CHAPTER 8 Stocks and Their Valuation

1
CHAPTER 8Stocks and Their Valuation

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

2
Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Managements goal Maximize the stock price

3
Social/Ethical Question

• Should management be equally concerned about
  employees, customers, suppliers, and the
  public, or just the stockholders?
• In an enterprise economy, management should work
  for stockholders subject to constraints
  (environmental, fair hiring, etc.) and
  competition.

4
Types of stock market transactions

• Secondary market
• Primary market
• Initial public offering market (going public)

5
Different approaches for valuing common stock

• Dividend growth model
• Corporate value model
• Using the multiples of comparable firms

6
Dividend growth model

• Value of a stock is the present value of the
  future dividends expected to be generated by the
  stock.

7
Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• If g is constant, the dividend growth formula
  converges to

8
Future dividends and their present values
9
What happens if g gt ks?

• If g gt ks, the constant growth formula leads to a
  negative stock price, which does not make sense.
• The constant growth model can only be used if
• ks gt g
• g is expected to be constant forever

10
If kRF 7, kM 12, and ß 1.2, what is the
required rate of return on the firms stock?

• Use the SML to calculate the required rate of
  return (ks)
• ks kRF (kM kRF)ß
• 7 (12 - 7)1.2
• 13

11
If D0 2 and g is a constant 6, find the
expected dividend stream for the next 3 years,
and their PVs.
12
What is the stocks market value?

• Using the constant growth model

13
What is the expected market price of the stock,
one year from now?

• D1 will have been paid out already. So, P1 is
  the present value (as of year 1) of D2, D3, D4,
  etc.
• Could also find expected P1 as

14
What is the expected dividend yield, capital
gains yield, and total return during the first
year?

• Dividend yield
• D1 / P0 2.12 / 30.29 7.0
• Capital gains yield
• (P1 P0) / P0
• (32.10 - 30.29) / 30.29 6.0
• Total return (ks)
• Dividend Yield Capital Gains Yield
• 7.0 6.0 13.0

15
What would the expected price today be, if g 0?

• The dividend stream would be a perpetuity.

16
Supernormal growthWhat if g 30 for 3 years
before achieving long-run growth of 6?

• Can no longer use just the constant growth model
  to find stock value.
• However, the growth does become constant after 3
  years.

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Steps for Supernormal Growth

• 1. Find PV of dividends during nonconstant growth
  period
• 2. Find the P at end of nonconstant growth
  period, discount to PV
• 3. Add 1 and 2 together to get P0

18
Valuing common stock with nonconstant growth

P

19
Find expected dividend and capital gains yields
during the first and fourth years.

• Dividend yield (first year) D1 / P0
• 2.60 / 54.11 4.81
• Capital gains yield (first year)
• 13.00 - 4.81 8.19
• During nonconstant growth, dividend yield and
  capital gains yield are not constant, and capital
  gains yield ? g.
• After t 3, the stock has constant growth and
  dividend yield 7, while capital gains yield
  6.

20
Nonconstant growthWhat if g 0 for 3 years
before long-run growth of 6?
21
Find expected dividend and capital gains yields
during the first and fourth years.

• Dividend yield (first year)
• 2.00 / 25.72 7.78
• Capital gains yield (first year)
• 13.00 - 7.78 5.22
• After t 3, the stock has constant growth and
  dividend yield 7, while capital gains yield
  6.

22
If the stock was expected to have negative growth
(g -6), would anyone buy the stock, and what
is its value?

• The firm still has earnings and pays dividends,
  even though they may be declining, they still
  have value.

23
Find expected annual dividend and capital gains
yields.

• Capital gains yield
• g -6.00
• Dividend yield
• 13.00 - (-6.00) 19.00
• Since the stock is experiencing constant growth,
  dividend yield and capital gains yield are
  constant. Dividend yield is sufficiently large
  (19) to offset a negative capital gains.

