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CHAPTER 7

Stocks, Stock Valuation, and


Stock Market Equilibrium

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Topics in Chapter
Features of common stock
Valuing common stock
Preferred stock
Stock market equilibrium
Efficient markets hypothesis
Implications of market efficiency for
financial decisions

2
The Big Picture:
The Intrinsic Value of Common Stock
Free cash flow
(FCF)

Dividends (Dt)

D1 D2 D
ValueStock = + + ... +
(1 + rs )1 (1 + rs)2 (1 + rs)

Market interest rates Firms debt/equity mix


Cost of
Market risk aversion equity (rs) Firms business risk
Common Stock: Owners,
Directors, and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Preemptive right.
Since managers are agents of
shareholders, their goal should be:
Maximize stock price.
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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

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What is a 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.

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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.

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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.

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Bonds vs. Stocks

Issuer Cost Cost


(dividends pd out
(company) int. paid out (i)
Cap gains

Bond value or price today Stock value or price today


Discount the CFs by (i) Discount the CFs by (R)
(reqrd return) (reqrd return)
Cfs = Int pmts; principal Cfs = Dividends
PV, PMT,FV,N,i

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Bonds vs. Stocks

Bonds Value Stocks Value


or Price Today or Price Today

= sum of the PVs of the = sum of the PVs of the


future CFs; future CFs;
That is discount CFs (int Discount CFs (divids) by
Pmts (PMT) & Principal (R) (reqrd return) to get Po
(FV)) by i% over some (PV)
period (N) to get PV
PMT,FV,N,I known; solve
for PV
10
Different Approaches for
Valuing Common Stock
Dividend growth model
Constant growth stocks
Nonconstant growth stocks
Free cash flow method
Using the multiples of comparable firms

11
Why Invest in Stock?

For Growth in Value


From Dividends & Cap Gains
Generating Total Return = R

Stock Price = Growth = g


Dividend Return or Yield = Annual divid / Price of stock= D1 / Po
Return on Stock = Return on Divid + Growth (cap gains)
R = D1 /Po + g (but want price today)
Rg = D1 /Po
Finally: Po = D1 / R - g

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Constant Growth Approach to
Equity Valuations
Po = D1 / R g
Discounting the Divids (or CFs) by R-g (return
adjusted for constant growth)
Constant growth model: works when g is constant
rate (%) & R > g
If g > R, then have supernormal or non-constant growth
If so, then look at PVs of CFs generated the stock to determine its
price today
If we need R (reqd return) to use as disct factor, we can
use SML relationship from CAPM
SML: Ri = rRF + (RM - rRF)bi .
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Stock Value = PV of Dividends

^ D1 D2 D3 D
P0 = + + ++
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)

What is a constant growth stock?

One whose dividends are expected to grow


forever at a constant rate, g.
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For a constant growth stock:

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

If g is constant and less than rs, then:


^ D0(1 + g) D1
P0 = =
rs g rs g
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Dividend Growth and PV of
Dividends: P0 = (PV of Dt)
$
Dt = D0(1 + g)t

0.25 Dt
PV of Dt =
(1 + r)t

If g > r, P0 = !
Years (t)
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What happens if g > rs?

^ D0(1 + g)1 D0(1 + g)2 D0(1 + rs)


P0 = + ++
(1 + rs)1 (1 + rs)2 (1 + rs)
(1 + g)t ^
If g > rs, then > 1, and P0 =
(1 + rs)t

So g must be less than rs for the constant


growth model to be applicable!!
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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%.

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Projected Dividends
D0 = $2 and constant g = 6%

D1 = D0(1 + g) = $2(1.06) = $2.12


D2 = D1(1 + g) = $2.12(1.06) = $2.2472
D3 = D2(1 + g) = $2.2472(1.06) = $2.3820

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Expected Dividends and PVs
(rs = 13%, D0 = $2, g = 6%)

0 g = 6% 1 2 3

2.12 2.2472 2.3820


1.8761 13%

1.7599
1.6508

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Intrinsic Stock Value:
D0 = $2.00, rs = 13%, g = 6%

Constant growth model:

^ D0(1 + g) D1
P0 = =
rs g rs g

$2.12 $2.12
= = = $30.29.
0.13 0.06 0.07
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Expected value one year from
now:
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on.

