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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

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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?

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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

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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

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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.

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DDM Model

Thus

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0111 DRadjustedriskk

P

PPDrIE

k

PDP

1

110

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DDM Model

1

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111

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tt

t

k

D

k

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k

DP

k

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The Constant-Growth-Rate DDM

When the dividends grow at a constant rate g:

gk

D

k

g

k

DP

gDDt

t

tt

1

1

1

10

11

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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(

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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

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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

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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

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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, 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

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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.

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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.

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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.

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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.