Brealey 9 e IPPTCh 07

Chapter 7
Valuing Stocks
7- 1
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
Stocks and the Stock Market (1 of 5)
 Primary Market
– Market for the sale of new securities by
corporations
 Initial Public Offering (IPO)
– First offering of stock to the general public
 Primary Offering
– The corporation sells shares in the firm
Wall Street
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 Common Stock
– Ownership shares in a publicly held corporation
 Secondary Market
– Market in which previously issued securities are
traded among investors
 Dividend
– Periodic cash distribution from the firm to the
shareholders
 P/E Ratio
– Ratio of stock price to earnings per share

 Bid Price
– The prices at which investors are willing to buy shares
 Ask Price
– The prices at which current shareholders are willing to sell their shares
Example
If an investor wishes to purchase 100 shares of FedEx with
a bid price of $159.78 and an ask price of $159.99, how
much could the investor expect to pay for the shares?
What is the P/E Ratio and Dividend Yield?
Payment P/E Ratio

100 × 159.99 = $15,999
Dividend Yield

Share price history for FedEx

Market Values, Book Values, and Liquidation Values (1 of 2)
 The difference between a firm’s actual

market value and its’ liquidation or book
value is attributable to its “going-concern
value”
– Factors of “Going Concern Value”
• Extra earning power
• Intangible assets
• Value of future investments

Market Values, Book Values, and Liquidation Values (2 of 2)
 Book Value
– Net worth of the firm according to the balance
sheet
 Liquidation Value
– Net proceeds that could be realized by selling
the firm’s assets and paying off its creditors
 Market Value Balance Sheet
– Financial statement that uses market value of
all assets and liabilities

Valuing Common Stocks (1 of 10)
 Stock Valuation Methods

– Valuation by comparables
• Ratios
• Multiples
– Intrinsic Value
• Present value of future cash payoffs from a stock or
other security
– Dividend Discount Model

¿1+ 𝑃 1
𝑉 0=
1+𝑟
V0 = The intrinsic value of the share
Div1 = The expected dividend per share at the end
of the year
P1 = The predicted stock price in year 1
r = The discount rate for the stock’s expected
cash flows
Example
What is the intrinsic value of a share of stock if
expected dividends are $3/share and the
expected price in 1 year is $81/share? Assume a
discount rate of 12%.
¿1+ 𝑃 1 3+81
𝑉 0= = = $ 75
1+𝑟 1.12

 Expected Return
– The percentage yield that an investor forecasts
from a specific investment over a set period of
time. Sometimes called the holding period
return (HPR)
Div1  P1  P0
Expected return  r 
P0

Example (continued)
Using the prior example, what is the expected
return assuming the stock price started the year
at $75?
3  81  75
Expected return  r   .12
75
Expected return = 12%

The formula can be broken into two parts:

Dividend yield + Capital appreciation
Div1 P1  P0
Expected return  r  
P0 P0

Example (continued)
Using the prior example, what is the expected
dividend yield and capital gain?
3 81  75
Expected return  r    .04  .08  .12
75 75
Expected dividend yield = 4%
Expected capital gain = 8%

 Dividend Discount Model

– Discounted cash-flow model which states that
today’s stock price equals the present value of
all expected future dividends
Div1 Div 2 Div t  Pt

P0    ... 
(1  r ) (1  r )
1 2
(1  r ) t
t - Time horizon for your investment

Example
Current forecasts are for XYZ Company to pay dividends of
$3, $3.24, and $3.50 over the next three years,
respectively. At the end of three years you anticipate
selling your stock at a market price of $94.48. What is the
price of the stock given a 12% expected return?
3.00 3.24 3.50  94.48

PV   
(1  .12) (1  .12)
1 2
(1  .12)3
PV  $75.00


Simplifying the Dividend Discount Model (1 of 9)
If we forecast no growth, and plan to hold out

stock indefinitely, we will then value the stock as a
PERPETUITY
Div1 EPS1
Perpetuity  P0  or
r r
Assumes all earnings are

paid to shareholders

 Constant-Growth DDM
– A version of the dividend growth model in which
dividends grow at a constant rate (Gordon Growth
Model)
Div1
P0 
rg
Given any combination of variables in the

equation, you can solve for the unknown variable

Example
What is the value of a stock that expects to pay a
$0.74 dividend next year, and then increase the
dividend at a rate of 5% per year, indefinitely?
Assume a 7.8% expected return.
Div1 $0.74
P0    $26.43
r  g .078  .05

If a firm elects to pay a lower dividend, and reinvest the funds,

the stock price may increase because future dividends may be
higher
 Payout Ratio
– Fraction of earnings paid out as dividends
 Plowback Ratio
– Fraction of earnings retained by the firm
 Sustainable Growth Rate
– The firm’s growth rate if it plows back a constant fraction of
earnings, maintains a constant return on equity, and keeps its
debt ratio constant

 Growth can be derived from applying the return

on equity to the percentage of earnings plowed
back into operations
 Present Value of Growth Opportunities (PVGO)

– Net present value of a firm’s future investments

Example
Aqua America has an ROE of 12.5% and a book value per
share of $9.86. It intends to plowback 40% of its earnings
and the opportunity cost of capital is 7.8%. What is the
stock price?
EPS=$ 9.86× .1 25=$ 1.233

