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  1. 1. CHAPTER 6 VALUING STOCKS TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 6.1 STOCKS AND THE STOCK MARKET A. Financial markets provide a source of financing for businesses and governments. They also provide financial investment opportunities for individual and institutional investors. B. The initial, funds-raising sale of securities, usually with an investment banker, is in the primary market; subsequent trading between investors for liquidity, financial investing, and portfolio rebalancing is in the secondary market. C. There are two types of primary market issues: an initial offering or IPO and a seasoned offering. An IPO is the first sale of newly issued stock to “public” investors. The company receives the funds and investors receive the shares. We say the company “goes public” when it undertakes an IPO. A seasoned offering is the sale of additional shares by a company that has already gone public. In a seasoned offering, the company raises additional equity financing from investors who receive new shares in return. Reading the Stock Market Listings A. Figure 6.1 lists a number of stock quotations. Note that the dividend is “annualized”. That is, if the company normally pays quarterly dividends, the reported dividend is four times its quarterly dividend. The dividend yield is the annualized dividend divided by the closing price. B. Why do the dividend yields vary? Expected price appreciation and risk. C. The price-earnings (P/E) multiple is the closing price divided by the earnings per share. Commonly used in valuation assessment, the ratio indicates the number of years of current earnings the market is willing to pay to own the stock. For example, if the current price is $100 and the earnings per share are $10, the P/E multiple is 10. Given the current earnings per share, it would take 10 years for the stock to generate earnings equal to the current price, ignoring the time value of money! 6.2 BOOK VALUES, LIQUIDATION VALUES, AND MARKET VALUES A. Book value of common shares represents the accounting value of assets less the accounting value of liabilities. 6-1 Copyright © 2006 McGraw-Hill Ryerson Limited
  2. 2. B. Book value is biased toward historical or original costs. C. Liquidation value of common shares represents the proceeds from the quick sale of individual assets minus liabilities owed. D. Going concern value represents the difference between a minimum liquidation value and actual or “true” value (market), the worth of an on-going business by investors considering, (1) future earning power of existing tangible and intangible assets and (2) the value of future investment opportunities of the firm. E. Market value represents the value assigned a firm by investors in a reasonable market driven by the expected level and variability of cash flows. When the market/book ratio exceeds one, the economic value of the assets exceeds the accounting value or the expected rate of return to shareholders exceeds their minimally acceptable rate of return. A MARKET-VALUE BALANCE SHEET Assets Liabilities and Shareholders’ Equity Assets in place Market value of debt and other obligations Investment Opportunities Market value of shareholders’ equity 6.3 VALUING COMMON STOCKS Today’s Price and Tomorrow’s Price A. The expected and actual realized rate of return to common shareholders comes from 1) cash dividends, DIV1, and 2) capital gains or losses, P1 - P0. B. The rate of return is calculated as: Rate of return = = = C. If you know what the future dividend and selling price in one year will be, you can calculate the actual rate of return. With expected dividends and expected future price, you can calculate the expected rate of return. D. Taxes reduce the expected and actual rate of return earned on a stock investment. To calculate the after-tax rate of return, convert both dividends and capital gain to their after-tax amounts by subtracting the appropriate taxes: After-tax Rate of return = E. Investors compare expected returns, based on expected dividends and price changes, with minimum required returns, comparable returns on similar securities (opportunity costs). 6-2 Copyright © 2006 McGraw-Hill Ryerson Limited
  3. 3. F. If expected returns exceed comparable returns elsewhere, investors will want to purchase the stock, bidding the price up and the expected return down to the minimum acceptable return. G. At any market price, expected returns equal that return required by investors. H. All securities of the same risk are priced to offer the same expected rate of return. The Dividend Discount Model A. The dividend discount model, or discounted cash flow model, states that share value equals the present value of all expected future dividends. B. With a specific investment time period or horizon, H, the intrinsic share value (value determined by the evidence) is: DIV1 DIV2 DIVH PH P0 = + 2 + .... H + 1+ r (1+ r) (1+ r) (1+ r) H C. The stock price at the horizon date, PH, is the present value of cash dividends received beyond the horizon date. D. As the horizon date changes, the present value of the stock will remain the same as dividends are expected to grow at the rate of “g” (see Example 6.3, Table 6.4, and Figure 6.2). E. At extreme horizon dates the present value of PH becomes insignificant; thus the dividend discount model share value equals the present value of future, expected dividends. 