You are on page 1of 58

Chapter 8

Stocks and Their Valuation


:

8-1

Stocks and Their Valuation

Features of common stock

Determining common stock values

Efficient markets

Preferred stock

8-2

Common stock

:




.

.
8-3


Advantages
.1 .
.2 .
.3 .
.4 .
.5
.
.6
.

8-4


:Disadvantages
.1 .
.2
.
.3
.
.4
.
8-5


Facts about common stock

Represents ownership.

Ownership implies control.


.
Stockholders elect directors.

8-6


Facts about common stock

Directors hire management.



Managements goal: Maximize stock price.

8-7

.1
.2

8-8

:
.
.


?Whats classified stock
?How might classified stock be used
Classified stock has special provisions.


() 5
() 5
.
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.

8-9


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.

8-10


When is a stock sale an 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.

8-11


Types of stock market transactions

Secondary market

Primary market

Initial public offering market (going public)

8-12


Different approaches for valuing common stock

Dividend growth model

Corporate value model

Using the multiples of comparable firms

8-13


Dividend growth model

:
D0 1 g
p0
rs g

8-14


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

D3
D1
D2
D
P0

...
1
2
3
) (1 rs ) (1 rs
) (1 rs
(1 rs )
^

8-15


( )


Constant growth stock
A stock whose dividends are expected to grow forever at a constant rate, g.

g:

If g is constant, the dividend


growth formula converges to:



8-16

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

D 0 (1 g) D1
P0

rs - g
rs - g
^

Future dividends and their present values


$

D t D0 ( 1 g )

Dt
PV of D t
( 1 r )t

0.25

P0 PVD t
0

Years (t)

8-17

?What happens if g > rs


If g > ks, the constant growth formula leads to a negative stock price, which does
not make sense.

g rs

The constant growth model can only be used if:

rs g

rs > g

g is expected to be constant forever

g .
8-18

and = 1.2,

If rRF = 7%,

rM = 12%,

?what is the required rate of return on the firms stock

Use the SML to calculate the required rate of return (rs):

rs = rRF + (rM rRF)


= 7% + (12% - 7%)1.2
= 13%
%13

8-19

= rRF
= rM

If D0 = $2 and g is a constant 6%, find


the expected dividend stream for the next 3 years, and their PVs.
:
g = %6

D0 = $2

g = 6%

D0 = 2.00
PVD 1

D1
( 1 r )1

2
D1 = D0 (1+g)1

2.12

3
D2 = D0 (1+g)2

2.247

D3 = D0 (1+g)3

2.382

1.8761

D2
PVD 2
( 1 r )2

1.7599

D3
( 1 r )3

1.6509

PVD 3

ks = %13

rs = 13%

8-20


What is the stocks market value?

Using the constant growth model:

D1
$2.12
P0

rs - g 0.13 - 0.06
$2.12

0.07
$30.29

8-21


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.

D2
$2.247
P1

rs - g 0.13 - 0.06
^

$32.10

Could also find expected P1 as:

P1 P0 (1 rs)

P1 P0 (1.06) $32.10
8-22

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

Dividend yield

D
P = $2.12 / $30.29 = 7.0%
1

Capital gains yield

P P
P
1

= ($32.10 - $30.29) / $30.29 = 6.0%

Total return (rs)

rs = Dividend Yield + Capital Gains Yield


= 7.0% + 6.0% = 13.0%

8-23


?What would the expected price today be, if g = 0
The dividend stream would be a perpetuity.

...
2.00

2.00

rs = 13%

2.00

PMT $2.00
P0

$15.38
r
0.13
^

8-24

) (
Supernormal growth:
What if g = 30% for 3 years
before achieving long-run growth of 6%?
6 30% =g

Can no longer use just the constant growth model to find stock value.

However, the growth does become constant after 3 years.

8-25


Valuing common stock with nonconstant growth
6% 30% =g

0 r = 13% 1
s
g = 30%

D0 = 2.00
PVD 1

D1
( 1 r )1

PVD 2
PVD 3

D2
( 1 r )2

D3
( 1 r )3

PVD 4

D4
( 1 r )3

D1 = D0 (1+g)1

g = 30%

2.600

D2 = D0 (1+g)2

D3 = D0 (1+g)3

g = 30%

...

g = 6%

4.394 4.65
8

3.380

2.301

D3 = D0

D4 = 4.394 (1+0.06)1

or

2.647
3.045

4.658

$3
P

46.114

54.107

= P0

0.13

0.06

D4 = D3 (1+g)
D4 = 4.394 (1+0.06)
= 4.658

$66.54

8-26


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

Dividend yield (first year) = $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
notconstant, and capital gains yield g.(30%)

After t = 3, the stock has constant growth and dividend yield = 7%,
while capital gains yield = 6% and capital gains yield = g 6%.


g =
7% = 3
6% 8-27
6%=

Nonconstant growth:
What if g = 0% for 3 years before long-run growth of 6%?
=
6%

