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- Chapter eight - Chapter eight Presentation Transcript

  • CHAPTER 8 Stocks, Stock Valuation, and Stock Market Equilibrium
  • Topics in Chapter
    • Features of common stock
    • Determining common stock values
    • Efficient markets
    • Preferred stock
  • Common Stock: Owners, Directors, and Managers
    • Represents ownership.
    • Ownership implies control.
    • Stockholders elect directors.
    • Directors hire management.
    • Since managers are “agents” of shareholders, their goal should be: Maximize stock price.
  • 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.
  • 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.
  • 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.
  • Different Approaches for Valuing Common Stock
    • Dividend growth model
    • Using the multiples of comparable firms
    • Free cash flow method (covered in Chapter 15)
  • Stock Value = PV of Dividends 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 ∞ + + +…+
  • For a constant growth stock: 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 and less than r s , then: P 0 = ^ D 0 (1+g) r s - g = D 1 r s - g
  • Dividend Growth and PV of Dividends: P 0 = ∑( PVof D t ) $ 0.25 Years (t) D t = D 0 (1 + g) t PV of D t = D t (1 + r) t If g > r, P 0 = ∞ !
  • What happens if g > r s ? P 0 = ^ (1+r s ) 1 (1+r s ) 2 (1+r s ) ∞ D 0 (1+g) 1 D 0 (1+g) 2 D 0 (1+r s ) ∞ + +…+ (1+g) t (1+r s ) t If g > r s , then P 0 = ∞. ^ > 1, and So g must be less than r s to use the constant growth model.
  • 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 :
  • Projected Dividends
    • D 0 = 2 and constant g = 6%
    • 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
  • Expected Dividends and PVs (r s = 13%, D 0 = $2, g = 6%) 0 1 2.2472 2 2.3820 3 g=6% 4 1.8761 1.7599 1.6508 13% 2.12
  • Intrinsic 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
  • Expected value one year from now:
    • D 1 will have been paid, so expected dividends are D 2 , D 3 , D 4 and so on.
    P 1 = ^ D 2 r s - g = $2.2427 0.07 = $32.10
  • Expected Dividend Yield and Capital Gains Yield (Year 1) Dividend yield = = = 7.0%. $2.12 $30.29 D 1 P 0 CG Yield = = P 1 - P 0 ^ P 0 $32.10 - $30.29 $30.29 = 6.0%.
  • Total Year-1 Return
    • Total return = Dividend yield + Capital gains yield.
    • Total return = 7% + 6% = 13%.
    • Total return = 13% = r s .
    • For constant growth stock:
      • Capital gains yield = 6% = g.
  • Rearrange model to rate of return form: 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.
  • 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 ^
  • Supernormal Growth Stock
    • Supernormal growth of 30% for 3 years, and then long-run constant g = 6%.
    • Can no longer use constant growth model.
    • However, growth becomes constant after 3 years.
  • Nonconstant growth followed by constant growth (D 0 = $2): 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% 2.60 3.38 4.394 4.6576 ^ P 3 = ^ $4.6576 0.13 – 0.06 = $66.5371
  • Expected Dividend Yield and Capital Gains Yield (t = 0) CG Yield = 13.0% - 4.8% = 8.2%. (More…) Dividend yield = = = 4.8%. $2.60 $54.11 D 1 P 0 At t = 0:
  • Expected Dividend Yield and Capital Gains Yield (t = 4)
    • During nonconstant growth, dividend yield and capital gains yield are not constant.
    • If current growth is greater than g, current capital gains yield is greater than g.
    • After t = 3, g = constant = 6%, so the t = 4 capital gains gains yield = 6%.
    • Because r s = 13%, the t = 4 dividend yield = 13% - 6% = 7%.
  • Is the stock price based on short-term growth?
    • The current stock price is $54.11.
    • The PV of dividends beyond year 3 is $46.11 (P 3 discounted back to t = 0).
    • The percentage of stock price due to “long-term” dividends is:
    = 85.2%. $46.11 $54.11
  • 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?
    • See next slide.
  • Intrinsic Stock Value vs. 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.
  • Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. 0 1.7699 1.5663 1.3861 20.9895 1 2 3 4 r s =13% 25.7118 g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 2.12  P 3 0.07 30.2857  
  • Dividend Yield and Capital Gains Yield (t = 0)
    • Dividend Yield = D 1 / P 0
    • Dividend Yield = $2.00 / $25.72
    • Dividend Yield = 7.8%
    • CGY = 13.0% - 7.8% = 5.2%.
  • Dividend Yield and Capital Gains Yield (t = 3)
    • Now have constant growth, so:
    • Capital gains yield = g = 6%
    • Dividend yield = r s – g
    • Dividend yield = 13% - 6% = 7%
  • If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0: ^ = = = $9.89. $2.00(0.94) 0.13 - (-0.06) $1.88 0.19 P 0 = ^ D 0 (1+g) r s - g = D 1 r s - g
  • Annual Dividend and Capital Gains Yields Capital gains yield = g = -6.0%. Dividend yield = 13.0% - (-6.0%) = 19.0%. Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield.
  • 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.
  • Using Entity Multiples
    • The entity value (V) is:
      • the market value of equity (# shares of stock multiplied by the price per share)
      • plus the value of debt.
    • Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc.
    • Calculate the average entity ratio for a sample of comparable firms. For example,
      • V/EBITDA
      • V/Customers
  • Using Entity Multiples (Continued)
    • Find the entity value of the firm in question. For example,
      • Multiply the firm’s sales by the V/Sales multiple.
      • Multiply the firm’s # of customers by the V/Customers ratio
    • The result is the total value of the firm.
    • Subtract the firm’s debt to get the total value of equity.
    • Divide by the number of shares to get the price per share.
