Stocks and Their Valuation

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CHAPTER 7

• Stocks and Their Valuation

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Common Stock

• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors hire management.
• Since managers are agents of shareholders,
  their goal should be Maximize stock price.

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Classified Stock

• Classified stock has special provisions.
• Could classify existing stock as founders
  shares, with voting rights but dividend
  restrictions.
• New shares might be called Class A shares, with
  voting restrictions but full dividend rights.

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Tracking Stock

• The dividends of tracking stock are tied to a
  particular division, rather than the company as a
  whole.
• Investors can separately value the divisions.
• Its easier to compensate division managers with
  the tracking stock.
• But tracking stock usually has no voting rights,
  and the financial disclosure for the division is
  not as regulated as for the company.

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Initial Public Offering (IPO)

• A firm goes public through an IPO when the
  stock is first offered to the public.
• Prior to an IPO, shares are typically owned by
  the firms managers, key employees, and, in many
  situations, venture capital providers.

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Seasoned Equity Offering (SEO)

• A seasoned equity offering occurs when a company
  with public stock issues additional shares.
• After an IPO or SEO, the stock trades in the
  secondary market, such as the NYSE or Nasdaq.

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Different Approaches for Valuing Common Stock

• Dividend growth model
• Using the multiples of comparable firms
• Free cash flow method (will be covered in Chapter
  15)

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Dividend Growth ModelStock Value PV of
Dividends
where P0 is value of the stock, D dividend,
and rs is the required return on common stock.
What is a constant growth stock? One whose
dividends are expected to grow forever at a
constant rate, g.
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For a constant growth stock
D1 D0(1g)1 D2 D0(1g)2 Dt Dt(1g)t
If g is constant and less than rs, then
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Required rate of return beta 1.2, rRF 7,
and RPM 5.
Use the SML to calculate rs
rs rRF (RPM)bFirm 7 (5) (1.2) 13.
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Projected Dividends

• D0 current, most recent dividend 2 and
  constant g 6
• D1 next dividend, expected dividend, dividend
  one period from now
• D1 D0(1g) 2(1.06) 2.12
• D2 D1(1g) 2.12(1.06) 2.2472
• D3 D2(1g) 2.2472(1.06) 2.3820

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Expected Dividends and PVs (rs 13)
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Intrinsic/Present Stock Value D0 2.00, rs
13, g 6.
Constant growth model
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Expected Return on StockRearrange model
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If g 0, the dividend stream is a perpetuity.
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Nonconstant growth followed by constant growth
0
1
2
3
4
rs13
g 30
g 30
g 30
g 6
D0 2.00 2.60 3.38 4.394
4.6576
2.3009
2.6470
3.0453

4.6576
46.1135
P3
66.5371
0.13 0.06

54.1067 P0
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Valuing Preferred Stock

• Hybrid security.
• Similar to bonds in that preferred stockholders
  receive a fixed dividend which must be paid
  before dividends can be paid on common stock.
• However, unlike bonds, preferred stock dividends
  can be omitted without fear of pushing the firm
  into bankruptcy.

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Expected return, given Vps 50 and annual
dividend 5
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Intrinsic Stock Value vs. Quarterly Earnings

• If most of a stocks value is due to long-term
  cash flows, why do so many managers focus on
  quarterly earnings? -Sometimes changes in
  quarterly earnings are a signal of future
  changes in cash flows. This would affect the
  current stock price.
• - Sometimes managers have bonuses tied to
  quarterly earnings.

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Using Stock Price Multiples to Estimate Stock
Price

• Analysts often use the P/E multiple (the price
  per share divided by the earnings per share).
• Example
• Estimate the average P/E ratio of comparable
  firms. This is the P/E multiple.
• Multiply this average P/E ratio by the expected
  earnings of the company to estimate its stock
  price.

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Problems with Market Multiple Methods

• It is often hard to find comparable firms.
• The average ratio for the sample of comparable
  firms often has a wide range.
• For example, the average P/E ratio might be 20,
  but the range could be from 10 to 50. How do you
  know whether your firm should be compared to the
  low, average, or high performers?

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Whats the Efficient MarketHypothesis (EMH)?

• Securities are normally in equilibrium and are
  fairly priced. One cannot beat the market
  except through good luck or inside information.

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Weak-form EMH

• Cant profit by looking at past trends. A recent
  decline is no reason to think stocks will go up
  (or down) in the future. Evidence supports
  weak-form EMH, but technical analysis is still
  used.

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Semistrong-form EMH

• All publicly available information is reflected
  in stock prices, so it doesnt pay to pore over
  annual reports looking for undervalued stocks.
  Largely true.

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Strong-form EMH

• All information, even inside information, is
  embedded in stock prices. Not true--insiders can
  gain by trading on the basis of insider
  information, but thats illegal.

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Markets are generally efficient because

• 100,000 or so trained analysts--MBAs, CFAs, and
  PhDs--work for firms like Fidelity, Merrill,
  Morgan, and Prudential.
• These analysts have similar access to data and
  megabucks to invest.
• Thus, news is reflected in P0 almost
  instantaneously.