made:
1. Dividends will grow at constant rate.
2. Constant growth rate will be less than
capitalization rate that will be applied to value
of stream of growing dividends.
• Value of share of common stock:
P0 = D1/(K-g)
Where P0 = present value of share of common stock
D1 = expected dividend in year 1
K = appropriate capitalization rate
g = expected future growth rate of dividends
• Ex. Suppose XYZ common stock is expected to pay
dividend of $2.16 in coming year. This dividend is
expected to increase at average annual rate of 8%
per year. Appropriate capitalization rate is 15%. What
is present value of XYZ’s common stock?
P0 = $2.16/(0.15-0.08)
P0 = 30.86
• What if expected future growth rate is not
constant?
– Each year’s expected dividend must be discounted
separately out to year for which it is estimated that
dividend growth will “settle down” to some constant rate.
– Use dividend-capitalization model to determine value of
stock at end of last year of irregular growth.
– Present value of stock price at end of irregular growth
period plus present value of dividends received during
irregular growth period equals present value of stock.
• What if growth rate exceeds capitalization
rate?
– For temporary supernormal growth, discount value of
dividends received during that period separately.
– Use dividend-capitalization model to determine value of
stock at end of supernormal growth period.
– Present value of stock equals present value of dividends
received during supernormal growth period plus present
value of stock price at end of same period.
• What if stocks pay no dividends and sell for
positive prices (capitalizing dividends)?
– Estimate whether company will be able to start
paying dividends in future.
– Use dividend-capitalization model to determine
value of stock at time.
– Discount this value back to present to determine
present value of stock.
• See Exhibit 15.2: Application of dividend-
capitalization model to no-growth stock, normal
growth stock, and supernormal growth stock.
– High-growth stocks sell at higher multiples of earnings
than do lower-growth stocks because growing dividends
impart more value to stock price.
– High-growth stocks have much lower dividend yields than
low-growth stocks because value of growth potential of
high-growth stock drives up price of stock and thus drives
down dividend payment as percentage of stock price.
Intrinsic Values and Market Values
• Intrinsic value: value of share of stock as determined
by a valuation model
• When market price equals intrinsic value, stock price
is in equilibrium.
– Remember, there are different common-stock valuation
methods!
– Changes in market-capitalization rates used by investors
and changes in growth outlook for stock cause intrinsic
value and market price to fluctuate, and thereby prevents
equilibrium.
• If market price is less than intrinsic value,
stock is undervalued and should be
purchased.
• If market price is greater than intrinsic value,
stock is overvalued and should be sold.
• If market price equals intrinsic value, stock is
in equilibrium and may be held or purchased.
• Efficient markets hypothesis (EMH):
– Large number of well-educated, professional market participants have
access to same databases
– All of these participants analyze these data in same way
– Most draw same conclusions about intrinsic value of most stocks
– Market activities cause most stocks to be priced at their intrinsic
values
• Price at which rate of return earned on common-stock investment
is commensurate with risk involved in investment
– It is not possible to “beat the market” by earning an
above-average rate of return.

Valuation of Financial Assets Stocks (Equity) : Business Finance 1

Uploaded by

Copyright:

Available Formats

Valuation of Financial Assets Stocks (Equity) : Business Finance 1

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Valuation of Financial Assets Stocks (Equity) : Business Finance 1

Uploaded by

Copyright:

Available Formats

Valuation of Financial Assets

Muslim Reza Mooman

1. Given risk characteristics of a particular

V = D/(1+K) + D/(1+K)2 + D/(1+K)3 + … + D/(1+K)∞

Where V = value of preferred stock

You might also like