1 CHAPTER 7 Stocks, Stock Valuation, and Stock Market Equilibrium 2 Topics in Chapter Features of common stock Valuing common stock Preferred stock Stock market equilibrium Efficient markets hypothesis Implications of market efficiency for financial decisions 1 ValueStock = + + + D1 D2 D∞ (1 + rs )1 (1 + rs)∞ (1 + rs)2 Dividends (Dt) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of equity (rs) Free cash flow (FCF) The Big Picture: The Intrinsic Value of Common Stock ... For value box in Ch 4 time value FM13. 4 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. 5 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. 6 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. 7 Different Approaches for Valuing Common Stock Dividend growth model Constant growth stocks Nonconstant growth stocks Free cash flow method (covered in Chapter 11) Using the multiples of comparable firms 8 Stock Value = PV of Dividends What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g. P0 = ^ (1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞ D1 D2 D3 D∞ + + + … + 9 For a constant growth stock: D1 = D0(1 + g)1 D2 = D0(1 + g)2 Dt = D0(1 + g)t If g is constant and less than rs, then: P0 = ^ D0(1 + g) rs – g = D1 rs – g 10 Dividend Growth and PV of Dividends: P0 = ∑(PV of Dt) $ 0.25 Years (t) Dt = D0(1 + g)t PV of Dt = Dt (1 + r)t If g > r, P0 = ∞ ! 11 What happens if g > rs? P0 = ^ (1 + rs)1 (1 + rs)2 (1 + rs)∞ D0(1 + g)1 D0(1 + g)2 D0(1 + rs)∞ + + … + (1 + g)t (1 + rs)t P0 = ∞ ^ > 1, and So g must be less than rs for the constant growth model to be applicable!! If g > rs, then 12 Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%. rs = rRF + (RPM)bFirm = 7% + (5%)(1.2) = 13%. Use the SML to calculate rs: 13 Projected Dividends D0 = $2 and constant g = 6% D1 = D0(1 + g) = $2(1.06) = $2.12 D2 = D1(1 + g) = $2.12(1.06) = $2.2472 D3 = D2(1 + g) = $2.2472(1.06) = $2.3820 11 14 Expected Div.

1. 1
CHAPTER 7
Stocks, Stock Valuation, and
Stock Market Equilibrium
2
Topics in Chapter
Features of common stock
Valuing common stock
Preferred stock
Stock market equilibrium
Efficient markets hypothesis
Implications of market efficiency for financial decisions

2. 1
ValueStock = + + +
D1
D2
D∞
(1 + rs )1
(1 + rs)∞
(1 + rs)2
Dividends (Dt)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s debt/equity mix
Cost of
equity (rs)
Free cash flow
(FCF)
The Big Picture:
The Intrinsic Value of Common Stock
...

3. For value box in Ch 4 time value FM13.
4
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.
5
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. 6
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.
7
Different Approaches for Valuing Common Stock
Dividend growth model
Constant growth stocks
Nonconstant growth stocks
Free cash flow method (covered in Chapter 11)
Using the multiples of comparable firms

5. 8
Stock Value = PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever at a constant
rate, g.
P0 =
^
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞
D1 D2 D3 D∞
+
+
+ … +
9
For a constant growth stock:
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
If g is constant and less than rs, then:

6. P0 =
^
D0(1 + g)
rs – g
=
D1
rs – g
10
Dividend Growth and PV of Dividends: P0 = ∑(PV of Dt)

7. $
0.25
Years (t)
Dt = D0(1 + g)t
PV of Dt =
Dt
(1 + r)t
If g > r, P0 = ∞ !
11
What happens if g > rs?
P0 =
^
(1 + rs)1 (1 + rs)2 (1 + rs)∞
D0(1 + g)1 D0(1 + g)2 D0(1 + rs)∞
+
+ … +
(1 + g)t
(1 + rs)t
P0 = ∞
^

8. > 1, and
So g must be less than rs for the constant growth model to be
applicable!!
If g > rs, then
12
Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%.
rs = rRF + (RPM)bFirm
= 7% + (5%)(1.2)
= 13%.
Use the SML to calculate rs:
13
Projected Dividends
D0 = $2 and constant g = 6%
D1 = D0(1 + g) = $2(1.06) = $2.12
D2 = D1(1 + g) = $2.12(1.06) = $2.2472
D3 = D2(1 + g) = $2.2472(1.06) = $2.3820

9. 11
14
Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)
0
1
2.2472
2
2.3820
3
g = 6%
1.8761
1.7599
1.6508
13%

