STOCKS VALUATION

By : Kharul Azhar Bin Ramli

By : kazhar

Contents:
A) PREFERRED STOCK
1. Definition of Preferred Stock
2. Preferred Stock Valuation
3. Preferred Stockholders Expected Rate of Return
B) COMMON STOCK
1. Definition of Common Stock
2. Characteristics of Common Stock
3. Common Stock Valuation
4. Common Stockholders Expected Rate of Return

What is Value

In general, the value of an asset is the price that

a willing and able buyer pays to a willing and
able seller.
Note that if either the buyer or seller is not both
willing and able, then an offer does not establish
the value of the asset.

Valuation of Financial Assets

Process of determining the fair market
value of a financial asset on the basis of
present value of the expected cash flows
Three step process:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate
to discount the cash flows.
3. Compute the present value of the
expected cash flows by discounted them
with interest rate determine in step 2.

Intrinsic Value
Maximum price which an investor is ready
to pay for purchase of a security.
Intrinsic value is present value and is also
called estimated value or economic value.
Intrinsic value is compared with market
value of security and is based on these
factors:
Future cash inflows
Timing of return
Required rate of return i.e. k
k=risk free rate of return + risk
premium.

By : kazhar

Preferred Stock
Hybrid security -- Characteristics of both
common stock and bonds
Bond Characteristics:
Dividends are limited or fixed either as a
percentage of par value or specific dollar
amount
Failure to pay dividends does not bring on
bankruptcy dividends are cumulative

Common stock characteristics:

No fixed maturity date
Dividends are not deductible

By : kazhar

Usually sold for $25, $50, or $100 per

share.

Example: In 1988, Xerox issued $75 million

of 8.25% preferred stock at $50 per share.
$4.125 is the fixed, annual dividend per
share.

By : kazhar

Features of Preferred Stocks

Multiple series of preferred stock
Preferred stocks claim on assets and
income
Cumulative features
Protective provisions
Convertibility
Adjustable rate
Participation
PIK preferred
Retirement features
9

By : kazhar

Multiple Series
If a company desires, it can issue more
than one series of preferred stock, and
each series can have different
characteristics.
Convertibility
Priority status

Claim on Assets and Income

Honored before common stockholders, but
after bonds.
Must pay dividends to preferred
stockholders before it pays common
stockholder dividends.
10

By : kazhar

Cumulative Dividends
Cumulative features require that all past,
unpaid preferred stock dividends be paid before
any common stock dividends are declared

Protective Provisions
Protective provisions generally allow for voting
rights in the event of nonpayment of dividends,
or they restrict the payment of common stock
dividends if sinking-funds payments are not
met or if the firm is in financial difficulty.
11

By : kazhar

Convertibility
Many preferred stock can be converted into a
predetermined number of shares of common
stock.
Almost one-third of preferred issued today is
convertible preferred.

Adjustable rate
Provide investors with some protection
against wide swings in the stock value.
preferred have dividends tied to interest rates.12

By : kazhar

Participation
Allows the preferred stockholder to participate in
earnings beyond the payment of the stated
dividend

PIK preferred
Pay-in-kind preferred stocks pay additional
preferred shares to investors rather than cash
dividends

Retirement features
preferred stock has no set maturity ,there are
some method of retiring the stock.
Callable preferred
Sinking fund provision

13

By : kazhar

Callable Preferred
entitles a company to repurchase its preferred
stock (or bonds) from their holders at stated
prices over a given time period.
Call feature usually involves an initial
premium of 10% above par value
Sinking-Fund Provision
requires the firm to set aside an amount of
money periodically for the retirement of its
preferred stock.
Money used to purchase the preferred stock in
the open market or to call the stock,
14
whichever method is cheaper.