6.4 SIMPLIFYING THE DIVIDEND DISCOUNT MODEL The Dividend Discount Model with No Growth A. When all earnings are paid as cash dividends, no growth is possible (reinvestment = depreciation to maintain the current stock of capital). B. The stock value of a no-growth firm is the expected dividend capitalized (perpetuity) at the required rate of return or: DIV1 P0 = r C. Assuming all earnings are paid as dividends, 6-3 Copyright © 2006 McGraw-Hill Ryerson Limited
  4. 4. EPS1 P0 = r where EPS1 represents next year’s earnings per share. The Constant-Growth Dividend Discount Model A. The Constant-Growth Discount Model is an arithmetic expression calculating the present value of a perpetual stream of cash flows, DIV, growing at a constant rate of growth, g, and discounted at a required rate of return, r: DIV1 P0 = r-g B. With a sustained positive growth rate in the economy and business activity, the Gordon Model and its assumptions are reasonable. C. DIV1 represents the dividend received at the end of period one. D. The constant-growth formula is valid only when “g” is less than “r.” E. P0 is directly related to DIV1 and g; inversely related to r. Estimating Expected Rates of Return A. In constant-growth business situations, if g is capitalized in the market in higher stock prices, r may be a proxy for the market expected rate of return on similar risk situations. B. The expected rate of return is a combination of the dividend yield, DIV1/P0, and capital appreciation rate, g, or: DIV1 r= +g P0 C. The required rate of return, r, is a market-determined rate related to the risk-free rate adjusted upward for risk, given expectations of DIV1 and g. The stock price, P0, adjusts to equate the market-expected rate with the required rate of return. Non-constant Growth A. The no-growth and constant-growth dividend discount models above assume two patterns of cash flows while reality presents the analyst with many variations. The dividend discount model is easily adapted. 6-4 Copyright © 2006 McGraw-Hill Ryerson Limited
  5. 5. B. Changing future dividend patterns from non-growth to constant-growth to variable-growth rates over a given horizon requires that the analyst estimate the stock price by forecasting the cash-flow patterns and discounting the cash flows at the market-required rate of return. C. The terminal value, PH, represents the present value of the cash flows beyond the horizon. 6.5 GROWTH STOCKS AND INCOME STOCKS A. Income stock returns are derived from the dividend yield, DIV/price, and are associated with businesses with a high payout ratio, the fraction of earnings paid out as dividends. B. Growth stock returns are derived from a combination of no or relatively small dividend yields (low payout ratio) and a high plowback ratio or earnings retention ratio (the proportion of current period earnings or free cash flow retained in firm), and earning high asset returns, in excess of that required by the market, on reinvested earnings. C. The sustainable growth rate, g, discussed in the constant-growth rate discussion above, relates to the expected asset returns on reinvested capital adjusted for the proportion of earnings plowed back into the firm. Dividends (payout ratio) limit the level of reinvested capital and the growth potential of future earnings and dividends. g = return on equity x plowback ratio, where the return on equity is the expected return on equity capital plowed back into earning assets. D. Similar stock prices ($41.67) will result from a 100 percent payout ratio and any less payout where the plowed back earnings earn just the required rate of return. E. When rates of return on reinvested capital exceed the required rate of return, added value, often called “value added” or the present value of growth opportunities or (PVGO), is capitalized in the market price of the stock. The Price-Earnings Ratio A. Higher price-earnings ratios are associated with higher expected growth opportunities and lower earnings-price ratios (earnings yield), reflecting that some portion of the required rate of return is expected to be derived from growth opportunities. B. Expected future earnings are expected cash flows less any reinvestment 6-5 Copyright © 2006 McGraw-Hill Ryerson Limited
