Rsm Capital

RSM332 Capital Market Theory

Lecture 5: Valuation of Stocks

Liyan Yang

Rotman School of Management

Lecture agenda L d

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Characteristics of stock Valuation of common stocks  Stock price: PV of future dividends  Gordon models

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Zero-growth Constant growth Differential growth

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NPV of growth opportunities (NPVGO) Price earnings ratio

Liyan Yang

RSM332 Capital Market Theory

2

Nature of stocks N f k

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Include preferred and common shares Represent ownership claims on the underlying entity Usually have no specified maturity date Equities pay dividends from after-tax earnings at the after tax discretion of the board of directors

Liyan Yang

RSM332 Capital Market Theory

3

Preferred stock P f d k

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Dividend payments  Fixed in advance (like bond coupons)  Made before dividends to holders of common stock  Omission of dividend payment does not constitute default  Cumulative provision: unpaid dividends carried forward Rights of preferred stockholders  Voting rights: can elect 1/3 of the members of the board of directors if the firm skips preferred dividend payments  Convertibility: often convertible into common stock  Claim on assets: priority over holders of common stock, but stock not over bondholders

Liyan Yang

RSM332 Capital Market Theory

4

Common stock C k

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Dividend payments  Variable  Subordinated to dividend payments to preferred stockholders and to bondholders Rights of common stockholders  Voting rights: they elect the Board of Directors, which chooses top management p g  Claim on assets: they are paid after bondholders and preferred stockholders

Liyan Yang

RSM332 Capital Market Theory

5

Valuation f V l i of common stock k

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Value of stocks P = PV of expected future cash flows  Logic: If P < PV, then buying stocks constitutes a project with positive NPV, all consumers buy stocks, pushing prices up; If P < PV, then sell… ⇒ In equilibrium,...