Market for securities

- Primary Market (Underwriting)

o Venture Capital
- Secondary Market (Resale market)
o NYSE, NASDAQ

Equities
- An ownership position in a corporation
- Payout in 2 forms
o Cash Dividends
o Stock Dividends
- Key characteristics of Common Stock
o Residual claimant to corporate assets (after bondholders)
o No upper bound to the upside
o Limited liability (only liable to what you put in)
o Voting rights
o Market accessibility and ease of short sales
- All purchase and sales of the shares of a company will go through brokerages.
- Limit orders
o Investors will state a price that they are willing to buy/sell the shares for

o
 Bids: price at which current investors are prepared to sell at
 Asks: prices at which investors are prepared to sell at
 The prices are arranged from best to worse
 The bis-ask spread is at 31 cents per share (264.07 – 263.76)
- Market order
o To buy/sell at the best available price
- Types of stocks market
o Most major stock markets around the world including NYSE
 Electronic market
 Auction market, however, the auctioneers are the computers
o Nasdaq
 Not an auction market
 Trades take place between the investor and one of a group of professional dealers
who are prepared to buy and sell the stock
- Important ratios
o EPS: Earnings per share
o P/E ratio: ratio of stock prices to EPS
o Dividend yield: ratio of dividend to price
- ETFs (exchange-traded funds)
o Portfolios of stocks that can be bought or sold in a single trade
o With a few exceptions, ETFs are not actively managed.
o Many ETFs simply aim to track a well-known market index such as the Dow jones or S&P
500
o Others track specific industries or commodities
- Close-end mutual funds
o Invest in portfolio of securities
o Includes country funds that invest in portfolios of stocks in specific counties
o Unlike ETFs, Close-end mutual funds are actively managed and seek to “beat the market”
- Book values
o Balance sheets that show assets liabilities and equities
o Cons
 They only show the historical costs that do not incorporate inflation
 Usually excludes intangible assets such as trademarks and patents
  Do not capture going-concern value (Going concern value is created when a
collection of assets is organized into a healthy operating business)
o Pros
 Can be a useful benchmark
 May be useful clues about liquidation value
 However intangible assets (generally not captured in the balance sheets) can
be important even in liquidation. When Kodak filed for bankruptcy, its
portfolio of 79,000 patents was subsequently sold for $525 million

Valuations
- Valuation by comparable
o To value a business, one can start by examining how much investors in the comparable
companies are prepared to pay per dollar of earnings
o They can see what the business would be worth if it traded at the comparables’ price-earning
ratio

o
 P/B ratio: ratio of market price (per share) to book value (per share)
 Looking at the industry for oil and gas, there are companies with negative P/E ratios.
This shows that P/E ratios are almost useless when valuing start-ups since there is no
earnings to compare with.
o Valuation by comparables is useful when there isn’t a stock price for a company (private
company)
- Stock prices and dividends
o Equation for DCF


The discount rate is always changing, and the discount rate used here is risk
adjusted (the risk changes too, riskiness of both the market and the business)
 The company does not get to determine the discount rate. The discount rate
is determined by the market based on the risks of the security
o Assuming constant growth and constant dividends payout (Gordon growth model)


 The anticipated growth rate has to be less than r; as g approaches r, the stock
price becomes infinite
 r = expected rate of return on other securities of comparable risk
 r can be determined using the following formula


o Shows that the expected rate of return is given by the dividend
yield and growth
o * Firms often keep their dividends constant, cutting dividends may
suggest a cash flow issue and generally sends out negative signals
to investors. Once a firm decides to pay dividends, it is likely to
stay constant for long periods
  Growth rate g can be estimated by:
o Consulting the views of security analysts
o Looking at the payout ratio (ratio of dividends to earnings per
share)


 The company will reinvest 40% of the EPS back into the
business


 If the company earns 12.6% on book equity and reinvest
40% of the earnings. Book equity will increase by
0.4*0.126 = 0.05. Thus, the growth rate is 5%. Dividends
growth will also be 5%
 Growth rate = g = plowback ratio x ROE
 Issues with using this assumption
o One cannot assume regular future growth and take it as a given
o Estimates of g may be erroneous
o Multi-stage DCF
 E.g., Company A issues dividends of %0.50, stock price is $50, plowback ratio is
80% of EPS and Company A has a return on equity (ROE) of 25%
 Growth rate = 0.80 x 0.25 = 0.2
 r = .50/50 + 0.2 = 0.21
 However, it is impossible for a company to grow at 20% per year forever.
Eventually, profitability will fall, and firms will respond by investing less
 Assuming that profitability fell to 16% and the company respond by
plowing back only 50% of the earnings
 g = 0.15 x 0.5 = 0.08


 With the above set of numbers, the general DCF formula can be used:


o P3 = the year 4 dividend value discounted to year 3

o
o Solve for when P0 = $50; r = 0.099
 2 stages in the company growth:
o First stage (year 1 & 2): ROE of 25%, plowing back 80% of
earnings; g = 20%
o Second stage (Year 3): g fell to 8%
- Stock price and EPS (Example 1: Company with no growth)
o E.g., A company that does not grow at all. It does not plow back any earnings and simply
produces a constant stream of dividends
 The dividends will be equal to the earnings per share since all earnings are paid out
as dividends
 Assuming that the dividends paid is $10 per share and the stock price is $100
 
o The expected return for growing firms equals the earnings – price ratio if the return from
earnings reinvested is equal to the market capitalization rate
 Assuming that the company invested $10 per share into a project that will earn $1 per
share.
 The risk of the project is the same as the existing business, then its cash flow can be
discounted at the 10% rate to find the NPV (at t = 1)


 The reduction in value caused by the decrease in dividends at t = 1 will be
offset by the extra dividends in later years
 Thus, the market capitalization rate equals the earnings-price ratio


