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Stocks, Stock Valuation, and

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Stocks, Stock Valuation, and Stock Market Equilibrium ... Not true--insiders can gain by trading on the basis of insider information, but that s illegal. – 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
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.

4
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.

5
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.

6
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.

7
Different Approaches for Valuing Common Stock
  • Dividend growth model
  • Using the multiples of comparable firms
  • Free cash flow method (covered in Chapter 15)

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.
9
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
10
Expected Dividends and PVs (rs 13, D0 2, g
6)
11
Intrinsic Stock Value D0 2.00, rs 13, g
6.
Constant growth model
12
Expected value one year from now
  • D1 will have been paid, so expected dividends are
    D2, D3, D4 and so on.

13
Expected Dividend Yield and Capital Gains Yield
(Year 1)
14
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.

15
Rearrange model to rate of return form
16
If g 0, the dividend stream is a perpetuity.
17
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.

18
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
19
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.

20
Suppose g 0 for t 1 to 3, and then g is a
constant 6.
21
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.

22
Why are stock prices volatile?
  • rs rRF (RPM)bi could change.
  • Inflation expectations
  • Risk aversion
  • Company risk
  • g could change.

23
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?
24
Stock Prices vs. Changes in rs and g
g g g
rs 4 5 6
9 40.00 50.00 66.67
10 33.33 40.00 50.00
11 28.57 33.33 40.00
25
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.

26
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)
27
In equilibrium, expected returns must equal
required returns
28
How is equilibrium established?
29
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)
30
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.

31
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.

32
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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