8-1 CHAPTER 8 Stocks and Their Valuation

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  • 1. CHAPTER 8 Stocks and Their Valuation
    • Features of common stock
    • Determining common stock values
    • Efficient markets
    • Preferred stock
  • 2. Facts about common stock
    • Represents ownership
    • Ownership implies control
    • Stockholders elect directors
    • Directors elect management
    • Management’s goal: Maximize the stock price
  • 3. Social/Ethical Question
    • Should management be equally concerned about employees, customers, suppliers, and “the public,” or just the stockholders?
    • In an enterprise economy, management should work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition.
  • 4. Types of stock market transactions
    • Secondary market
    • Primary market
    • Initial public offering market (“going public”)
  • 5. Different approaches for valuing common stock
    • Dividend growth model
    • Corporate value model
    • Using the multiples of comparable firms
  • 6. Dividend growth model
    • Value of a stock is the present value of the future dividends expected to be generated by the stock.
  • 7. Constant growth stock
    • A stock whose dividends are expected to grow forever at a constant rate, g.
    • D 1 = D 0 (1+g) 1
    • D 2 = D 0 (1+g) 2
    • D t = D 0 (1+g) t
    • If g is constant, the dividend growth formula converges to:
  • 8. Future dividends and their present values $ 0.25 Years (t) 0
  • 9. What happens if g > k s ?
    • If g > k s , the constant growth formula leads to a negative stock price, which does not make sense.
    • The constant growth model can only be used if:
      • k s > g
      • g is expected to be constant forever
  • 10. If k RF = 7%, k M = 12%, and β = 1.2, what is the required rate of return on the firm’s stock?
    • Use the SML to calculate the required rate of return (k s ):
    • k s = k RF + (k M – k RF ) β
    • = 7% + (12% - 7%)1.2
    • = 13%
  • 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. What is the stock’s market value?
    • Using the constant growth model:
  • 13. What is the expected market price of the stock, one year from now?
    • 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.
    • Could also find expected P 1 as:
  • 14. What is the expected dividend yield, capital gains yield, and total return during the first year?
    • Dividend yield
      • = D 1 / P 0 = $2.12 / $30.29 = 7.0%
    • Capital gains yield
      • = (P 1 – P 0 ) / P 0
      • = ($32.10 - $30.29) / $30.29 = 6.0%
    • Total return (k s )
      • = Dividend Yield + Capital Gains Yield
      • = 7.0% + 6.0% = 13.0%
  • 15. What would the expected price today be, if g = 0?
    • The dividend stream would be a perpetuity.
    2.00 2.00 2.00 0 1 2 3 k s = 13% ...
  • 16. Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
    • Can no longer use just the constant growth model to find stock value.
    • However, the growth does become constant after 3 years.
  • 17. 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
  • 18. Find expected dividend and capital gains yields during the first and fourth years.
    • Dividend yield (first year)
      • = $2.60 / $54.11 = 4.81%
    • Capital gains yield (first year)
      • = 13.00% - 4.81% = 8.19%
    • During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ≠ g.
    • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
  • 19. 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
  • 20. Find expected dividend and capital gains yields during the first and fourth years.
    • Dividend yield (first year)
      • = $2.00 / $25.72 = 7.78%
    • Capital gains yield (first year)
      • = 13.00% - 7.78% = 5.22%
    • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
  • 21. If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value?
    • The firm still has earnings and pays dividends, even though they may be declining, they still have value.
  • 22. Find expected annual dividend and capital gains yields.
    • Capital gains yield
      • = g = -6.00%
    • Dividend yield
      • = 13.00% - (-6.00%) = 19.00%
    • 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.
  • 23. What is market equilibrium?
    • In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell.
    • In equilibrium, expected returns must equal required returns.
  • 24. Market equilibrium
    • Expected returns are obtained by estimating dividends and expected capital gains.
    • Required returns are obtained by estimating risk and applying the CAPM.
  • 25. How is market equilibrium established?
    • If expected return exceeds required return …
      • The current price (P 0 ) is “too low” and offers a bargain.
      • Buy orders will be greater than sell orders.
      • P 0 will be bid up until expected return equals required return
  • 26. Factors that affect stock price
    • Required return (k s ) could change
      • Changing inflation could cause k RF to change
      • Market risk premium or exposure to market risk ( β ) could change
    • Growth rate (g) could change
      • Due to economic (market) conditions
      • Due to firm conditions
  • 27. What is the Efficient Market Hypothesis (EMH)?
    • Securities are normally in equilibrium and are “fairly priced.”
    • Investors cannot “beat the market” except through good luck or better information.
    • Levels of market efficiency
      • Weak-form efficiency
      • Semistrong-form efficiency
      • Strong-form efficiency
  • 28. Weak-form efficiency
    • 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.
  • 29. Semistrong-form efficiency
    • All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks.
    • Largely true, but superior analysts can still profit by finding and using new information
  • 30. Strong-form efficiency
    • 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.
  • 31. Is the stock market efficient?
    • Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was:
      • Highly efficient in the weak form.
      • Reasonably efficient in the semistrong form.
      • Not efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits.
    • Behavioral finance – incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations.
  • 32. Preferred stock
    • Hybrid security
    • Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders.
    • However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.
  • 33. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return?
    • V p = D / k p
    • $50 = $5 / k p
    • k p = $5 / $50
    • = 0.10 = 10%