8-1 CHAPTER 8 Stocks and Their Valuation

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8-1 CHAPTER 8 Stocks and Their Valuation

  1. 1. CHAPTER 8 Stocks and Their Valuation <ul><li>Features of common stock </li></ul><ul><li>Determining common stock values </li></ul><ul><li>Efficient markets </li></ul><ul><li>Preferred stock </li></ul>
  2. 2. Facts about common stock <ul><li>Represents ownership </li></ul><ul><li>Ownership implies control </li></ul><ul><li>Stockholders elect directors </li></ul><ul><li>Directors elect management </li></ul><ul><li>Management’s goal: Maximize the stock price </li></ul>
  3. 3. Social/Ethical Question <ul><li>Should management be equally concerned about employees, customers, suppliers, and “the public,” or just the stockholders? </li></ul><ul><li>In an enterprise economy, management should work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition. </li></ul>
  4. 4. Types of stock market transactions <ul><li>Secondary market </li></ul><ul><li>Primary market </li></ul><ul><li>Initial public offering market (“going public”) </li></ul>
  5. 5. Different approaches for valuing common stock <ul><li>Dividend growth model </li></ul><ul><li>Corporate value model </li></ul><ul><li>Using the multiples of comparable firms </li></ul>
  6. 6. Dividend growth model <ul><li>Value of a stock is the present value of the future dividends expected to be generated by the stock. </li></ul>
  7. 7. Constant growth stock <ul><li>A stock whose dividends are expected to grow forever at a constant rate, g. </li></ul><ul><li>D 1 = D 0 (1+g) 1 </li></ul><ul><li>D 2 = D 0 (1+g) 2 </li></ul><ul><li>D t = D 0 (1+g) t </li></ul><ul><li>If g is constant, the dividend growth formula converges to: </li></ul>
  8. 8. Future dividends and their present values $ 0.25 Years (t) 0
  9. 9. What happens if g > k s ? <ul><li>If g > k s , the constant growth formula leads to a negative stock price, which does not make sense. </li></ul><ul><li>The constant growth model can only be used if: </li></ul><ul><ul><li>k s > g </li></ul></ul><ul><ul><li>g is expected to be constant forever </li></ul></ul>
  10. 10. If k RF = 7%, k M = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? <ul><li>Use the SML to calculate the required rate of return (k s ): </li></ul><ul><li>k s = k RF + (k M – k RF ) β </li></ul><ul><li>= 7% + (12% - 7%)1.2 </li></ul><ul><li>= 13% </li></ul>
  11. 11. If D 0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs. 1.8761 1.7599 D 0 = 2.00 1.6509 k s = 13% g = 6% 0 1 2.247 2 2.382 3 2.12
  12. 12. What is the stock’s market value? <ul><li>Using the constant growth model: </li></ul>
  13. 13. What is the expected market price of the stock, one year from now? <ul><li>D 1 will have been paid out already. So, P 1 is the present value (as of year 1) of D 2 , D 3 , D 4 , etc. </li></ul><ul><li>Could also find expected P 1 as: </li></ul>
  14. 14. What is the expected dividend yield, capital gains yield, and total return during the first year? <ul><li>Dividend yield </li></ul><ul><ul><li>= D 1 / P 0 = $2.12 / $30.29 = 7.0% </li></ul></ul><ul><li>Capital gains yield </li></ul><ul><ul><li>= (P 1 – P 0 ) / P 0 </li></ul></ul><ul><ul><li>= ($32.10 - $30.29) / $30.29 = 6.0% </li></ul></ul><ul><li>Total return (k s ) </li></ul><ul><ul><li>= Dividend Yield + Capital Gains Yield </li></ul></ul><ul><ul><li>= 7.0% + 6.0% = 13.0% </li></ul></ul>
  15. 15. What would the expected price today be, if g = 0? <ul><li>The dividend stream would be a perpetuity. </li></ul>2.00 2.00 2.00 0 1 2 3 k s = 13% ...