10. 2.12
11
15
Intrinsic Stock Value:
D0 = $2.00, rs = 13%, g = 6%
Constant growth model:
= = = $30.29.
0.13 – 0.06
$2.12
$2.12
0.07
P0 =
^
D0(1 + g)
rs – g
=

11. D1
rs – g
16
Expected value one year from now:
P1 =
^
D2
rs – g
=
$2.2472
0.07
= $32.10
D1 will have been paid, so expected dividends are D2, D3, D4
and so on.
17

12. Expected Dividend Yield and Capital Gains Yield (Year 1)
Dividend yield = = = 7.0%.
$2.12
$30.29
D1
P0
CG Yield = =
P1 – P0
^
P0
$32.10 – $30.29
$30.29
= 6.0%.
14
18
Total Year 1 Return
Total return = Dividend yield + Capital gains
yield.

13. Total return = 7% + 6% = 13%.
Total return = 13% = rs.
For constant growth stock:
Capital gains yield = 6% = g.
19
Rearrange model to rate of return form:
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.
^
P0 =
^
D1
rs – g
to
D1
P0
rs
^
=
+ g.

14. 20
If g = 0, the dividend stream is a perpetuity.
2.00
2.00
2.00
0
1
2
3
rs = 13%
P0 = = = $15.38.
PMT
r
$2.00
0.13
^

15. 16
21
Supernormal Growth Stock
Supernormal growth of 30% for Year 0 to Year 1, 25% for Year
1 to Year 2, 15% for Year 2 to Year 3, and then long-run
constant g = 6%.
Can no longer use constant growth model.
However, growth becomes constant after 3 years.
17
22
Nonconstant growth followed by constant growth (D0 = $2):
0

16. 2.3009
2.5452
2.5903
39.2246
1
2
3
4
rs = 13%
46.6610 = P0
g = 30%
g = 25%
g = 15%
g = 6%
2.6000 3.2500 3.7375 3.9618
^
P3 =
^
$3.9618
0.13 – 0.06

17. = $56.5971
18
23
Expected Dividend Yield and Capital Gains Yield (t = 0)
CG Yield = 13.0% – 5.6% = 7.4%.
Dividend yield = = = 5.6%
$2.60
$46.66
D1
P0
At t = 0:
(More…)

18. 14
24
Expected Dividend Yield and Capital Gains Yield (after t = 3)
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
capital gains yield = 6%.
Because rs = 13%, after t = 3 dividend
yield = 13% – 6% = 7%.
20
25
Is the stock price based on
short-term growth?
The current stock price is $46.66.

19. The PV of dividends beyond Year 3 is:
^
P3 / (1+rs)3 = $39.22 (see slide 22)
= 84.1%.
$39.22
$46.66
The percentage of stock price due to “long-term” dividends is:
26
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.
27
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

20. price.
Sometimes managers have bonuses tied to quarterly earnings.
28
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

21. 4
rs = 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
=
=
^
21

22. 29
Dividend Yield and Capital Gains Yield (t = 0)
Dividend Yield = D1/P0
Dividend Yield = $2.00/$25.72
Dividend Yield = 7.8%
CGY = 13.0% – 7.8% = 5.2%.
30
Dividend Yield and Capital Gains Yield (after t = 3)
Now have constant growth, so:
Capital gains yield = g = 6%
Dividend yield = rs – g
Dividend yield = 13% – 6% = 7%
31

23. If g = -6%, would anyone buy the stock? If so, at what price?
Firm still has earnings and still pays
dividends, so P0 > 0:
^
= = = $9.89.
$2.00(0.94)
0.13 – (-0.06)
$1.88
0.19
P0 =
^
D0(1 + g)
rs – g
=
D1
rs – g
32
Annual Dividend and Capital Gains Yields
Capital gains yield = g = -6.0%.
Dividend yield = 13.0% – (-6.0%)
= 19.0%.

24. Both yields are constant over time, with the high dividend yield
(19%) offsetting the negative capital gains yield.
24
33
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.
34

25. 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
35
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 firm’s total value.
Subtract the firm’s debt to get the total value of its equity.
Divide by the number of shares to calculate the price per share.

26. 36
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?
37
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.

