Basic Stock Valuation

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CHAPTER 5

• Basic Stock Valuation

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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.

3
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.

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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.

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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 firms managers, key employees, and, in many
  situations, venture capital providers.

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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.

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Different Approaches for Valuing Common Stock

• Dividend growth model
• Using the multiples of comparable firms
• Free cash flow method (covered in Chapter 11)

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Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
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For a constant growth stock
D1 D0(1g)1 D2 D0(1g)2 Dt D0(1g)t
If g is constant and less than rs, then
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Dividend Growth and PV of Dividends P0 ?(PVof
Dt)
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What happens if g gt rs?

D0(1g)1 D0(1g)2 D0(1rs)8
P0


(1rs)1 (1rs)2
(1rs)8
(1g)t

If g gt rs, then
P0 8.
gt 1, and
(1rs)t
So g must be less than rs to use the constant
growth model.
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Required rate of return beta 1.2, rRF 7,
and RPM 5.
Use the SML to calculate rs
rs rRF (RPM)bFirm 7 (5) (1.2) 13.
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Projected Dividends

• D0 2 and constant g 6
• D1 D0(1g) 2(1.06) 2.12
• D2 D1(1g) 2.12(1.06) 2.2472
• D3 D2(1g) 2.2472(1.06) 2.3820

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Expected Dividends and PVs (rs 13)
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Intrinsic Stock Value D0 2.00, rs 13, g
6.
Constant growth model
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Expected value one year from now

• D1 will have been paid, so expected dividends are
  D2, D3, D4 and so on.

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Expected Dividend Yield and Capital Gains Yield
(Year 1)
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Total Year-1 Return

• Total return Dividend yield Capital gains
  yield.
• Total return 7 6 13.
• Total return 13 rs.
• For constant growth stock
• Capital gains yield 6 g.

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Rearrange model to rate of return form
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If g 0, the dividend stream is a perpetuity.
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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.

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Nonconstant growth followed by constant growth
0
1
2
3
4
rs13
g 30
g 30
g 30
g 6
D0 2.00 2.60 3.38 4.394
4.6576
2.3009
2.6470
3.0453

4.6576
46.1135
P3
66.5371
0.13 0.06

54.1067 P0
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Expected Dividend Yield and Capital Gains Yield
(t 0)
CG Yield 13.0 - 4.8 8.2.
(More)
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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 rs 13, the t 4 dividend yield 13
  - 6 7.

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Is the stock price based onshort-term growth?

• The current stock price is 54.11.
• The PV of dividends beyond year 3 is 46.11 (P3
  discounted back to t 0).
• The percentage of stock price due to long-term
  dividends is

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Intrinsic Stock Value vs. Quarterly Earnings

• If most of a stocks value is due to long-term
  cash flows, why do so many managers focus on
  quarterly earnings?
• See next slide.

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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.

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Suppose g 0 for t 1 to 3, and then g is a
constant 6.
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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.

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Dividend Yield and Capital Gains Yield (t 3)

• Now have constant growth, so
• Capital gains yield g 6
• Dividend yield rs g
• Dividend yield 13 - 6 7

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If g -6, would anyone buy the stock? If so,
at what price?
Firm still has earnings and still pays dividends,
so P0 gt 0
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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.
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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.

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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

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Using Entity Multiples (Continued)

• Find the entity value of the firm in question.
  For example,
• Multiply the firms sales by the V/Sales
  multiple.
• Multiply the firms of customers by the
  V/Customers ratio
• The result is the total value of the firm.
• Subtract the firms debt to get the total value
  of equity.
• Divide by the number of shares to get the price
  per share.

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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?

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Why are stock prices volatile?

• rs rRF (RPM)bi could change.
• Inflation expectations
• Risk aversion
• Company risk
• g could change.

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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 change?
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Stock Prices vs. Changes in rs and g
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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 arent volatile, then this means
  there isnt a good flow of information.

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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)
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In equilibrium, expected returns must equal
required returns
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How is equilibrium established?
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Whats the Efficient MarketHypothesis (EMH)?

• Securities are normally in equilibrium and are
  fairly priced. One cannot beat the market
  except through good luck or inside information.

(More)
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Weak-form EMH

• Cant 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.

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Semistrong-form EMH

• All publicly available information is reflected
  in stock prices, so it doesnt pay to pore over
  annual reports looking for undervalued stocks.
  Largely true.

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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 thats illegal.

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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 P0 almost
  instantaneously.

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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.

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Expected return, given Vps 50 and annual
dividend 5