  16. 16. Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%? <ul><li>Can no longer use just the constant growth model to find stock value. </li></ul><ul><li>However, the growth does become constant after 3 years. </li></ul>
  17. 17. Steps for Supernormal Growth <ul><li>1. Find PV of dividends during nonconstant growth period </li></ul><ul><li>2. Find the P at end of nonconstant growth period, discount to PV </li></ul><ul><li>3. Add #1 and #2 together to get P 0 </li></ul>
  18. 18. Valuing common stock with nonconstant growth  P ^ k s = 13% g = 30% g = 30% g = 30% g = 6%  0.06 $66.54 3 4.658 0.13   2.301 2.647 3.045 46.114 54.107 = P 0 0 1 2 3 4 D 0 = 2.00 2.600 3.380 4.394 ... 4.658
  19. 19. Find expected dividend and capital gains yields during the first and fourth years. <ul><li>Dividend yield (first year) D 1 / P 0 </li></ul><ul><ul><li>= $2.60 / $54.11 = 4.81% </li></ul></ul><ul><li>Capital gains yield (first year) </li></ul><ul><ul><li>= 13.00% - 4.81% = 8.19% </li></ul></ul><ul><li>During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ≠ g. </li></ul><ul><li>After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%. </li></ul>
  20. 20. Nonconstant growth: What if g = 0% for 3 years before long-run growth of 6%? k s = 13% g = 0% g = 0% g = 0% g = 6% 0.06  $30.29 P 3 2.12 0.13    1.77 1.57 1.39 20.99 25.72 = P 0 ^ 0 1 2 3 4 D 0 = 2.00 2.00 2.00 2.00 ... 2.12
  21. 21. Find expected dividend and capital gains yields during the first and fourth years. <ul><li>Dividend yield (first year) </li></ul><ul><ul><li>= $2.00 / $25.72 = 7.78% </li></ul></ul><ul><li>Capital gains yield (first year) </li></ul><ul><ul><li>= 13.00% - 7.78% = 5.22% </li></ul></ul><ul><li>After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%. </li></ul>
  22. 22. If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? <ul><li>The firm still has earnings and pays dividends, even though they may be declining, they still have value. </li></ul>
  23. 23. Find expected annual dividend and capital gains yields. <ul><li>Capital gains yield </li></ul><ul><ul><li>= g = -6.00% </li></ul></ul><ul><li>Dividend yield </li></ul><ul><ul><li>= 13.00% - (-6.00%) = 19.00% </li></ul></ul><ul><li>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. </li></ul>
  24. 24. Corporate value model <ul><li>Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. </li></ul><ul><li>Remember, free cash flow is the firm’s after-tax operating income less the net capital investment </li></ul><ul><ul><li>FCF = NOPAT – Net capital investment </li></ul></ul>
  25. 25. Applying the corporate value model <ul><li>Find the market value (MV) of the firm. </li></ul><ul><ul><li>Find PV of firm’s future FCFs </li></ul></ul><ul><li>Subtract MV of firm’s debt and preferred stock to get MV of common stock. </li></ul><ul><ul><li>MV of = MV of – MV of debt and common stock firm preferred </li></ul></ul><ul><li>Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value). </li></ul><ul><ul><li>P 0 = MV of common stock / # of shares </li></ul></ul>
  26. 26. Issues regarding the corporate value model <ul><li>Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast. </li></ul><ul><li>Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. </li></ul><ul><li>Terminal value (TV n ) represents value of firm at the point that growth becomes constant. </li></ul>
  27. 27. Given the long-run g FCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value. g = 6% k = 10% 21.20 0 1 2 3 4 -5 10 20 ... 416.942 -4.545 8.264 15.026 398.197 21.20 530 = = TV 3 0.10 0.06 -
  28. 28. If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share? <ul><li>MV of equity = MV of firm – MV of debt </li></ul><ul><li>= $416.94m - $40m </li></ul><ul><li>= $376.94 million </li></ul><ul><li>Value per share = MV of equity / # of shares </li></ul><ul><li>= $376.94m / 10m </li></ul><ul><li>= $37.69 </li></ul>