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Corporate value model

• Also called the free cash flow method. Suggests
  the value of the entire firm equals the present
  value of the firms free cash flows.
• Remember, free cash flow is the firms after-tax
  operating income less the net capital investment
• FCF NOPAT Net capital investment

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Applying the corporate value model

• Find the market value (MV) of the firm.
• Find PV of firms future FCFs
• Subtract MV of firms debt and preferred stock to
  get MV of common stock.
• MV of MV of MV of debt andcommon
  stock firm preferred
• Divide MV of common stock by the number of shares
  outstanding to get intrinsic stock price (value).
• P0 MV of common stock / of shares

26
Issues regarding the corporate value model

• Often preferred to the dividend growth model,
  especially when considering number of firms that
  dont pay dividends or when dividends are hard to
  forecast.
• Similar to dividend growth model, assumes at some
  point free cash flow will grow at a constant
  rate.
• Terminal value (TVn) represents value of firm at
  the point that growth becomes constant.

27
Given the long-run gFCF 6, and WACC of 10,
use the corporate value model to find the firms
intrinsic value.
28
If the firm has 40 million in debt and has 10
million shares of stock, what is the firms
intrinsic value per share?

• MV of equity MV of firm MV of debt
• 416.94m - 40m
• 376.94 million
• Value per share MV of equity / of shares
• 376.94m / 10m
• 37.69

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Firm multiples method

• Analysts often use the following multiples to
  value stocks.
• P / E
• P / CF
• P / Sales
• EXAMPLE Based on comparable firms, estimate the
  appropriate P/E. Multiply this by expected
  earnings to back out an estimate of the stock
  price.

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What is market equilibrium?

• In equilibrium, stock prices are stable and there
  is no general tendency for people to buy versus
  to sell.
• In equilibrium, expected returns must equal
  required returns.

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Market equilibrium

• Expected returns are obtained by estimating
  dividends and expected capital gains.
• Required returns are obtained by estimating risk
  and applying the CAPM.

32
How is market equilibrium established?

• 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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Factors that affect stock price

• Required return (ks) could change
• Changing inflation could cause kRF to change
• Market risk premium or exposure to market risk
  (ß) could change
• Growth rate (g) could change
• Due to economic (market) conditions
• Due to firm conditions

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What is the Efficient Market Hypothesis (EMH)?

• Securities are normally in equilibrium and are
  fairly priced.
• Investors cannot beat the market except through
  good luck or better information.
• Levels of market efficiency
• Weak-form efficiency
• Semistrong-form efficiency
• Strong-form efficiency

35
Weak-form efficiency

• 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.

36
Semistrong-form efficiency

• All publicly available information is reflected
  in stock prices, so it doesnt pay to over
  analyze annual reports looking for undervalued
  stocks.
• Largely true, but superior analysts can still
  profit by finding and using new information

37
Strong-form efficiency

• 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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Is the stock market efficient?

• Empirical studies have been conducted to test the
  three forms of efficiency. Most of which suggest
  the stock market was
• Highly efficient in the weak form.
• Reasonably efficient in the semistrong form.
• Not efficient in the strong form. Insiders could
  and did make abnormal (and sometimes illegal)
  profits.
• Behavioral finance incorporates elements of
  cognitive psychology to better understand how
  individuals and markets respond to different
  situations.

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Implications of Market Efficiency (EMH)

• If EMH holds, its a waste of time to analyze
  stocks to seek bargains
• No trading rules can be used to beat the market
  
• Difficult to beat the market unless
• Above-average information
• Above-average skill in stock analysis
• Above-average luck
• Conclusion Buy and hold low-cost index fund,
  like SP 500 (Expense ratio .07). Over a
  recent 15-year period, the SP Index beat 97 of
  all stock mutual funds.

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Preferred stock

• Hybrid security
• Like bonds, preferred stockholders receive a
  fixed dividend that must be paid before dividends
  are paid to common stockholders.
• However, companies can omit preferred dividend
  payments without fear of pushing the firm into
  bankruptcy.

41
If preferred stock with an annual dividend of 5
sells for 50, what is the preferred stocks
expected return?

• Vp D / kp
• 50 5 / kp
• kp 5 / 50
• 0.10 10