Growthrate=.
40 ×.1 2 5=.0 5∨5 .0 %
¿1=$ 1.2 33 ×.6 0=$ 0.7 4
𝑃 = 0. 7 4 =$ 26.43
0
.0 78 −.0 5

Example (continued)
If Aqua America decides not to reinvest any earnings,
what is the value of the stock and what is the PVGO of the
firm that is lost?
EPS=$ 9.86× .1 25=$ 1.233
𝑃 = 1.2 33 =$ 1 5.81
0
.0 78
PVGO=26.43− 15.81=$ 10.62

Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a 12%
expected return. Instead, we decide to plowback 40% of the earnings
at the firm’s current return on equity of 20%. What is the value of the
stock before and after the plowback decision?
No Growth With Growth

5 g .20.40 .08
P0   $41.67
.12 3
P0   $75.00
.12 .08

Example (continued)
If the company did not plowback some earnings, the stock
price would remain at $41.67. With the plowback, the price
rose to $75.00.
The difference between these two numbers (75.00 - 41.67 =

33.33) is called the Present Value of Growth Opportunities
(PVGO).

Valuing Non-Constant Growth (1 of 3)
 Valuing Non-Constant Growth
Div1 Div 2 Div H PH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

Example
Given the following earnings and dividends, an 8.5%
discount rate and a perpetual growth rate of 5%,which
begins in year 6, what is the value of the stock?
2.85 3.14 3.45 3.79 4.17

PV15       13.50
(1  085) (1  .085)
1 2
(1  .085) (1  .085)
3 4
(1  .085) 5
PV = 4. 17 ×1.05 = 4.3 8

=125.14
5
.085 −.05 .085 −.05
Example (continued)
Given the following earnings and dividends, an 8.5%
discount rate and a perpetual growth rate of 5%,which
begins in year 6, what is the value of the stock?
𝑃 =13.50+ 125.14 =$ 96.72

0 5
1.085

No Free Lunches (1 of 2)
 Technical Analysts
– Investors who attempt to identify undervalued
stocks by searching for patterns in past stock
prices
– Forecast stock prices based on watching the
fluctuations in historical prices (thus “wiggle
watchers”)

No Free Lunches (2 of 2)
Average Annual Return on Mutual Funds and the
Market Index

Random Walk Theory (1 of 6)
 Security prices change randomly, with no

predictable trends or patterns
 Statistically speaking, the movement of
stock prices is random
– Skewed positive over the long term

Coin Toss Game Heads

$106.09
Heads
$103.00
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails

S&P 500 Five Year Trend or

Five Years of the Coin Toss Game?
200
Level
160
120
80
Month

S&P 500 Five Year Trend or

Five Years of the Coin Toss Game?
240
Level
200
160
120
80
Month

Scatter plot of NYSE Composite Index over two successive weeks.
Where’s the pattern?

Cycles
disappear
once
identified
Another Tool
 Fundamental Analysts
– Investors who attempt to find mispriced
securities by analyzing fundamental information,
such as accounting data and business prospects
– Research the value of stocks using NPV and other
measurements of cash flow

Efficient Market Theory (1 of 3)
 Efficient Market
– Market in which prices reflect all available information
 Weak Form Efficiency
– Market prices reflect all historical information
 Semi-Strong Form Efficiency
– Market prices reflect all publicly available information
 Strong Form Efficiency
– Market prices reflect all information, both public and
private

C u m u l a ti v e A b n o r m a l R e t u r n (% )
Impact of leaked information
Announcement Date
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to Announcement Date
The average return 1972–2001 on stocks of firms over the six
months following an announcement of quarterly earnings. The 10%
of stocks with the best earnings news (portfolio 10) outperformed
those with the worst news (portfolio1) by about 1% per month.

Market Anomalies
 Existing Anomalies
– The Momentum Factor
– The New-Issue Puzzle
 Old Anomalies
– The Small Firm Effect
– The January Effect
– The PE Effect
– The Neglected Firm Effect
– The Value Line Effect

Behavioral Finance
 Attitudes towards risk

 Beliefs about probabilities
 Sentiment
Belief
Sentiment

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Chapter 7

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 3

Payment P/E Ratio

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Share price history for FedEx

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 The difference between a firm’s actual

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 Stock Valuation Methods

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Expected return = 12%

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The formula can be broken into two parts:

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Expected dividend yield = 4%

Expected capital gain = 8%

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 Dividend Discount Model

Div1 Div 2 Div t  Pt

t - Time horizon for your investment

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3.00 3.24 3.50  94.48

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If we forecast no growth, and plan to hold out

Assumes all earnings are

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Given any combination of variables in the

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If a firm elects to pay a lower dividend, and reinvest the funds,

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 Growth can be derived from applying the return

 Present Value of Growth Opportunities (PVGO)

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EPS=$ 9.86× .1 25=$ 1.233

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EPS=$ 9.86× .1 25=$ 1.233

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No Growth With Growth

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The difference between these two numbers (75.00 - 41.67 =

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 Valuing Non-Constant Growth

Div1 Div 2 Div H PH

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2.85 3.14 3.45 3.79 4.17

PV = 4. 17 ×1.05 = 4.3 8

𝑃 =13.50+ 125.14 =$ 96.72

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 Security prices change randomly, with no

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Coin Toss Game Heads

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S&P 500 Five Year Trend or

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S&P 500 Five Year Trend or

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