^ D2 $2.2472
P1 = = = $32.10
rs g 0.07

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Return = Dividend Yield +
Capital Gains Yield

D1
Dividend yield =
P0

^
P1 P0 New - Old
CG Yield = =
P0 Old

23
Expected Dividend Yield and
Capital Gains Yield (Year 1)

D1 $2.12
Dividend yield = = = 7.0%.
P0 $30.29

^
P1 P0 $32.10 $30.29
CG Yield = =
P0 $30.29
= 6.0%.
24
Total Year 1 Return
Total return = Div yield + Cap gains yield.
Total return = 7% + 6% = 13%.
Total return = 13% = rs.
For constant growth stock:
Capital gains yield = 6% = g.

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Rearrange model to rate of
return form:

^ D1 ^ D1
P0 = to rs = + g.
rs g P0

Then, ^
rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.

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If g = 0, the dividend stream
is a perpetuity.

0 r = 13% 1 2 3
s

2.00 2.00 2.00

^ PMT $2.00
P0 = = = $15.38.
r 0.13
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Supernormal Growth Stock I

Supernormal growth of 30% for first three


years, then 6% constant g thereafter. Just
paid dividend of $2.00 /sh, & required return
for investments of this risk is 13%. Whats
the price today (Po)?
Can no longer use constant growth model.
However, growth becomes constant after 3
years.

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Nonconstant growth followed
by constant growth
0 1 2 3 4
rs = ? %
g=?% g=?% g=?% g=?%
Do=?(1+g) D1=? D2=? D3=? D4=?

?
?
?
^ D4
? P3 =
R-g
^
?? = P0
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Nonconstant growth followed
by constant growth (D0 = $2):
0 1 2 3 4
rs = 13%
g = 30% g = 30% g = 30% g = 6%
Do=2.00(1+g) D1=2.60 D2=3.38 D3=4.39 D4=4.66

2.30
2.65
3.05
^ $4.66
46.11 P3 = = $66.54
0.13 0.06
^
54.11 = P0
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Using Cfs
After Determining: Future Divs & gk
terminal value (price)
CFo = Do CFo =0
CF1 = D1 CF1 = 2.60

CF2 = D2 CF2 = 3.38

CF3 = D3 + P3 CF3 = 4.39 + 66.54

i=R% =70.93
Po = NPV = ? i = 13 %

Po = NPV = ? = $54.11

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Expected Dividend Yield and
Capital Gains Yield (t = 0)

Today (@ t =0):
D1 $2.60
Dividend yield = = = 4.81%
P0 $54.11

CG Yield = 13.0% 4.81% = 8.19%.

32
Expected Divd & Cap Gains Yield
(after t = 3)
During nonconstant growth, dividend yield
and capital gains yield are not constant.
If current growth is greater than gk, current
capital gains yield is greater than g.
After year 3 (t = 3), gk = constant = 6%, so
CGY = 6%.
Because rs = 13%, after yr 3 div yld =
13% 6% = 7%.

33
Is stock price based on
short-term growth?
The current stock price is $54.11.
The PV of dividends beyond Year 3 is:
=terminal
^
or horizon value in year 3 (P3) discounted
to present by reqd Return (R=13%) = $46.11

% of stock price due to long-


term dividends is:
$46.11
= 85.2%.
$54.11
34
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?

35
Intrinsic Stock Value vs.
Quarterly Earnings
Sometimes changes in quarterly
earnings are a signal of future changes
in cash flows. This affects current
stock price (Po).
Sometimes managers have bonuses
tied to quarterly earnings.

36
Supernormal Growth Stock II
Supernormal growth of 30% for Year 0
to Year 1, 25% for Year 1 to Year 2,
15% for Year 2 to Year 3, and then
long-run constant g = 6%.
Can no longer use constant growth
model.
However, growth becomes constant
after 3 years.

37
38
Nonconstant growth followed
by constant growth (D0 = $2):
0 1 2 3 4
rs = 13%
g = 30% g = 25% g = 15% g = 6%
2.6000 3.2500 3.7375 3.9618

2.3009
2.5452
2.5903
^ $3.9618
39.2246 P3 = = $56.5971
0.13 0.06
^
46.6610 = P0
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Expected Dividend Yield and
Capital Gains Yield (t = 0)

At t = 0:
D1 $2.60
Dividend yield = = = 5.6%
P0 $46.66

CG Yield = 13.0% 5.6% = 7.4%.

(More)
40
Expected Dividend Yield and
Capital Gains Yield (after t = 3)
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
capital gains yield = 6%.
Because rs = 13%, after t = 3 dividend
yield = 13% 6% = 7%.