  29. 29. Firm multiples method <ul><li>Analysts often use the following multiples to value stocks. </li></ul><ul><ul><li>P / E </li></ul></ul><ul><ul><li>P / CF </li></ul></ul><ul><ul><li>P / Sales </li></ul></ul><ul><li>EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. </li></ul>
  30. 30. What is market equilibrium? <ul><li>In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. </li></ul><ul><li>In equilibrium, expected returns must equal required returns. </li></ul>
  31. 31. Market equilibrium <ul><li>Expected returns are obtained by estimating dividends and expected capital gains. </li></ul><ul><li>Required returns are obtained by estimating risk and applying the CAPM. </li></ul>
  32. 32. How is market equilibrium established? <ul><li>If expected return exceeds required return … </li></ul><ul><ul><li>The current price (P 0 ) is “too low” and offers a bargain. </li></ul></ul><ul><ul><li>Buy orders will be greater than sell orders. </li></ul></ul><ul><ul><li>P 0 will be bid up until expected return equals required return </li></ul></ul>
  33. 33. Factors that affect stock price <ul><li>Required return (k s ) could change </li></ul><ul><ul><li>Changing inflation could cause k RF to change </li></ul></ul><ul><ul><li>Market risk premium or exposure to market risk ( β ) could change </li></ul></ul><ul><li>Growth rate (g) could change </li></ul><ul><ul><li>Due to economic (market) conditions </li></ul></ul><ul><ul><li>Due to firm conditions </li></ul></ul>
  34. 34. What is the Efficient Market Hypothesis (EMH)? <ul><li>Securities are normally in equilibrium and are “fairly priced.” </li></ul><ul><li>Investors cannot “beat the market” except through good luck or better information. </li></ul><ul><li>Levels of market efficiency </li></ul><ul><ul><li>Weak-form efficiency </li></ul></ul><ul><ul><li>Semistrong-form efficiency </li></ul></ul><ul><ul><li>Strong-form efficiency </li></ul></ul>
  35. 35. Weak-form efficiency <ul><li>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. </li></ul><ul><li>Evidence supports weak-form EMH, but “technical analysis” is still used. </li></ul>
  36. 36. Semistrong-form efficiency <ul><li>All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks. </li></ul><ul><li>Largely true, but superior analysts can still profit by finding and using new information </li></ul>
  37. 37. Strong-form efficiency <ul><li>All information, even inside information, is embedded in stock prices. </li></ul><ul><li>Not true--insiders can gain by trading on the basis of insider information, but that’s illegal. </li></ul>
  38. 38. Is the stock market efficient? <ul><li>Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was: </li></ul><ul><ul><li>Highly efficient in the weak form. </li></ul></ul><ul><ul><li>Reasonably efficient in the semistrong form. </li></ul></ul><ul><ul><li>Not efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits. </li></ul></ul><ul><li>Behavioral finance – incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations. </li></ul>
  39. 39. Implications of Market Efficiency (EMH) <ul><li>If EMH holds, it’s a waste of time to analyze stocks to seek bargains </li></ul><ul><li>No trading rules can be used to “beat the market” </li></ul><ul><li>Difficult to “beat the market” unless: </li></ul><ul><ul><li>Above-average information </li></ul></ul><ul><ul><li>Above-average skill in stock analysis </li></ul></ul><ul><ul><li>Above-average luck </li></ul></ul><ul><li>Conclusion: Buy and hold low-cost index fund, like S&P 500 (Expense ratio = .07%). Over a recent 15-year period, the S&P Index beat 97% of all stock mutual funds. </li></ul>
  40. 40. Preferred stock <ul><li>Hybrid security </li></ul><ul><li>Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. </li></ul><ul><li>However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy. </li></ul>
  41. 41. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? <ul><li>V p = D / k p </li></ul><ul><li>$50 = $5 / k p </li></ul><ul><li>k p = $5 / $50 </li></ul><ul><li>= 0.10 = 10% </li></ul>

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