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CHAPTER 7 Stocks and Their Valuation
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  • 1. CHAPTER 7 Stocks and Their Valuation
  • 2. Common Stock
    • Represents ownership.
    • Ownership implies control.
    • Stockholders elect directors.
    • Directors hire management.
    • Since managers are “agents” of shareholders, their goal should be: Maximize stock price.
  • 3. 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.
  • 4. 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.
  • 5. Initial Public Offering (IPO)
    • A firm “goes public” through an IPO when the stock is first offered to the public.
    • Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.
  • 6. Seasoned Equity Offering (SEO)
    • A seasoned equity offering occurs when a company with public stock issues additional shares.
    • After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.
  • 7. Different Approaches for Valuing Common Stock
    • Dividend growth model
    • Using the multiples of comparable firms
    • Free cash flow method (will be covered in Chapter 15)
  • 8. Dividend Growth Model: Stock Value = PV of Dividends where P 0 is value of the stock, D = dividend, and r s is the required return on common stock. What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g. P 0 = ^ (1+r s ) 1 (1+r s ) 2 (1+r s ) 3 (1+r s ) ∞ D 1 D 2 D 3 D ∞ + + +…+
  • 9. For a constant growth stock: D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D t (1+g) t If g is constant and less than r s , then: P 0 = ^ D 0 (1+g) r s - g = D 1 r s - g
  • 10. Required rate of return: beta = 1.2, r RF = 7%, and RPM = 5%. r s = r RF + (RP M )b Firm = 7% + (5%) (1.2) = 13%. Use the SML to calculate r s :
  • 11. Projected Dividends
    • D 0 = current, most recent dividend =2 and constant g = 6%
    • D1 = next dividend, expected dividend, dividend one period from now
      • D 1 = D 0 (1+g) = 2(1.06) = 2.12
      • D 2 = D 1 (1+g) = 2.12(1.06) = 2.2472
      • D 3 = D 2 (1+g) = 2.2472(1.06) = 2.3820
  • 12. Expected Dividends and PVs (r s = 13%) 0 1 2.2472 2 2.3820 3 g=6% 4 1.8761 1.7599 1.6508 D 0 =2.00 13% 2.12
  • 13. Intrinsic/Present Stock Value: D 0 = 2.00, r s = 13%, g = 6%. Constant growth model: = = $30.29. 0.13 - 0.06 $2.12 $2.12 0.07 P 0 = ^ D 0 (1+g) r s - g = D 1 r s - g
  • 14. Expected Return on Stock: Rearrange model Then, r s = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. ^ P 0 = ^ D 1 r s - g to D 1 P 0 r s ^ = + g.
  • 15. If g = 0, the dividend stream is a perpetuity. 2.00 2.00 2.00 0 1 2 3 r s =13% P 0 = = = $15.38. PMT r $2.00 0.13 ^
  • 16. Nonconstant growth followed by constant growth: 0 2.3009 2.6470 3.0453 46.1135 1 2 3 4 r s =13% 54.1067 = P 0 g = 30% g = 30% g = 30% g = 6% D 0 = 2.00 2.60 3.38 4.394 4.6576 ^ P 3 = ^ $4.6576 0.13 – 0.06 = $66.5371
  • 17. Valuing 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.
  • 18. Expected return, given V ps = $50 and annual dividend = $5 V ps = $50 = $5 r ps ^ r ps $5 $50 ^ = = 0.10 = 10.0%
  • 19. 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? -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.
  • 20. 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.
  • 21. 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?
  • 22. 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.
  • 23. 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.
  • 24. 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.
  • 25. 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.
  • 26. Markets are generally efficient because:
    • 100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential.
    • These analysts have similar access to data and megabucks to invest.
    • Thus, news is reflected in P 0 almost instantaneously.