By : kazhar

Valuing Preferred Stock

A preferred stock can usually be valued like a
perpetuity.
The value of a preferred stock is the present
value of all future dividends.
Calculate the value of preferred stock:
Vps = D =
Annual dividend
kps
Required rate of return
15

By : kazhar

Valuing Preferred Stock

Vps=

annual dividend
required rate of return

= D
k ps

Example:
Xeroxs Series C preferred stock pays
an 8.25% on a $50 par value and the
investors required rate of return is 9.5%.
Vps = D

kps

=
16

By : kazhar

Example:
1) Calculate the value of a preferred stock

that pays a dividend of $6 per share

and your required rate of return is 12%
D=6
kps = 12%
Vps = D

kps

By : kazhar

2) What is the value of a preferred stock where

the dividend rate is 14% on a $100 par

value? The appropriate discount rate for a
stock of this risk level is 12%
D = 14% x 100 = 14
kps = 12%
Vps = D =
kps

By : kazhar

Expected Rate of Return of Preferred

Stock (kps )
The preferred stockholders expected rate of return;

kps = D

P0

Just adjust the valuation

model;
Where;
D : Annual dividend

Info!!
P0 : Market Price
When the expected rate of return (kps)is greater
than the required rate of return (kps), you should
buy the stock
BUY when

kps > kps

EXAMPLE :
If you know the preferred stock price is $40, and
the preferred dividend is $4.125.
a)What is your expected rate of return?
b)If your require rate of return is 11%, given the
current price should you buy more stock?

Solution:
a) kps = $4.125 / $40 =
b)

By : kazhar

1) Calculate the expected return of preferred stocks that :

a) Pay dividend $1.25 per share & currently sold for $35.15

kps = D/ Po
=
b) Currently sold for $48.50 per share and pay dividend of
$4.25 per share.

kps = D / Po
=

By : kazhar

2) RBCs preferred stock, which currently sells for

$55.50 per share and pays dividends of $2.50
per share
a) What is your expected rate of return?
kps = D/ Po
=
b) If you require rate of return is 4%, should you
buy the stock?

By : kazhar

1. Pioneers preferred stock is selling for $33 in

the market and pays a $3.60 annual dividend
a) What is the expected rate of return on the stock?
b) If an investors required rate of return is 10% what is the
value of the stock ?
c) Should the investor acquire the stock?

2. Kendra Corporations preferred shares are

trading for $25 in the market and pays a $4.50
annual dividend. Assume that you, the investor
, have a required rate of return of 14%.
a) What is the stock value to you, the investor?
b) What is the expected rate of return on the stock?
c) Should you purchase the stock?

By : kazhar

Common Stock
Certificate that indicates ownership
in a corporation
Common stockholders are the true
owners of the firm
Share in the residual profits of the
company
25

By : kazhar

Features of Common Stock

Claim on income
Claim on assets
Voting rights
Preemptive rights
Limited liability

26

By : kazhar

Claim on Assets
a common stockholder has a residual claim
on the firms assets in case of liquidation
after bondholders and preferred
stockholders has been satisfied.

Claim on Income
a common stockholder has a claim on the
firms residual income after bondholders
and preferred stockholders has been paid.
27

By :kazhar

Voting rights

A common stockholder has a right to vote for the

firms board of directors. - selects the management
team that runs the companys day-to-day operations.
Proxy
Proxy fight
Cumulative voting - provide the holders with multiple votes
per share, increasing their influence and control over the
company

Preemptive rights

stockholders may share proportionally in any new

stock issues.

Limited liability

Common stockholders are the actual owners but their

liability is limited to the amount of their investment.
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Differences between Bonds

and Stocks

Valuing Common Stock:

Present Value of Future
Dividends
The value of a common stock is the present value

By : kazhar

of all future cash flows.

Common stock does not provide a predetermined,
constant dividend.
Dividend tend to increase with the growth in
corporate earnings.

