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Stocks, Stock Valuation, and

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If stock prices aren't volatile, then this means there isn't a good flow of information. ... In equilibrium, stock prices are stable. ... – PowerPoint PPT presentation

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Title: Stocks, Stock Valuation, and


1
CHAPTER 8
  • Stocks, Stock Valuation, and
  • Stock Market Equilibrium

2
Topics in Chapter
  • Features of common stock
  • Determining common stock values
  • Efficient markets
  • Preferred stock

3
Why study stock pricing?
  • To know the value of enterprise
  • Understanding what drives the value of an
    enterprise
  • Timing and valuation

4
Common Stock Owners, Directors, and Managers
  • Represents ownership.
  • Ownership implies control- what kind?
  • 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
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.

8
Seasoned Equity Offering (SEO)- secondary offering
  • 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.

9
What does going public mean?
  • Reputation
  • Loss of control
  • Access to capital
  • Better valuation gauge?
  • Higher valuation? Theory of Diversified investor
    base

10
The down side of public
  • More scrutiny
  • Higher costs
  • Easier target
  • Loss of certain benefits

11
Different Approaches for Valuing Common Stock
  • Dividend growth model
  • Using the multiples of comparable firms
  • Free cash flow method (covered in Chapter 15)

12
Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
13
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
14
Dividend Growth and PV of Dividends P0 ?(PVof
Dt)
15
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.
16
Source of growth rate- g
  • Growth rate can be estimated by
  • ROIC Retention rate

17
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.
18
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

19
Expected Dividends and PVs (rs 13, D0 2, g
6)
20
Intrinsic Stock Value D0 2.00, rs 13, g
6.
Constant growth model
21
Expected value one year from now
  • D1 will have been paid, so expected dividends are
    D2, D3, D4 and so on.

22
Expected Dividend Yield and Capital Gains Yield
(Year 1)
23
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.

24
Rearrange model to rate of return form
25
If g 0, the dividend stream is a perpetuity.
26
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.

27
Nonconstant growth followed by constant growth
(D0 2)
rs13
0
1
2
3
4
g 30
g 30
g 30
g 6
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
28
Expected Dividend Yield and Capital Gains Yield
(t 0)
CG Yield 13.0 - 4.8 8.2.
(More)
29
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.

30
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

31
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.

32
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.

33
Suppose g 0 for t 1 to 3, and then g is a
constant 6.
34
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.

35
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

36
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
37
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.
38
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.

39
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

40
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.

41
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?

42
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.

43
Expected return, given Vps 50 and annual
dividend 5
44
Why are stock prices volatile?
  • rs rRF (RPM)bi could change.
  • Inflation expectations
  • Risk aversion
  • Company risk
  • g could change.

45
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?
46
Stock Prices vs. Changes in rs and g
47
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.

48
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)
49
In equilibrium, expected returns must equal
required returns
50
How is equilibrium established?
51
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)
52
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.

53
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.

54
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.

55
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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