CHAPTER 8 Stocks and Their Valuation

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CHAPTER 8Stocks and Their Valuation

• Features of common stock
• Determining common stock values
• Efficient markets
• Preferred stock

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Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Managements goal Maximize the stock price

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Types of stock market transactions

• Secondary market
• Primary market
• Initial public offering market (going public)

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Different approaches for valuing common stock

• Dividend growth model
• Corporate value model
• Using the multiples of comparable firms

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What Determines the Price of a Companys Stock?

• Dividend Discount Model - Computation of todays
  stock price which states that share value equals
  the present value of all expected future
  dividends.
• H - Time horizon for your investment.

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Valuing Common Stocks

• Example
• Current forecasts are for XYZ Company to pay
  dividends of 3, 3.24, and 3.50 over the next
  three years, respectively. At the end of three
  years you anticipate selling your stock at a
  market price of 94.48. What is the price of the
  stock given a 12 expected return?

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Valuing Common Stocks

• Example
• Current forecasts are for XYZ Company to pay
  dividends of 3, 3.24, and 3.50 over the next
  three years, respectively. At the end of three
  years you anticipate selling your stock at a
  market price of 94.48. What is the price of the
  stock given a 12 expected return?

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How Common Stocks Are Valued - Conclusion
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The Constant Growth Model

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• If g is constant, the dividend growth formula
  converges to

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If kRF 7, kM 12, and ß 1.2, what is the
required rate of return on the firms stock?

• Use the SML to calculate the required rate of
  return (ks)
• ks kRF (kM kRF)ß
• 7 (12 - 7)1.2
• 13

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If D0 2 and g is a constant 6, find the
expected dividend stream for the next 3 years,
and their PVs.
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What is the stocks market value?

• Using the constant growth model

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What is the expected dividend yield, capital
gains yield, and total return during the first
year?

• Dividend yield
• D1 / P0 2.12 / 30.29 7.0
• Capital gains yield
• (P1 P0) / P0
• (32.10 - 30.29) / 30.29 6.0
• Total return (ks)
• Dividend Yield Capital Gains Yield
• 7.0 6.0 13.0

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Supernormal growthWhat if g 30 for 3 years
before achieving long-run growth of 6?

• Can no longer use just the constant growth model
  to find stock value.
• However, the growth does become constant after 3
  years.

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Valuing common stock with nonconstant growth

P

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Valuing Common Stocks

• Expected Return - The percentage yield that an
  investor forecasts from a specific investment
  over a set period of time. Sometimes called the
  market capitalization rate.

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Valuing Common Stocks

• The formula can be broken into two parts.
• Dividend Yield Capital Appreciation

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Corporate value model

• Also called the Free Cash Flow (FCF) method.
  Suggests the value of the entire firm equals the
  present value of the firms free cash flows.
• Remember, free cash flow is the firms after-tax
  operating income less the net capital investment
• FCF NOPAT Net capital investment

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Applying the corporate value model

• Find the market value (MV) of the firm.
• Find PV of firms future FCFs
• Subtract MV of firms debt and preferred stock to
  get MV of common stock.
• MV of MV of MV of debt andcommon
  stock firm preferred
• Divide MV of common stock by the number of shares
  outstanding to get intrinsic stock price (value).
• P0 MV of common stock / of shares

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Issues regarding the corporate value model

• Often preferred to the dividend growth model,
  especially when considering number of firms that
  dont pay dividends or when dividends are hard to
  forecast.
• Similar to dividend growth model, assumes at some
  point free cash flow will grow at a constant
  rate.
• Terminal value (TVn) represents value of firm at
  the point that growth becomes constant.

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Given the long-run gFCF 6, and WACC of 10,
use the corporate value model to find the firms
intrinsic value.
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If the firm has 40 million in debt and has 10
million shares of stock, what is the firms
intrinsic value per share?

• MV of equity MV of firm MV of debt
• 416.94m - 40m
• 376.94 million
• Value per share MV of equity / of shares
• 376.94m / 10m
• 37.69

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Firm multiples method

• Analysts often use the following multiples to
  value stocks.
• P / E
• P / CF
• P / Sales
• EXAMPLE Based on comparable firms, estimate the
  appropriate P/E. Multiply this by expected
  earnings to back out an estimate of the stock
  price.

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What is market equilibrium?

• In equilibrium, stock prices are stable and there
  is no general tendency for people to buy versus
  to sell.
• In equilibrium, expected returns must equal
  required returns.

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Market equilibrium

• Expected returns are obtained by estimating
  dividends and expected capital gains.
• Required returns are obtained by estimating risk
  and applying the CAPM.

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How is market equilibrium established?

• If expected return exceeds required return
• The current price (P0) is too low and offers a
  bargain.
• Buy orders will be greater than sell orders.
• P0 will be bid up until expected return equals
  required return

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What is the Efficient Market Hypothesis (EMH)?

• Securities are normally in equilibrium and are
  fairly priced.
• Investors cannot beat the market except through
  good luck or better information.
• Levels of market efficiency
• Weak-form efficiency
• Semistrong-form efficiency
• Strong-form efficiency

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Weak-form efficiency

• 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 efficiency

• All publicly available information is reflected
  in stock prices, so it doesnt pay to over
  analyze annual reports looking for undervalued
  stocks.
• Largely true, but superior analysts can still
  profit by finding and using new information

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Strong-form efficiency

• 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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Is the stock market efficient?

• Empirical studies have been conducted to test the
  three forms of efficiency. Most of which suggest
  the stock market was
• Highly efficient in the weak form.
• Reasonably efficient in the semistrong form.
• Not efficient in the strong form. Insiders could
  and did make abnormal (and sometimes illegal)
  profits.
• Behavioral finance incorporates elements of
  cognitive psychology to better understand how
  individuals and markets respond to different
  situations.

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Preferred stock

• Hybrid security
• Like bonds, preferred stockholders receive a
  fixed dividend that must be paid before dividends
  are paid to common stockholders.
• However, companies can omit preferred dividend
  payments without fear of pushing the firm into
  bankruptcy.

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If preferred stock with an annual dividend of 5
sells for 50, what is the preferred stocks
expected return?

• Vp D / kp
• 50 5 / kp
• kp 5 / 50
• 0.10 10