Dual-Class IPOs, Share Recapitalizations, and Unifications A.pptVIP

* * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Stock Valuation Professor Thomas Chemmanur * Stock Valuation Common stock represents ownership of the firm: stockholders elect the board of directors who control the firm by overseeing management. Stockholders are also entitled to the cash flows generated by the firm. Stockholders ? Board of Directors ? Management However, stock holders are residual claimants: they get only the cash flow left over after paying interest to debt holders and other claimants. At this stage, we will assume that the firm is 100% equity financed, postponing a discussion of the impact of other claims till we talk about the firms capital structure choice. * Stock valuation: constant dividend growth model Consider a firm which pays dividends D1, D2, ...etc for the first H periods. Let PH be the price of the stock at t = H. Then, from our present value class, we know that the current market price of the stock, P0 is given by, Where r is the discounting rate which corresponding to the riskiness of the stock. But we know that PH is given by, * Stock valuation: constant dividend growth model Using (2) in (1) and simplifying, The problem in using (3) is that, to begin with, we dont know what the dividend stream is! Let us make the simplifying assumption that dividends grow at a constant rate g. Then, if D0 was the dividend in the last (current) period, D1 = D0 (1 + g); D2 = D1 (1+g) = D0(1+g)2; D3 = D0(1+g)3, etc. Using this assumption in (3), * Stock valuation: constant dividend growth model The term in the square brackets is an infinite geometric series of the form I talked about in the class on present values, with common ratio (1+g)/(1+r). Applying the formula for the sum of an infinite geometric series, (4) reduces to: (5) is often referred to as the constant growth formula for stock valuation. The above formula can be used only when r g, since otherwise the common ratio (1+g)/(1+r) of the geometric ser