Stocks and Their Valuation

1
CHAPTER 7

• Stocks and Their Valuation

2
Topics

• Features of common stock
• Determining common stock values
• Efficient markets
• Preferred stock

3
Common Stock Owners, Directors, and Managers

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

4
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.

5
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.

6
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.

7
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.

8
Different Approaches for Valuing Common Stock

• Dividend growth model
• Using the multiples of comparable firms
• Free cash flow method (covered in Chapter 13)

9
Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
10
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
11
Dividend Growth and PV of Dividends P0 ?(PVof
Dt)
12
What happens if g gt rs?

D0(1g)1 D0(1g)2 D0(1rs)8
P0


(1rs)1 (1rs)2
(1rs)8
(1g)t

If g gt rs, then
P0 8.
gt 1, and
(1rs)t
So g must be less than rs to use the constant
growth model.
13
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.
14
Projected Dividends

• D0 2 and constant g 6
• 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

15
Expected Dividends and PVs (rs 13)
16
Intrinsic Stock Value D0 2.00, rs 13, g
6.
Constant growth model
17
Expected value one year from now

• D1 will have been paid, so expected dividends are
  D2, D3, D4 and so on.

18
Expected Dividend Yield and Capital Gains Yield
(Year 1)
19
Total Year-1 Return

• Total return Dividend yield Capital gains
  yield.
• Total return 7 6 13.
• Total return 13 rs.
• For constant growth stock
• Capital gains yield 6 g.

20
Rearrange model to rate of return form
21
If g 0, the dividend stream is a perpetuity.
22
Supernormal Growth Stock

• Supernormal growth of 30 for 3 years, and then
  long-run constant g 6.
• Can no longer use constant growth model.
• However, growth becomes constant after 3 years.

23
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
24
Expected Dividend Yield and Capital Gains Yield
(t 0)
CG Yield 13.0 - 4.8 8.2.
(More)
25
Expected Dividend Yield and Capital Gains Yield
(t 4)

• During nonconstant growth, dividend yield and
  capital gains yield are not constant.
• If current growth is greater than g, current
  capital gains yield is greater than g.
• After t 3, g constant 6, so the t 4
  capital gains gains yield 6.
• Because rs 13, the t 4 dividend yield 13
  - 6 7.

26
Is the stock price based onshort-term growth?

• The current stock price is 54.11.
• The PV of dividends beyond year 3 is 46.11 (P3
  discounted back to t 0).
• The percentage of stock price due to long-term
  dividends is

27
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?
• See next slide.

28
Intrinsic Stock Value vs. 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.

29
Suppose g 0 for t 1 to 3, and then g is a
constant 6.
30
Dividend Yield and Capital Gains Yield (t 0)

• Dividend Yield D1 / P0
• Dividend Yield 2.00 / 25.72
• Dividend Yield 7.8
• CGY 13.0 - 7.8 5.2.

31
Dividend Yield and Capital Gains Yield (t 3)

• Now have constant growth, so
• Capital gains yield g 6
• Dividend yield rs g
• Dividend yield 13 - 6 7

32
If g -6, would anyone buy the stock? If so,
at what price?
Firm still has earnings and still pays dividends,
so P0 gt 0
33
Annual Dividend and Capital Gains Yields
Capital gains yield g -6.0. Dividend
yield 13.0 - (-6.0) 19.0. Both yields
are constant over time, with the high dividend
yield (19) offsetting the negative capital gains
yield.
34
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.

35
Using Entity Multiples

• The entity value (V) is
• the market value of equity ( shares of stock
  multiplied by the price per share)
• plus the value of debt.
• Pick a measure, such as EBITDA, Sales, Customers,
  Eyeballs, etc.
• Calculate the average entity ratio for a sample
  of comparable firms. For example,
• V/EBITDA
• V/Customers

36
Using Entity Multiples (Continued)

• Find the entity value of the firm in question.
  For example,
• Multiply the firms sales by the V/Sales
  multiple.
• Multiply the firms of customers by the
  V/Customers ratio
• The result is the total value of the firm.
• Subtract the firms debt to get the total value
  of equity.
• Divide by the number of shares to get the price
  per share.

37
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?

38
Why are stock prices volatile?

• rs rRF (RPM)bi could change.
• Inflation expectations
• Risk aversion
• Company risk
• g could change.

39
Consider the following situation.
D1 2, rs 10, and g 5 P0 D1 / (rs-g)
2 / (0.10 - 0.05) 40. What happens if rs
or g change?
40
Stock Prices vs. Changes in rs and g
41
Are volatile stock prices consistent with
rational pricing?

• Small changes in expected g and rs cause large
  changes in stock prices.
• As new information arrives, investors continually
  update their estimates of g and rs.
• If stock prices arent volatile, then this means
  there isnt a good flow of information.

42
What is market equilibrium?

• In equilibrium, stock prices are stable. There is
  no general tendency for people to buy versus to
  sell.
• The expected price, P, must equal the actual
  price, P. In other words, the fundamental value
  must be the same as the price.

(More)
43
In equilibrium, expected returns must equal
required returns
44
How is equilibrium established?
45
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.

(More)
46
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.

47
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.

48
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.

49
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.

50
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.

51
Expected return, given Vps 50 and annual
dividend 5