  6. 6. associated with the economic depreciation of earning assets or earnings (cash flow) above that needed to maintain the earning power of the firm. Valuing Entire Businesses A. The valuation of a share can be extended to the valuation of the equity of a company. Either discount the company's total dividend payout by required rate of return to equity less the dividend growth rate or multiply the share price by the number of shares outstanding. 6.6 THERE ARE NO FREE LUNCHES ON WALL STREET OR BAY STREET A. Does knowing how to value a stock allow an investor to make an instant fortune on the stock market? No, because the market is an excellent processor of information. B. Investors, seeking to find stocks that will earn superior returns, use various ways to analyze stocks. Method 1: Technical Analysis A. Technical analysts attempt to find patterns in security price movements and trade accordingly. Their trading tends to quickly offset any price trend and keep the markets efficient. B. Research has shown time and again that security market price changes are unrelated to prior price changes with no predictable trends or patterns. The prices tend to be a random walk over time. See Figure 6.4. Method 2: Fundamental Analysis A. Fundamental analysts attempt to find under- or over-valued securities by analyzing “fundamental” information, such as earnings, asset values, etc., to uncover yet undiscovered information about the future of a business. They attempt to forecast the impact of the information; technical analysts are studying past prices, looking for predictable patterns. B. Unfortunately, with so many investors following the news, it is very difficult to consistently make superior returns by buying or selling stock after the announcement of news. C. Trading on corporate information before the news is released to the market may be a successful strategy to beat the market. However, if the information is from an insider of the company, including managers, employees and others with a close relationship to the company, it is inside information and illegal to trade on. 6-6 Copyright © 2006 McGraw-Hill Ryerson Limited
  7. 7. Penalties for insider trading can be very heavy, including large fines and jail time. A Theory to Fit the Facts A. The stock market is an efficient market, where security prices rapidly reflect all relevant information, currently available, about asset values. B. Investors react quickly to new information, trying to take advantage of it. In the process, stock prices quickly adjust to the new information and eliminate the profit opportunities. C. The efficient-market theory implies that portfolio managers work in a very competitive market with little or no added advantage over the next portfolio manager. They make few extraordinary returns, not because they are incompetent, but because the markets are so competitive and there are few easy profits. There are no free lunches on Wall Street or Bay Street. D. The efficient market theory implies that security market prices represent fair value. Fair market value changes with new information about the future cash flows associated with a security. E. The three degrees of efficiency are defined relative to three types of information. F. The first form of market efficiency is weak-form efficiency, where market prices rapidly reflect all information contained in the history of past prices. Past price movements are random; the past cannot predict future price changes. Technical analysis is valueless in a weak-form efficient market. G. A second form of market efficiency, semi-strong form efficiency, is a market situation in which market prices reflect all publicly available information. See Figure 6.7. New information is quickly reflected in the price of the stock, and investors were not able to earn superior returns by buying or selling after the announcement date. H. A third form of market efficiency, strong-form efficiency, is a situation in which prices rapidly reflect all information that could be used to determine true value. In this market-pricing situation, all securities would always be fairly priced and no investor would be able to make superior, accurate forecasts of future price changes. Even professional portfolio managers do not consistently outperform the market, thus supporting the creation of “index” portfolios, assembled to match popular market indices. Some Puzzles and Anomalies A. Though the efficient markets hypothesis is well supported by research, there are unexplained events and exceptions. 6-7 Copyright © 2006 McGraw-Hill Ryerson Limited
  8. 8. B. Stock prices appear to underreact to unexpectedly good earnings announcements. C. The long-run underperformance of new equity issues is a puzzle. 6.7 BEHAVIOURAL FINANCE AND THE RISE AND FALL OF THE DOT.COMS A. Behavioural finance, a relatively new field of finance, attempts to explain stock market performance using behavioural psychology. B. This approach rejects the notion of rational market investors. Instead investors' attitudes towards risk and beliefs about probabilities lead them to "irrational exuberance" and an over-valued stock market. C. Whether behavioural finance will help to better understand the stock market is still to be seen. In the mean time, it is difficult for investment managers and corporate management to spot mispriced securities. 6-8 Copyright © 2006 McGraw-Hill Ryerson Limited