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Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques used for stock valuation must make some assumptions regarding the structure of the dividends.
A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the foreseeable future. This condition fits many established firms, which tend to grow over the long run at the same rate as the economy, fairly well. The value of a constant growth stock can be determined using the following equation:
where
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Constant Growth Stock Valuation Example |
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Find the stock price given that the current dividend is $2 per share, dividends are expected to grow at a rate of 6% in the forseeable future, and the required return is 12%.
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The constant growth stock equation can be rearranged to obtain an expression for the expected return on the stock as follows:
When expressed in this manner, it is apparent that the expected return on the stock equals the expected dividend yield plus the expected capital gains yield where the dividend yield and capital gains yield are defined as follows:
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A more general form of the Constant Growth Stock Valuation formula which can be used to find the price of the stock at any period t in the future is given by the following:
Many firms enjoy periods of rapid growth. These periods may result from the introduction of a new product, a new technology, or an innovative marketing strategy. However, the period of rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and catch up with the firm.
These firms cannot be valued properly using the Constant Growth Stock Valuation approach. This section presents a more general approach which allows for the dividends/growth rates during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from that point on at a constant rate which reflects the long-term growth rate in the economy.
Stocks which are experiencing the above pattern of growth are called nonconstant, supernormal, or erratic growth stocks.
The value of a nonconstant growth stock can be determined using the following equation:
where
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Nonconstant Growth Stock Valuation Example |
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The current dividend on a stock is $2 per share and investors require a rate of return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then at a rate of 5% per year from that point on. Find the price of the stock. Solution: There are 3 years of nonconstant growth, thus, T = 3. Before substituting into the formula given above it is necessary to calculate the expected dividends for years 1 through 4 using the provided growth rates.
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Preferred stock is defined as equity with priority over common stock with respect to the payment of dividends and the distribution of assets in a liquidation. Preferred stock is a hybrid security which shares features with both common stock and debt.
Preferred stock is similar to common stock in that it entitles its owners to receive dividends which the firm must pay out of after-tax income. Moreover, the use of preferred stock as a source of financing does not increase the probability of bankruptcy for the firm.
However, like the coupon payments on debt, the dividends on preferred stock are generally fixed. Also, the claims of the preferred stockholders against the assets of the firm are fixed as are the claims of the debt holders.
Preferred stock has the following features:
Par Value
The par value represents the claim of the preferred stockholder against the value of the firm.
Preferred Dividend / Preferred Dividend Rate
The preferred dividend rate is expressed as a percentage of the par value of the preferred stock. The annual preferred dividend is determined by multiplying the preferred dividend rate times the par value of the preferred stock.
Since the preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred stock can be determined using the following equation:
where
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Preferred Stock Valuation Example |
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Find the price of a share of preferred stock given that the par value is $100 per share, the preferred dividend rate is 8%, and the required return is 10%. Solution:
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Constant Growth Stock Price: |
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Expected Return: |
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Nonconstant Growth Stock: |
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Preferred Stock: |
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