CHAPTER 8 Stocks and Their Valuation <ul><li>Features of common stock </li></ul><ul><li>Determining common stock values </...
Facts about common stock <ul><li>Represents ownership </li></ul><ul><li>Ownership implies control </li></ul><ul><li>Stockh...
Social/Ethical Question <ul><li>Should management be equally concerned about employees, customers, suppliers, and “the pub...
Types of stock market transactions <ul><li>Secondary market </li></ul><ul><li>Primary market </li></ul><ul><li>Initial pub...
Different approaches for valuing common stock <ul><li>Dividend growth model </li></ul><ul><li>Corporate value model </li><...
Dividend growth model <ul><li>Value of a stock is the present value of the future dividends expected to be generated by th...
Constant growth stock <ul><li>A stock whose dividends are expected to grow forever at a constant rate, g. </li></ul><ul><l...
Future dividends and their present values $ 0.25 Years (t) 0
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...
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 ...
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 ...
What is the stock’s market value? <ul><li>Using the constant growth model: </li></ul>
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 ...
What is the expected dividend yield, capital gains yield, and total return during the first year? <ul><li>Dividend yield <...
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...
Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%? <ul><li>Can no longer use just the...
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  ...
Find expected dividend and capital gains yields during the first and fourth years. <ul><li>Dividend yield (first year) </l...
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 ...
Find expected dividend and capital gains yields during the first and fourth years. <ul><li>Dividend yield (first year) </l...
If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? <ul><li>Th...
Find expected annual dividend and capital gains yields. <ul><li>Capital gains yield </li></ul><ul><ul><li>= g = -6.00% </l...
What is market equilibrium? <ul><li>In equilibrium, stock prices are stable and there is no general tendency for people to...
Market equilibrium <ul><li>Expected returns are obtained by estimating dividends and expected capital gains. </li></ul><ul...
How is market equilibrium established? <ul><li>If expected return exceeds required return … </li></ul><ul><ul><li>The curr...
Factors that affect stock price <ul><li>Required return (k s ) could change </li></ul><ul><ul><li>Changing inflation could...
What is the Efficient Market Hypothesis (EMH)? <ul><li>Securities are normally in equilibrium and are “fairly priced.”  </...
Weak-form efficiency <ul><li>Can’t profit by looking at past trends.  A recent decline is no reason to think stocks will g...
Semistrong-form efficiency <ul><li>All publicly available information is reflected in stock prices, so it doesn’t pay to o...
Strong-form efficiency <ul><li>All information, even inside information, is embedded in stock prices.  </li></ul><ul><li>N...
Is the stock market efficient? <ul><li>Empirical studies have been conducted to test the three forms of efficiency.  Most ...
Preferred stock <ul><li>Hybrid security </li></ul><ul><li>Like bonds, preferred stockholders receive a fixed dividend that...
If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? <ul><li>V p...
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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. 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. 18. Find expected dividend and capital gains yields during the first and fourth years. <ul><li>Dividend yield (first year) </li></ul><ul><ul><li>= $2.60 / $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>
  19. 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. 20. 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>
  21. 21. 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>
  22. 22. 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>
  23. 23. 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>
  24. 24. 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>
  25. 25. 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>
  26. 26. 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>
  27. 27. 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>
  28. 28. 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>
  29. 29. 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>
  30. 30. 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>
  31. 31. 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>
  32. 32. 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>
  33. 33. 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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