0 r = 13% 1
s
g = 0%

D0 = 2.00
PVD 1

D1
( 1 r )1

D
PVD 2 2 2
(1 r )
PVD 3

D3
( 1 r )3

D
PVD 4 4 3
(1 r )

D1 = D0 (1+g)1

g = 0%

2.00

D2 = D0 (1+g)2

D3 = D0 (1+g)3

g = 0%

2.00

...

g = 6%

2.00

1.77

2.12
D3 = D0

D4 = 2 (1+0.06)1

or

1.57

D4 = D3 (1+g)
D4 = 2 (1+0.06) = 2.12

1.39

P$ 3

20.99

25.72

= P0

2.12
0.13 0.06

$30.29
8-28

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%.

8-29

If the stock was expected to have negative growth (g = -6%),


would anyone buy the stock, and what is its value?
g=-6%

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

D0 ( 1 g )
D1
P0

rs - g
rs - g
^

$2.00 (0.94) $1.88

$9.89
0.13 - (-0.06) 0.19
8-30


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

) 19%(
8-31


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

FCF = NOPAT Net capital investment

8-32


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
common =
stock

MV of
firm

MV of
debt and
preferred

Divide MV of common stock by the number of shares outstanding to get intrinsic stock
price (value).



MV of commonstock
p0
8-33
# of shares


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.

( TVn)

8-34

Given the long-run gFCF = 6%, and WACC of 10%,


use the corporate value model to find the firms intrinsic value.
= %6
(%10 = )WACC

3 g = 6%

21.20

20

...

2
10

0 r = 10% 1
-5
-4.545
8.264

21.20

= TV3
8-35

0.10 - 0.06

= 530

D1
( 1 r )1
D2
PVD 2
( 1 r )2
D3
PVD 3
( 1 r )3

15.026
398.197
416.942

PVD 1

D4
PVD 4
( 1 r )3

If the firm has $40 million in debt and has 10 million shares of stock,
what is the firms intrinsic value per share?
40
10

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
8-36


Firm multiples method
Analysts often use the following multiples to value stocks.

P/E

Price / Cash Flow

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.

: , .

8-37


P/E

8-38

7.7
=
P/E = 12
7.7 *12
=
92.4
=


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.

D1
rs
g
P0
^

rs rRF (rM rRF )



8-39

: rM=12
rRF = 8 B= 2 D0= 2.8571
g= 5% P0= 30$

rs rRF (rM rRF )


Ks = 8 + (12 8 )2 = 16%

D1 = 2.8571 (1+0.05)1 = 3$

D
rs 1 g
P0
^

D1 = D0 (1+g)1

3
rs
5% 15%
30
^

8-40


( )30

(. )27.27

3
5% 16%
27.27
:

rs rRF (rM rRF )


8-41

D1
rs
g
P0
^

rs


Market equilibrium

Expected returns are obtained by estimating dividends and expected capital gains.

rs

D1
g
P0

Required returns are obtained by estimating risk and applying the CAPM.


capm capital asset pricing model

rs rRF (rM rRF )


8-42


How is market equilibrium established?

If expected return exceeds required return

The current price (P0) is too low and offers a bargain.

. P0

Buy orders will be greater than sell orders.

P0 will be bid up until expected return equals required return

P0

8-43


Factors that affect stock price

Required return (rs) could change

Changing inflation could cause kRF to change

Market risk premium or exposure to market risk () could change

Growth rate (g) could change

Due to economic (market) conditions

) (

Due to firm conditions

8-44

():
(. )
() :
(. )

:
-1 : ( , )
-2( : , )...
-3 :
8-45


?)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.

" "
.
:


8-46

Levels of market efficiency

Weak-form efficiency

Semistrong-form efficiency

Strong-form efficiency


8-47


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.

"
"

3


8-48 .


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

8-49


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.

8-50


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.

Behavioral finance incorporates elements of cognitive psychology to better understand how individuals
and markets respond to different situations.

:
.
8-51


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.

8-52

If preferred stock with an annual dividend of $5 sells for $50, what


is the preferred stocks expected return?
$50 ( ) $5

V
r

$50

rp

$5

$5
= 0.10 = 10%
$50

Vp is the value of the preferred stock,


Dp is the preferred dividend
rp is the required rate of return

8-53


?How does preferred stock differ from common equity and debt

Preferred dividends are fixed, but they may be omitted without placing the firm in
default.



.
Preferred dividends are cumulative up to a limit.


.
Most preferred stocks prohibit the firm from paying common dividends when the
preferred is in arrears.

8-54


What is floating rate preferred?

Dividends are indexed to the rate on treasury securities instead of being fixed.

Excellent S-T corporate investment:

Only 30% of dividends are taxable to corporations.

%30

The floating rate generally keeps issue trading near par.

8-55


Advantage of preferred stock


.

.


.

8-56


Disadvantage of preferred stock



.


.

8-57

8-58