Growth factor
Infusion of capital (investor increase their
investment)
Financing, debt, common stock

Internal growth
Management retains some or all of the firms
profits for reinvestment in the firm

30

By : kazhar

Internal Growth
g = ROE x r
Where;
g = the growth rate of future earnings and
the
growth in the common stockholders
investment in the firm
ROE = the return on equity (net income/common
book value)
r = the companys percentage of
profits retained - profit retention rate
31

Common Stock
Valuation

By : kazhar

By : kazhar

Single Holding Period

investor holding the stock for only 1 year.
the value of stock should equal the PV of both the
expected dividend in year 1 (D1) and the
anticipated market price of the share at year end
(P1)

Vcs =

Vcs =

Present value
of dividend received in
one year (D1)

D1
(1 + Kcs)

+
+

Present value of
market price received in
one year (P1)

P1
(1 + Kcs)

By : kazhar

Example :

XYZ common stock is expected to pay $5.50 in

dividends next year and the market price is
projected to be $120 by year end. If the
investors required rate of return is 15%, what is
the current value of the stock?

Vcs

$120 : P1
$5.50 : D1

0
1
Vcs = (5.50/1 + 0.15) + (120/1+ 0.15)
= 4.783
+
104.348
= $ 109.13

By : kazhar

1) Honey common stock is expected to pay

RM2.05 in dividend next year, and the market
price is projected to be RM37.50 by year end. If
the investor decide to hold for a year and the
required rate of return is 12 percent, what is
the current value of the stock?
D1= $2.05

P1 = $37.50

Vcs = D1/(1 + kcs) + P1/(1 + kcs)

=

kcs = 12%

By : kazhar

2) Barker common stock market price and the

dividend at the end of the year is projected
to be RM55 and RM3 respectively. How much
is the stock value for you to satisfy your
required rate of return of 12 percent.
D1= $3

P1 = $55

kcs = 12%

Vcs = D1/(1 + kcs) + P1/(1 + kcs)

=

By : kazhar

Multiple Holding Period

Multiple Holding Period : for CS that has
no maturity date & is frequently held for
many years (perpetuities)
2 types ;
Constant Growth Model : where CS
dividends grow at a constant rate
every year
Non-constant Model (Supernormal
Growth) : where CS dividends grow at
non constant rate ever year.

By : kazhar

Constant Growth Stock

Constant Growth Model : where CS
dividends grow at a constant rate every
year
Formula :

D1

Vcs = kcs - g

D1 = the dividend at
the end of
period 1
kcs = the required
return
on the common
stock
g = the constant,

By : kazhar

Example :
XYZ stock recently paid a $5.00 dividend.
The dividend is expected to grow at 10% per
year. What would we be willing to pay if our
10%return
10%
10%
required
on
XYZ
stock is 15%?
$ 5.00
0

1)

Because the $5.00 is the current dividend (D 0),

2)

we must compute the next dividend (D1)

D1 = D0 (1 + g) = 5.00 (1+.10) = 5.5
Now, compute Vcs
Vcs = D1
=
5.50
= $110
kcs g
0.15 - 0.10

By : kazhar

1) Header Bhd. paid a RM3.50 dividend last year. At a

constant growth rate 5 percent, what is the value of
the common stock if the investors require a 20
percent rate of return?
Do = $3.50

g = 5%

kcs = 20%

Because the $3.50 is the current dividend (D 0), we must

compute the next dividend (D 1)

D1 = D0 (1 + g) = 3.50 (1+.05) =
3.675
Now, compute Vcs

Vcs =

D1
kcs g

3.675
0.20 - 0.05

= $24.50

By : kazhar

1)KPD Bhd. paid RM1 dividend last year.

Dividends are expected to grow at an 8 percent
annual rate for an indefinite number of years. If
your required rate of return is 11 percent, what
is the value of the stock?
2)Lon Jak Bhd common stock just paid a dividend
of $2.50. Dividends are expected to grow at a
rate of 8% indefinitely. If investors require a
rate of return on the stock of 15% what is the
value of Lon Jaks common stock today?