41
Is the stock price based on
short-term growth?
The current stock price is $46.66.
The PV of dividends beyond Year 3 is:
^
P3 / (1+rs)3 = $39.22

The percentage of stock price due


to long-term dividends is:
$39.22
= 84.1%.
$46.66
42
Suppose g = 0 for t = 1 to 3, and
then g is a constant 6%.

0 1 2 3 4
rs = 13%
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861 ^ = 2.12
20.9895 P3 = 30.2857
25.7118 0.07
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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%.

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Dividend Yield and Capital
Gains Yield (after t = 3)
Now have constant growth, so:
Capital gains yield = g = 6%
Dividend yield = rs g
Dividend yield = 13% 6% = 7%

45
Suppose negative growth:
If g = -6%, would anyone buy stock?
If so, at what price?

Firm still has earnings and still pays


dividends, so ^P0 > 0:
^ D0(1 + g) D1
P0 = =
rs g rs g

$2.00(1-.06) $1.88
= = = $9.89.
0.13 (-0.06) 0.19
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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.
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What if company pays no
dividends?
Discount Free Cash Flows (CFs which can be
returned to investors) instead of dividends
Where FCF = NOPAT Net Capital Spending

48
Uses of Free Cash Flows
Pay interest on debt
Repay principal on debt
Pay dividends to equityholders
Repurchase stock from equityholders
Buy mrktbl securities or other non-
operating assets

49
Equity Valuation using FCFs

A young firm just recorded a $<1.0> million FCF. It


expects the FCF 1-yr from today to be
$<5.0>million. In yrs 2 & 3, they are expected to
become positive at $10 and $20 million. In the 4th
yr, a constant growth in FCFs is expected to kick-in
at 6%. The required return for investments of this
risk is 10%. The firm has $40 million in debt, and
10 million shares outstanding. Whats the price per
share today?

50
Equity Valuation using FCFs

0 1 2 3 4
rs = 10%
g=6%
FCFo=<1> FCF1=<5> FCF2=10 FCF3=20 *(1+g) FCF4=?

?
?
?
^ FCF4
? P3 =
R-g
^
?? = P 0
51
Using Cfs for FCFs Equity Valuation
After Determining: Future Divs & gk
terminal value (price)
CFo = FCFo CFo =0
CF1 = FCF1 CF1 = <5>

CF2 = FCF2 CF2 = 10

CF3 = FCF3 + P3 CF3 = 20 + 530 =550.00

i=R% i = 10 %

Po = NPV =?= value of firm Po = NPV = ? = $416.94

52
Equity Valuation using FCFs
Value of firm = $416.94
- Debt 40.00
=Value of equity $376.94 / 10 mil shrs

=price per share of $37.69

53
Market Cap (Capitalization)
= Market Value of firms equity
= (price/sh)*(#shs outstanding)

54
Enterprise Value

= Value of firms underlying business,


unencumbered by Debt, and separate from
cash & marketable securities
Enterprise Value= MV of equity + Debt - cash
Think:: Enterprise Value = Net cost of
acquiring a firms equity, taking its cash, and
paying off debt. In essence, its equivalent
to owning the unlevered (debt-free)
business. 55
Market Cap & Enterprise Value I

H.J. Heinz has a share price of $46.78,


its shares outstanding were 319.2
million. It has a market-to-book ratio of
8.00, a book debt-equity ratio of 2.62,
and cash of $352 million.
Whats Heinzs market cap?
Whats its enterprise value?

56
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.

57
Multiples Approach I
Auto Industry Pinto Car Co
Industry P/E = 5 Pinto EPS = $1.50/sh

Industry Pinto
5/1 = P/E = ?/$1.50
So Pinto relative price per
share (P) = $7.50

If Pinto trading on NYSE =


$9.00 =overvalued (sell)
If $4.00 =undervalued (buy)
58
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

59
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 firms total value.
Subtract the firms debt to get the total value of its
equity.
Divide by the number of shares to calculate the
price per share.

60
Problems w/ Market Multiple Methods

It is often hard to find comparable firms.


What are relevant multiples?
New Co.s often lack earnings
Average ratio for sample of comparable firms often
has a wide range.
I.E, ave P/E ratio might be 20, but range from 10 to 50.
How do you know whether firm should be compared to
low, average, or high performers?
Differences between firms in comparables pool
i.e: growth rates, risk, cost of capital
61
What if an equitys dividend is
fixed? No g !
^ D1
P0 =
rs g

So, Po = D1 /rs
And return = D1 / Po

Its a perpetuity

62
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 firm into bankruptcy.
63
Expected return =?,
given Preferred stock share trading at $50
& pays annual dividend = $5

Vps = $50 = $5
^
rps

^
rps = $5
= 0.10 = 10.0%
$50

64
A determinant of Growth

Relationship between ROE, Retention Rate, EPS


growth, and Dividends
A firm has an ROE of 25% & Retention Rate of
80%. If the most recent EPS was $3.00, whats
the expected dividend at the end of the year?

