Stock and their Valuation:

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Stock and their Valuation Chapter
8     Background information on Stock   Control
of the firm   Proxy       Proxy
Fight   Preemptive Right
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• Types of stock transactions
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• Trade in outstanding shares
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• Primary Market (Additional shares sold by public
  firms)
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• IPO (going public)
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Stock Valuation   Terms Dt     Po     Pt(hat)  
  g
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Ks       Ks(hat)       Ks(bar)       D1/Po       (
P1(hat)-Po)/Po
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Stock Valuation Models   Using dividends to
value a stock   Vb           Vs P0(hat)
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Stock value with zero growth dividends are
expected to stay at the same dollar amount in the
future   P0           could also solve for
K(hat)s
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Constant growth the dollar amount of the
dividend is anticipated to grow at a constant
rate g   Dt Do(1g)t           Then this
amount can be discounted back with the
appropriate discount rate,(the required rate of
return) Ks
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Expected rate of Return   KS(hat) D1/Po g
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Example Assume you buy a share of stock for the
price today of 40 and you expect that it will
pay a dividend of 2 in one year and the future
dividends will grow at a constant rate of 6,
what is your expected rate of return?  
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For a constant growth stock, 5 conditions must be
met   1. The dividend is expected to grow
forever at a constant rate g. 2. The stock price
is expected to grow at the rate g. 3. Expected
dividend yield is constant. 4. Expected capital
gains yield is also constant at rate g. 5. The
expected total rate of return is equal to the
expected dividend yield plus the expected growth
rate KS(hat) D1/Po g
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Example Stock Market Equilibrium Recall the
Capital asset pricing model (SML) from chapter
5.                   Assume an average investor
holds Pentech in his portfolio. The last
dividend (yesterday) was 2.78, g is 8. The
investor has calculated the beta on Pentech to be
2.2. Pentech currently sells for 40, should the
investor buy the stock? (current Krf is 7, Km is
11)
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First we can calculate the expected rate of
return on Pentech using current price, dividend,
and g                 Then we can see where on
the SML Pentech should be  
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The investor will realize that Pentech is
yielding a rate of return that is less than what
is demanded for the corresponding risk level and
therefore will want to sell his shares. However,
other investors, knowing this same information,
will not be willing to buy the shares at the
price demanded by our investor (40) So what
price will investors be willing to pay? g 8 D1
3.00 K(hat)s 15.8 (from SML) P ???
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• For Equilibrium
• Pentech's expected rate of return as seen by our
  investor must be equal to the required rate of
  return
• The actual market price of the stock must equal
  its intrinsic value as estimated by our investor.
  
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• Expected returns are obtained by estimating
  dividends and expected capital gains.
• Required returns are obtained by estimating risk
  and applying the CAPM.
• If expected return exceeds required return
• - The current price (P0) is too low and
  offers a bargain.
• - Buy orders will be greater than sell orders.
• - P0 will be bid up until expected return
  equals required return.

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Changes in Equilibrium price If a stock price
always moves toward equilibrium, why is there so
much day to day flux in the price of a particular
stock?
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• Efficiency Market Hypothesis
• 1. Stocks are always in equilibrium
• 2. It is impossible for the investor to
  consistently "beat the market"
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• Weak Form No relationship exists between prior
  prices and future stock prices.
• Independence exists over time between prices.
• The value of historical information already lies
  in the current price. Therefore, reviewing past
  prices is unimportant.

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• Semi-Strong Stock prices immediately reflect new
  information
• All public information is incorporated in a
  stock's value.
• Fundamental analysis is not helpful in
  determining if a stock is over or under valued.
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• Strong form Stock prices reflect all
  information, public or private
• A perfect market exists.
• All information, even inside information, is
  embedded in stock prices.
• Not true(Martha) insiders can gain by trading on
  the basis of insider information, but thats
  illegal.
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