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# 8-1 CHAPTER 8 Stocks and Their Valuation

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### 8-1 CHAPTER 8 Stocks and Their Valuation

1. 1. CHAPTER 8 Stocks and Their Valuation <ul><li>Features of common stock </li></ul><ul><li>Determining common stock values </li></ul><ul><li>Efficient markets </li></ul><ul><li>Preferred stock </li></ul>
2. 2. Facts about 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 elect management </li></ul><ul><li>Management’s goal: Maximize the stock price </li></ul>
3. 3. Dividend growth model <ul><li>Value of a stock is the present value of the future dividends expected to be generated by the stock. </li></ul>
4. 4. Constant growth stock <ul><li>A stock whose dividends are expected to grow forever at a constant rate, g. </li></ul><ul><li>D 1 = D 0 (1+g) 1 </li></ul><ul><li>D 2 = D 0 (1+g) 2 </li></ul><ul><li>D t = D 0 (1+g) t </li></ul><ul><li>If g is constant, the dividend growth formula converges to: </li></ul>
5. 5. What happens if g > k s ? <ul><li>If g > k s , the constant growth formula leads to a negative stock price, which does not make sense. </li></ul><ul><li>The constant growth model can only be used if: </li></ul><ul><ul><li>k s > g </li></ul></ul><ul><ul><li>g is expected to be constant forever </li></ul></ul>
6. 6. If k RF = 7%, k M = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? <ul><li>Use the SML to calculate the required rate of return (k s ): </li></ul><ul><li>k s = k RF + (k M – k RF ) β </li></ul><ul><li>= 7% + (12% - 7%)1.2 </li></ul><ul><li>= 13% </li></ul>
7. 7. 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
8. 8. What is the stock’s market value? <ul><li>Using the constant growth model: </li></ul>
9. 9. What is the expected market price of the stock, one year from now? <ul><li>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. </li></ul><ul><li>Could also find expected P 1 as: </li></ul>
10. 10. What is the expected dividend yield, capital gains yield, and total return during the first year? <ul><li>Dividend yield </li></ul><ul><ul><li>= D 1 / P 0 = \$2.12 / \$30.29 = 7.0% </li></ul></ul><ul><li>Capital gains yield </li></ul><ul><ul><li>= (P 1 – P 0 ) / P 0 </li></ul></ul><ul><ul><li>= (\$32.10 - \$30.29) / \$30.29 = 6.0% </li></ul></ul><ul><li>Total return (k s ) </li></ul><ul><ul><li>= Dividend Yield + Capital Gains Yield </li></ul></ul><ul><ul><li>= 7.0% + 6.0% = 13.0% </li></ul></ul>
11. 11. What would the expected price today be, if g = 0? <ul><li>The dividend stream would be a perpetuity. Preferred Stock has a fixed dividend, so its g = 0. </li></ul>2.00 2.00 2.00 0 1 2 3 k s = 13% ...
12. 12. If preferred stock with an annual dividend of \$5 sells for \$50, what is the preferred stock’s expected return? <ul><li>V p = D / k p </li></ul><ul><li>\$50 = \$5 / k p </li></ul><ul><li>k p = \$5 / \$50 </li></ul><ul><li>= 0.10 = 10% </li></ul>
13. 13. Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%? <ul><li>Can no longer use just the constant growth model to find stock value. </li></ul><ul><li>However, the growth does become constant after 3 years. </li></ul>
14. 14. Firm multiples method <ul><li>Analysts often use the following multiples to value stocks. </li></ul><ul><ul><li>P / E </li></ul></ul><ul><ul><li>P / CF </li></ul></ul><ul><ul><li>P / Sales </li></ul></ul><ul><li>EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. </li></ul>
15. 15. What is market equilibrium? <ul><li>In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. </li></ul><ul><li>In equilibrium, expected returns must equal required returns. </li></ul>
16. 16. Market equilibrium <ul><li>Expected returns are obtained by estimating dividends and expected capital gains. </li></ul><ul><li>Required returns are obtained by estimating risk and applying the CAPM. </li></ul>
17. 17. What is the Efficient Market Hypothesis (EMH)? <ul><li>Securities are normally in equilibrium and are “fairly priced.” </li></ul><ul><li>Investors cannot “beat the market” except through good luck or better information. </li></ul><ul><li>Levels of market efficiency </li></ul><ul><ul><li>Weak-form efficiency </li></ul></ul><ul><ul><li>Semistrong-form efficiency </li></ul></ul><ul><ul><li>Strong-form efficiency </li></ul></ul>
18. 18. Is the stock market efficient? <ul><li>Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was: </li></ul><ul><ul><li>Highly efficient in the weak form. </li></ul></ul><ul><ul><li>Reasonably efficient in the semistrong form. </li></ul></ul><ul><ul><li>Not efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits. </li></ul></ul><ul><li>Behavioral finance – incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations. </li></ul>