65
Why are stock prices volatile?
^ D1
P0 =
rs g

rs = rRF + (RPM)bi could change.


Inflation expectations
Risk aversion
Company risk
g could change.
66
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 changes?

67
Stock Prices vs. Changes in rs
and g
g
rs 4% 5% 6%
9% $40.00 $50.00 $66.67
10% $33.33 $40.00 $50.00

11% $28.57 $33.33 $40.00

68
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.
69
What is market equilibrium?
In equilibrium, the intrinisic price must equal
the actual price.
If the actual price is lower than the
fundamental value, then the stock is a
bargain. Buy orders will exceed sell orders,
the actual price will be bid up. The opposite
occurs if the actual price is higher than the
fundamental value.

(More)
70
Intrinsic Values and Market Stock Prices
Managerial Actions, the Economic
Environment, and the Political Climate

True Expected True Perceived Expected Perceived


Future Cash Flows Risk Future Cash Flows Risk

Stocks Stocks
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
In equilibrium, expected returns
must equal required returns:

^
rs = D1/P0 + g = rs = rRF + (rM rRF)b.

72
Expected Return vs. Required Return

16% > 15% reqrd to invest


:: undervalued
Stock priced too low so buy
b/c bargain
As more people buy it,
Price & return
:: then reach equilibrium
level of return

10% < :: overvalued -SELL

73
How is equilibrium established?

^
^ D1
If rs = + g > rs, then P0 is too low.
P0
If the price is lower than the fundamental
value, then the stock is a bargain. Buy
orders will exceed sell orders, the price will
be bid up until:
D1/P0 + g = ^rs = rs.
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Whats the Efficient Market
Hypothesis (EMH)?
Securities are normally in equilibrium
and are fairly priced. One cannot
beat the market except through good
luck or inside information.
EMH does not assume all investors are
rational.
EMH assumes that stock market prices
track intrinsic values fairly closely.
(More)
75
EMH (continued)
If stock prices deviate from intrinsic
values, investors will quickly take
advantage of mispricing.
Prices will be driven to new equilibrium
level based on new information.
It is possible to have irrational investors
in a rational market.

76
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.

77
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.

78
Strong-form EMH
All information, even inside
information, is embedded in stock
prices. Not trueinsiders can gain
by trading on the basis of insider
information, but thats illegal.

79
Markets are generally
efficient because:
100,000 or so trained analystsMBAs,
CFAs, and PhDswork for firms like
Fidelity, Morgan, and Prudential.
These analysts have similar access to
data and megabucks to invest.
Thus, news is reflected in P0 almost
instantaneously.

80
Market Efficiency
For most stocks, for most of the time,
it is generally safe to assume that the
market is reasonably efficient.
However, periodically major shifts can
and do occur, causing most stocks to
move strongly up or down.

81
Implications of Market Efficiency
for Financial Decisions

Many investors have given up trying to


beat the market. This helps explain the
growing popularity of index funds,
which try to match overall market
returns by buying a basket of stocks
that make up a particular index.

82
Implications of Market Efficiency
for Financial Decisions
Important implications for stock issues,
repurchases, and tender offers.
If the market prices stocks fairly,
managerial decisions based on over- and
undervaluation might not make sense.
Managers have better information but
they cannot use for their own advantage
and cannot deliberately defraud
investors.
83
Rational Behavior vs. Animal Spirits,
Herding, and Anchoring Bias
Stock market bubbles of 2000 and 2008
suggest that something other than pure
rationality in investing is alive and well.
People anchor too closely on recent events
when predicting future events.
When market is performing better than average,
they tend to think it will continue to perform better
than average.
Other investors emulate them, following like a
herd of sheep.

84
Conclusions
Markets are rational to a large extent, but at
time they are also subject to irrational behavior.
One must do careful, rational analyses using the
tools and techniques covered in the book.
Recognize that actual prices can differ from
intrinsic values, sometimes by large amounts
and for long periods.
Good news! Differences between actual prices
and intrinsic values provide wonderful
opportunities for those able to capitalize on
them. 85