27. 33
38
Expected return, given Vps = $50 and annual dividend = $5
Vps
= $50 =
$5
rps
^
rps
$5
$50
^
=
= 0.10 = 10.0%
39
Why are stock prices volatile?
P0 =
^
D1
rs – g

28. rs = rRF + (RPM)bi could change.
Inflation expectations
Risk aversion
Company risk
g could change.
40
Consider the following situation.
D1 = $2, rs = 10%, and g = 5%:
P0 = D1/(rs – g) = $2/(0.10 – 0.05) = $40.
What happens if rs or g changes?
41
Stock Prices vs. Changes in rs and
ggrs4%5%6%9%$40.00$50.00$66.6710%$33.33$40.00$50.0011
%$28.57$33.33$40.00

29. 42
Are volatile stock prices consistent with rational pricing?
Small changes in expected g and rs cause large changes in stock
prices.
As new information arrives, investors continually update their
estimates of g and rs.
If stock prices aren’t volatile, then this means there isn’t a good
flow of information.
43
What is market equilibrium?
In equilibrium, the intrinisic price must equal the actual price.
If the actual price is lower than the fundamental value, then the
stock is a “bargain.” Buy orders will exceed sell orders, the
actual price will be bid up. The opposite occurs if the actual
price is higher than the fundamental value.
(More…)

30. 25
Stock’s
Intrinsic Value
“True” Expected
Future Cash Flows
“Perceived”
Risk
“True”
Risk
“Perceived” Expected
Future Cash Flows
Stock’s
Market Price
Intrinsic Values and Market Stock Prices
Managerial Actions, the Economic
Environment, and the Political Climate
Market Equilibrium:
Intrinsic Value = Stock Price

31. For value box in Ch 4 time value FM13.
45
rs = D1/P0 + g = rs = rRF + (rM – rRF)b.
^
In equilibrium, expected returns must equal required returns:
25
46
How is equilibrium established?
If rs = + g > rs, then P0 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:
D1/P0 + g = rs = rs.

32. ^
D1
^
^
P0
26
47
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.
EMH does not assume all investors are rational.
EMH assumes that stock market prices track intrinsic values
fairly closely.
(More…)

33. 28
48
EMH (continued)
If stock prices deviate from intrinsic values, investors will
quickly take advantage of mispricing.
Prices will be driven to new equilibrium level based on new
information.
It is possible to have irrational investors in a rational market.
28
49
Weak-form EMH

34. 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.
29
50
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.

35. 30
51
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.
31
52
Markets are generally
efficient because:
100,000 or so trained analysts—MBAs, CFAs, and PhDs—work
for firms like Fidelity, Morgan, and Prudential.
These analysts have similar access to data and megabucks to
invest.
Thus, news is reflected in P0 almost instantaneously.

36. 32
53
Market Efficiency
For most stocks, for most of the time, it is generally safe to
assume that the market is reasonably efficient.
However, periodically major shifts can and do occur, causing
most stocks to move strongly up or down.
32
54
Implications of Market Efficiency for Financial Decisions

37. Many investors have given up trying to beat the market. This
helps explain the growing popularity of index funds, which try
to match overall market returns by buying a basket of stocks
that make up a particular index.
32
55
Implications of Market Efficiency for Financial Decisions
Important implications for stock issues, repurchases, and tender
offers.
If the market prices stocks fairly, managerial decisions based on
over- and undervaluation might not make sense.
Managers have better information but they cannot use for their
own advantage and cannot deliberately defraud investors.

38. 32
56
Rational Behavior vs. Animal Spirits, Herding, and Anchoring
Bias
Stock market bubbles of 2000 and 2008 suggest that something
other than pure rationality in investing is alive and well.
People anchor too closely on recent events when predicting
future events.
When market is performing better than average, they tend to
think it will continue to perform better than average.
Other investors emulate them, following like a herd of sheep.
32
57
Conclusions
Markets are rational to a large extent, but at time they are also
subject to irrational behavior.
One must do careful, rational analyses using the tools and

39. techniques covered in the book.
Recognize that actual prices can differ from intrinsic values,
sometimes by large amounts and for long periods.
Good news! Differences between actual prices and intrinsic
values provide wonderful opportunities for those able to
capitalize on them.
32
Forum Topic Responses: One comprehensive forum topic
response is assigned weekly. Students are required to select and
research one of the forum topics listed below using a minimum
of 3 reference sources in addition to the textbook and then write
a 1,000-word or more response to the forum topic. APA format
is required. Also submit your forum topic response to Turnitin.
Comprehensive forum topic response contributions will be
critically graded on the thought quality of the response, work
effort, research, APA format, and analysis.
REMEMBER TO:
Use APA format - title page, running head, citations (MUST
HAVE), references
Do not plagiarize. Quote, paraphrase or summarize the data that

40. you take from a source. Include a citation. Plagiarism will result
in a serious loss of points.
Make sure your paper (the text) is 1,000 words or more.
Do not use Wikipedia or Investopedia or any ~pedia sources.
The text may be used but will not count toward the required 3
sources.
Select one of the following forum topics to research and write
about.
Forum Topics – Chapter 7: (Choose one)
-Stock
-Stock Valuation
-Efficient Market Hypothesis (EMH)
-Behavioral Finance