  • 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?
  • 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.
  • Expected return, given V ps = $50 and annual dividend = $5 V ps = $50 = $5 r ps ^ r ps $5 $50 ^ = = 0.10 = 10.0%
  • Why are stock prices volatile?
    • r s = r RF + (RP M )b i could change.
      • Inflation expectations
      • Risk aversion
      • Company risk
    • g could change.
    P 0 = ^ D 1 r s - g
  • Consider the following situation. D 1 = $2, r s = 10%, and g = 5%: P 0 = D 1 / (r s -g) = $2 / (0.10 - 0.05) = $40. What happens if r s or g change?
  • Stock Prices vs. Changes in r s and g 66.67 50.00 40.00 9% 40.00 33.33 28.57 11% 50.00 40.00 33.33 10% 6% 5% 4% r s g
  • Are volatile stock prices consistent with rational pricing?
    • Small changes in expected g and r s cause large changes in stock prices.
    • As new information arrives, investors continually update their estimates of g and r s .
    • If stock prices aren’t volatile, then this means there isn’t a good flow of information.
  • What is market equilibrium?
    • In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell.
    • The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price.
    (More…)
  • In equilibrium, expected returns must equal required returns: r s = D 1 /P 0 + g = r s = r RF + (r M - r RF )b. ^
  • How is equilibrium established? If r s = + g > r s , then P 0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the price will be bid up until: D 1 /P 0 + g = r s = r s . ^ ^ D 1 P 0 ^
  • 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.
    (More…)
  • 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.
  • 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.
  • 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.
  • 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.
  • Security Valuation
    • In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return .
  • Preferred Stock
    • A hybrid security :
    • it’s like common stock - no fixed maturity.
      • technically, it’s part of equity capital.
    • it’s like debt - preferred dividends are fixed.
      • missing a preferred dividend does not constitute default, but preferred dividends are cumulative .
    • Usually sold for $25, $50, or $100 per share.
    • Dividends are often quoted as a percentage of par.
      • Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share.
      • $4.125 is the fixed, annual dividend per share.
    Preferred Stock
    • May be callable and convertible .
    • Is usually non-voting .
    • Priority : lower than debt, higher than common stock.
    • Usually includes protective provisions .
    • May include a sinking fund provision.
    Preferred Stock
  • Preferred Stock Valuation
    • A preferred stock can usually be valued like a perpetuity:
    V = D k ps ps
  • Example:
    • Xerox preferred pays an 8.25% dividend on a $50 par value.
    • Suppose our required rate of return on Xerox preferred is 9.5% .
    V ps = 4.125 .095 = $43.42
  • Expected Rate of Return on Preferred
    • Just adjust the valuation model:
    D P o k ps =
  • Example
    • If we know the preferred stock price is $40 , and the preferred dividend is $4.125 , the expected return is:
    D P o k ps = = = .1031 4.125 40
  • The Financial Pages: Preferred Stocks
    • 52 weeks Yld Vol
    • Hi Lo Sym Div % PE 100s Close
    • 29 3 / 8 25 1 / 8 GenMotor pfG 2.28 8.8 … 27 25 7 / 8
    • Dividend: $2.28 on $25 par value
    • = 9.12% dividend rate.
    • Expected return: 2.28 / 25.875 = 8.8%.
  • Common Stock
    • is a variable-income security.
      • dividends may be increased or decreased, depending on earnings.
    • represents equity or ownership.
    • includes voting rights .
    • Priority : lower than debt and preferred.
  • Common Stock Characteristics
    • Claim on Income - a stockholder has a claim on the firm’s residual income.
    • Claim on Assets - a stockholder has a residual claim on the firm’s assets in case of liquidation.
    • Preemptive Rights - stockholders may share proportionally in any new stock issues.
    • Voting Rights - right to vote for the firm’s board of directors.
    • You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time.
    • If you require a 15% rate of return, what would you pay for the stock now?
    Common Stock Valuation (Single Holding Period) 0 1 ? 5.50 + 120
  • Common Stock Valuation (Single Holding Period)
    • Financial Calculator solution:
    • P/Y =1, I = 15, n=1, FV= 125.50
    • solve: PV = -109.13
    • or:
    • P/Y =1, I = 15, n=1, FV= 120,
    • PMT = 5.50
    • solve: PV = -109.13
  • The Financial Pages: Common Stocks
    • 52 weeks Yld Vol Net
    • Hi Lo Sym Div % PE 100s Hi Lo Close Chg
    • 139 81 IBM .48 .5 26 56598 108 106 106 5 / 8 -2
    • 119 75 MSFT … 60 254888 96 93 95 3 / 8 + 1 / 4
  • Common Stock Valuation (Multiple Holding Periods)
    • Constant Growth Model
    • Assumes common stock dividends will grow at a constant rate into the future.
    V cs = D 1 k cs - g
    • Constant Growth Model
    • Assumes common stock dividends will grow at a constant rate into the future.
    • D 1 = the dividend at the end of period 1.
    • k cs = the required return on the common stock.
    • g = the constant, annual dividend growth rate.
    V cs = D 1 k cs - g
  • Example
    • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15% ?
    D 0 = $5, so D 1 = 5 (1.10) = $5.50
  • Example
    • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15% ?
    V cs = = = $110 D 1 5.50 k cs - g .15 - .10
  • Expected Return on Common Stock
    • Just adjust the valuation model
    V cs = D k cs - g k = ( ) + g D 1 V cs
  • Expected Return on Common Stock
    • Just adjust the valuation model
    V cs = D k cs - g k = ( ) + g D 1 P o
  • Example
    • We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5% .
    k cs = ( ) + g D 1 P o k cs = ( ) + .05 = 16.11% 3.00 27