3. Big Shoe Co. just started their operation

last few years. Last year dividend was
$2.40. Due to unstable economic
conditions, the management decided to
retain more of their earnings to help
finance the growth. As a result they are
going to reduce their annual dividend
by 3 % indefinitely. If the required rate
of return on this stock is 15%, compute
the current value BS stock.

By : kazhar

Supernormal Growth

where g (growths) are different each year or

at least there are 2 different growths in cash
flow.

Steps of calculation:
a) Find the expected future cash dividends (D1,
D2, D3..Dn)
b) Find the price of the stock at the end of
non-constant growth period. (Pn)
c) Compute the PV of (a) & (b) to find the
intrinsic value of the stock, (P0)

By : kazhar

Let say a company is experiencing a

supernormal growth rate in cash
dividends of 25% for each of the next
4 years. After that, the dividend
growth rate is expected to be 5% per
year forever. The latest annual
dividend, is $0.75. The required
return is 22%. How much does the
companys stock worth?

By : kazhar

a) Find the expected future cash

dividends (D1, D2, D3..Dn)

FORMULA

Dt : D0 (1 + g)t
D5 = 1.831 (1.05)

D1 = 0.75
(1.25)
Dividend

0.75

0.938

1.172

1.465

1.831

1.923

D0

D1

Growth
Years

D2

D3

D4

D5

25%

25%

25%

25%

5%
5.

By : kazhar

b) Find the price of the stock at the end of

non-constant growth period. (Pn)

Pn = Dn+1 / (kcs g)
P4 = D5 / (kcs g)
=1.923 / 0.22 - 0.05
= $ 11.312

c) Compute the PV of (a) & (b) to find the

intrinsic value of the stock (P0)
P0 = D1/(1+ kcs) + D2 /(1+ kcs)2 + D3/(1+ kcs)3
+ D4/(1+ kcs)4 + P4/(1+ kcs)4
P0 = 0.938/(1.22) + 1.172/(1.22)2 + 1.465/(1.22)3
+ 1.831/(1.22)4 + 11.312/(1.22)4
=
$8.93

Exercise.. (supernormal

By : kazhar

growth)
1) A company currently pays a dividend of RM2 per share. It is
estimated that the companys dividend will grow at a rate of 20
percent per year for the next 2 years, then the dividend will
grow at a constant rate of 7 percent thereafter. Stockholders
require a return of 10 percent on the stock. Calculate the
value of the stock today?
2) WME Bhd.is expected to experience a 15 percent annual
growth rate for the next 5 years. By the end of 5 years this
growth rate will reduce to 5 percent per year indefinitely.
Stockholders require a return of 12 percent on WMEs stock.
The most recent annual dividend which was paid yesterday,
was RM1.75 per share. Calculate the value of the stock
today?

By : kazhar

Expected Rate of Return of

Common Stock (kcs )
The common stockholders expected rate of return

D1

kcs = (
P
o
g

)+

Info!!

where
D : dividend in year
1
P0 : Market price
g : growth rate

When the expected rate of return (kcs)is

greater than the required rate of return
(kcs), you should buy the stock

BUY when

kcs > kcs

By :
kazhar

Example :
The stock paid a dividend of $4 at the
end of last year and is expected to
increase each year at a 5% growth
rate. The stock sell for $75. Compute
the expected rate of return.

kcs =$ 4 x (1
+
+
.05)
0.05
$ 75+ 0.05 =
= 0.056
0.106 @ 10.6%

Exercise :

By : kazhar

Exercise:

1) The common stock of Zaidi Co. is selling for

RM32.84. The stock recently paid dividends
of RM2.94 per share and has a projected
constant growth rate of 9.5 percent. If you
purchase the stock at the market price,
what is your expected rate of return?
2) Mikes common stock currently sells for
RM22.50 per share. The companies
anticipate a constant growth rate of 10
percent and an end-of-year dividend of RM2
a. what is your expected rate of return?