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# 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%