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

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 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 Firm’s debt/equity

rates Cost of mix
Market risk equity Firm’s business
aversion risk
(rs)
Common Stock: Owners,
Directors, and Managers
 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.

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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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Different Approaches for
Valuing Common Stock
 Dividend growth model
 Constant growth stocks
 Nonconstant growth stocks
 Free cash flow method (covered in
Chapter 11)
 Using the multiples of comparable firms

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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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 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%.
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Total Year 1 Return
 Total return = Dividend yield +
Capital 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
 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.

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 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…)
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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%.

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 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 (see slide 22)

The percentage of stock price due

to “long-term” dividends is:
$39.22
= 84.1%.
$46.66
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Intrinsic Stock Value vs.
Quarterly Earnings
 If most of a stock’s value is due to
long-term cash flows, why do so many
managers focus on quarterly earnings?

 See next slide.

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Intrinsic Stock Value vs.
Quarterly Earnings
 Sometimes changes in quarterly
earnings are a signal of future changes
in cash flows. This would affect the
current stock price.
 Sometimes managers have bonuses
tied to quarterly earnings.

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 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%

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 If g = -6%, would anyone buy
the 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(0.94) $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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 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.

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 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

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 Using Entity Multiples
(Continued)
 Find the entity value of the firm in question. For
example,
 Multiply the firm’s sales by the V/Sales multiple.
 Multiply the firm’s # of customers by the V/Customers
ratio
 The result is the firm’s total value.
 Subtract the firm’s debt to get the total value of its
equity.
 Divide by the number of shares to calculate the
price per share.

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 Problems with Market Multiple
Methods
 It is often hard to find comparable firms.
 The average ratio for the sample of
comparable firms often has a wide range.
 For example, the average P/E ratio might be
20, but the range could be from 10 to 50.
How do you know whether your firm should
be compared to the low, average, or high
performers?

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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 the firm into bankruptcy.
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Expected return, given Vps = $50
and annual dividend = $5

Vps = $50 = $5
^
rps

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

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

 rs = rRF + (RPM)bi could change.

 Inflation expectations
 Risk aversion
 Company risk
 g could change.
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 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?

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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

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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 aren’t volatile, then
this means there isn’t a good flow of
information.
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 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…)
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 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

Stock’s Stock’s
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.

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 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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 What’s 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…)
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 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.

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Weak-form EMH
 Can’t 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.

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Semistrong-form EMH
 All publicly available information is
reflected in stock prices, so it doesn’t
pay to pore over annual reports looking
for undervalued stocks. Largely true.

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Strong-form EMH
 All information, even inside
information, is embedded in stock
prices. Not true—insiders can gain
by trading on the basis of insider
information, but that’s illegal.

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Markets are generally
efficient because:
 100,000 or so trained analysts—MBAs,
CFAs, and PhDs—work 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.

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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.

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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.

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 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.
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 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.

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 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.
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