 * EPS1 refers to the expected earnings next year
 This is only true when the NPV of the investment (PVGO) = 0
 In general, the stock can be seen as the capitalized value of average earnings under a
no-growth policy (present value of all future earnings), plus PVGO, the net present
value of growth opportunities


 Thus, increase in EPS ≠ good performance
- Example 2 (Company with constant growth)
o E.g., a company with market capitalization rate of 15% and is expected to pay a dividend of
%5 in the first year the dividend is predicted to increase indefinitely by 10% a year


o Suppose the company’s EPS = $8.33  payout ratio of 0.6 (5 / 8.33 = 0.6)
o Thus, the plow back ratio is 40%, assuming that ROE is 25%, this explains the growth rate of
10% (0.4*0.25=10)
o The capitalized value of fledgling’s EPS if it had a no-growth policy would be


o To determine the difference of $44.44
 Each year, the company plows back $3.33 (40%). The ROE each year is 25%. Thus,
cash generated by investment is 0.25 x 3.33 = 0.83 per year starting at t=2.
 The NPV of the investment will be


 In t=2, the company will invest $3.67 (10% more than in year 1). The NPV of the
investment at t=2


 Thus, the payoff to owners purchasing the stock of the company comes from
 (1) level stream of earnings, which could be paid out to as dividends if the
firm did not grow (PV of $55.56)
 (2) A set of tickets representing the opportunity to make investments with
positive NPVs
 To calculate the positive NPVs
 Year 1: $2.22; Year 2: $2.22 x 1.1 = $2.44; Year 3: $2.44 x 1.1 = $2.69 …
 Discount these to t=0 using the discount rate of 0.15
 
o The company is known as a growth stock since the NPVs of its future investment’s accounts
for 44% of the stock price
 Taking Alphabet (google) as an example
 Its stock is sold for $1,130 per share; its EPS is $41.54; P/E ratio of ≈ 27
 Assuming the Alphabet did not grow, and future EPS stays constant; Alphabet will
pay out a constant $41.54 per share
 Assuming the cost of equity is 8%, market value of Alphabet will be
$519.25 (41.54 / 0.08)
 This is $611 less than investors’ valuation of Alphabet’s stocks. Thus,
investors are valuing Alphabet’s future investment opportunities at $611 per
share
 Thus, Alphabet is a growth stock (large fraction of its market value comes
from expected NPV of future investment)

Valuation of entire business

- Free cash flow (FCF) – the amount of cash that a firm can pay out to investors after paying for all
investments necessary for growth
o For a rapidly growing company, the free cash flow could be 0 or negative as the profits earned
are all reinvested
- The value of a business is usually computed as the discount value of free cash flows out to a valuation
horizon (H), plus the forecasted value of the business at the horizon (also discounted back to present)

- E.g.:
- Estimating the Horizon value
o Method 1(Valuation by comparables based on P/E, market-to-book ratio etc.):
 Assuming that similar companies tend to sell at price-earnings ratios of about 11

 The PV of the business up to the horizon is $.9 million. Thus, PV (total)
= .90 + 13.5 = 14.4
 Assuming that the market-book ratios of similar manufacturing companies tend to
cluster around 1.5


 Issues with this method
 Book value is a poor measure of the true value of a company’s assets, and it
often misses important intangible assets
 Earnings may be biased by inflation and arbitrary accounting choices
 One is unable to determine if the sample of comparable companies is truly
comparable
o Method 2:
 DCF
 Long-run growth rate appears to be 6%. Discount rate is at 10%


 The PV of the near-term cash flow is .9 million. Thus, the total PV is .9 +
15.4 = 16.3
 Issues with DCF
  Small changes to assumptions can cause great changes to PV
 If the long-run growth rate increases to 7%
o Asset value will have to grow by extra 1% per year
o Extra investment of .18 million is required in period 7, reducing
FCF7 to .91 million. PVH = 30.3 million and PV = 17.1 million
(discounted to year 0)
 Warning 1: when using the constant growth DCF formula to calculate
horizon value, faster growth requires increased investment, reducing free
cash flow. Whereas slower growth requires less investment, increasing free
cash flow.
o The example above showed that increasing growth (to 7%)
increased PV (from 15.4 million to 17.1 million). Warning 1 isn’t
ignored, the increased investment and decreased FCF is accounted
for. Thus, the additional investment must have generated positive
NPV. We have added more PVGO to the value of the business.
o ROA of the company is assumed to be 12%, 2% higher than the
cost of capital (discount rate) of 10%. Thus, every dollar invested
will generate positive NPV
o One cannot assume that a business can keep growing and make
positive NPV forever. Sooner or later you and your competitors
will be on equal footing and any introduction of new productor
attempts to expand will be met with fierce competition, NPV will
average out to 0. PVGO is positive only when returns of
investment is more than the cost of capital.
 Warning 2: Always check to see whether horizon value includes post-
horizon PVGO. This can be done by changing the long-term growth rate, if
a higher growth rate increases horizon value (after taken care to respect
warning 1) then one is assuming post-horizon PVGO

o
o When PVGO = 0 then,


 When competition catches up and the firm can only earn
its cost of equity, the price-earnings ratio will equal 1/r, as
PVGO = 0.
o The business is valued as if it will not grow. The business can grow
but it can be ignored as it will not add net value since PVGO = 0.
o Thus, the horizon value can be calculated as a level stream of
earnings starting in period 7 continuing indefinitely

Free cash flow, dividends, and repurchases

- If the company in the above example is a public company with 1 million shares, it could pay out its
FCF as dividends
o i.e., 0 in period 1 to 3 then $.42 per share in period 4 …
- Dividends = repurchases = FCF