CHAPTER 7 Stocks and Their Valuation
Common Stock <ul><li>Represents ownership. </li></ul><ul><li>Ownership implies control. </li></ul><ul><li>Stockholders ele...
Classified Stock <ul><li>Classified stock has special provisions. </li></ul><ul><li>Could classify existing stock as found...
Tracking Stock <ul><li>The dividends of tracking stock are tied to a particular division, rather than the company as a who...
Initial Public Offering (IPO) <ul><li>A firm “goes public” through an IPO when the stock is first offered to the public. <...
Seasoned Equity Offering (SEO) <ul><li>A seasoned equity offering occurs when a company with public stock issues additiona...
Different Approaches for Valuing Common Stock <ul><li>Dividend growth model </li></ul><ul><li>Using the multiples of compa...
Dividend Growth Model: Stock Value = PV of Dividends where  P 0  is value of the stock, D = dividend, and r s  is the requ...
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 ,...
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 t...
Projected Dividends <ul><li>D 0  = current, most recent dividend =2 and constant g = 6% </li></ul><ul><li>D1 = next divide...
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
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...
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...
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 ^
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...
Valuing Preferred Stock <ul><li>Hybrid security. </li></ul><ul><li>Similar to bonds in that preferred stockholders receive...
Expected return, given V ps  = $50 and annual dividend = $5 V ps = $50 = $5 r ps ^ r ps $5 $50 ^ = = 0.10 = 10.0%
Intrinsic Stock Value vs. Quarterly Earnings <ul><li>If most of a stock’s value is due to long-term cash flows, why do so ...
Using Stock Price Multiples to Estimate Stock Price <ul><li>Analysts often use the P/E multiple (the price per share divid...
Problems with Market Multiple Methods <ul><li>It is often hard to find comparable firms. </li></ul><ul><li>The average rat...
What’s the Efficient Market Hypothesis (EMH)? <ul><li>Securities are normally in equilibrium and are “fairly priced.”  One...
Weak-form EMH <ul><li>Can’t profit by looking at past trends.  A recent decline is no reason to think stocks will go up (o...
Semistrong-form EMH <ul><li>All publicly available information is reflected in stock prices, so it doesn’t pay to pore ove...
Strong-form EMH <ul><li>All information, even inside information, is embedded in stock prices.  Not true--insiders can gai...
Markets are generally efficient because: <ul><li>100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like...
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CHAPTER 7 Stocks and Their Valuation

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  • CHAPTER 7 Stocks and Their Valuation

    1. 1. CHAPTER 7 Stocks and Their Valuation
    2. 2. 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 hire management. </li></ul><ul><li>Since managers are “agents” of shareholders, their goal should be: Maximize stock price. </li></ul>
    3. 3. Classified Stock <ul><li>Classified stock has special provisions. </li></ul><ul><li>Could classify existing stock as founders’ shares, with voting rights but dividend restrictions. </li></ul><ul><li>New shares might be called “Class A” shares, with voting restrictions but full dividend rights. </li></ul>
    4. 4. Tracking Stock <ul><li>The dividends of tracking stock are tied to a particular division, rather than the company as a whole. </li></ul><ul><ul><li>Investors can separately value the divisions. </li></ul></ul><ul><ul><li>Its easier to compensate division managers with the tracking stock. </li></ul></ul><ul><li>But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company. </li></ul>
    5. 5. Initial Public Offering (IPO) <ul><li>A firm “goes public” through an IPO when the stock is first offered to the public. </li></ul><ul><li>Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers. </li></ul>
    6. 6. Seasoned Equity Offering (SEO) <ul><li>A seasoned equity offering occurs when a company with public stock issues additional shares. </li></ul><ul><li>After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq. </li></ul>
    7. 7. Different Approaches for Valuing Common Stock <ul><li>Dividend growth model </li></ul><ul><li>Using the multiples of comparable firms </li></ul><ul><li>Free cash flow method (will be covered in Chapter 15) </li></ul>
    8. 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. 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. 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. 11. Projected Dividends <ul><li>D 0 = current, most recent dividend =2 and constant g = 6% </li></ul><ul><li>D1 = next dividend, expected dividend, dividend one period from now </li></ul><ul><ul><li>D 1 = D 0 (1+g) = 2(1.06) = 2.12 </li></ul></ul><ul><ul><li>D 2 = D 1 (1+g) = 2.12(1.06) = 2.2472 </li></ul></ul><ul><ul><li>D 3 = D 2 (1+g) = 2.2472(1.06) = 2.3820 </li></ul></ul>
    12. 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. 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. 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. 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. 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. 17. Valuing Preferred Stock <ul><li>Hybrid security. </li></ul><ul><li>Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. </li></ul><ul><li>However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy. </li></ul>
    18. 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. 19. Intrinsic Stock Value vs. Quarterly Earnings <ul><li>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. </li></ul><ul><ul><li>- Sometimes managers have bonuses tied to quarterly earnings. </li></ul></ul>
    20. 20. Using Stock Price Multiples to Estimate Stock Price <ul><li>Analysts often use the P/E multiple (the price per share divided by the earnings per share). </li></ul><ul><li>Example: </li></ul><ul><ul><li>Estimate the average P/E ratio of comparable firms. This is the P/E multiple. </li></ul></ul><ul><ul><li>Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. </li></ul></ul>
    21. 21. Problems with Market Multiple Methods <ul><li>It is often hard to find comparable firms. </li></ul><ul><li>The average ratio for the sample of comparable firms often has a wide range. </li></ul><ul><ul><li>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? </li></ul></ul>
    22. 22. What’s the Efficient Market Hypothesis (EMH)? <ul><li>Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information. </li></ul>
    23. 23. Weak-form EMH <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. Evidence supports weak-form EMH, but “technical analysis” is still used. </li></ul>
    24. 24. Semistrong-form EMH <ul><li>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. </li></ul>
    25. 25. Strong-form EMH <ul><li>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. </li></ul>
    26. 26. Markets are generally efficient because: <ul><li>100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential. </li></ul><ul><li>These analysts have similar access to data and megabucks to invest. </li></ul><ul><li>Thus, news is reflected in P 0 almost instantaneously. </li></ul>
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