Title: CHAPTER 9 Stocks and Their Valuation
1CHAPTER 9Stocks and Their Valuation
 Features of common stock
 Determining common stock values
 Efficient markets
 Preferred stock
2Facts about Common Stock
 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors elect management.
 Managements goal Maximize stock price.
3Social/Ethical Question
Should management be equally concerned about
employees, customers, suppliers, the public, or
just the stockholders? In enterprise economy,
work for stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
4Whats classified stock? How might classified
stock be used?
 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.
5When is a stock sale an initial public offering
(IPO)?
 A firm goes public through an IPO when the
stock is first offered to the public.
6Average Initial Returns on IPOs in Various
Countries
100 75 50 25
Japan
United States
Brazil
Portugal
Sweden
Malaysia
Canada
7Different Approaches for Valuing Common Stock
 Dividend growth model
 Free cash flow method
 Using the multiples of comparable firms
8Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
9For a Constant Growth Stock
D1 D0(1 g)1 D2 D0(1 g)2 Dt Dt(1 g)t
If g is constant, then
P0 .
D0(1 g) ks  g
D1 ks  g
100.25
0
Years (t)
11What happens if g gt ks?
 If kslt g, get negative stock price, which is
nonsense.  We cant use model unless (1) ksgt g and (2) g is
expected to be constant forever.
12Assume beta 1.2, kRF 7, and kM 12. What
is the required rate of return on the firms
stock?
Use the SML to calculate ks
ks kRF (kM kRF)bFirm 7 (12 7)
(1.2) 13.
13D0 was 2.00 and g is a constant 6. Find the
expected dividends for the next 3 years, and
their PVs. ks 13.
0
1
2
3
g 6
2.247
2.382
D0 2.00
2.12
13
1.8761
1.7599
1.6509
14Whats the stocks market value? D0 2.00, ks
13, g 6.
Constant growth model
D1
2.12
P0
ks g 0.13 0.06
2.12
30.29.
0.07
15What is the stocks market value one year from
now, P1?
 D1 will have been paid, so expected dividends are
D2, D3, D4 and so on. Thus, 
 Could also find P1 as follows
D2
2.247
P1
ks g 0.13 0.06
32.10.
P1 P0(1.06) 32.10.
16Find the expected dividend yield, capital gains
yield, and total return during the first year.
D1
2.12
Dividend yld
7.0.
P0
30.29
P1 P0
32.10 30.29
Cap gains yld
30.29
P0
6.0.
Total return 7.0 6.0 13.0.
17Rearrange model to rate of return form
Then, ks 2.12/30.29 0.06 0.07 0.06
13.
18What would P0 be if g 0?
The dividend stream would be a perpetuity.
0
1
2
3
13
...
2.00
2.00
2.00
PMT k
2.00 0.13
P0 15.38.
19If we have supernormal growth of 30 for 3 years,
then a longrun constant g 6, what is P0? k
is still 13.
 Can no longer use constant growth model.
 However, growth becomes constant after 3 years.
20Nonconstant growth followed by constant growth
0
1
2
3
4
...
ks 13
g 30
g 30
g 30
g 6
D0 2.00 2.600 3.380 4.394
4.658
2.301
2.647
3.045
.
4.658
66.54
P
46.116
3
.
.
13
0
06

0
54.109 P0
21What is the expected dividend yield and capital
gains yield at t 0? At t 4?
2.60 54.11
Div. yield0 4.81.
Cap. gain0 13.00 4.81 8.19.
22 During nonconstant growth, D/P and capital gains
yield are not constant, and capital gains yield
is less than g.  After t 3, g constant 6 capital gains
yield k 13 so D/P 13 6 7.
23Suppose g 0 for t 1 to 3, and then g is a
constant 6. What is P0?
0
1
2
3
4
...
ks13
g 0
g 0
g 0
g 6
2.00 2.00 2.00 2.00 2.12
1.77
1.57
2.12
1.39
P
30.29.
20.99
3
.
0
07
25.72
24What is D/P and capital gains yield at t 0 and
at t 3?
D1
2.00 25.72
7.78.
t 0
P0
CGY 13 7.78 5.22.
t 3 Now have constant growth with g capital
gains yield 6 and D/P 7.
25If g 6, would anyone buy the stock? If so,
at what price?
Firm still has earnings and still pays dividends,
so P0 gt 0
(
)
D
g
1
D
1
0
P
0


k
g
k
g
s
s
2.00(0.94) 1.88 0.13 (0.06) 0.19
9.89.
26What is the annual D/P and capital gains yield?
Capital gains yield g 6.0, Dividend yield
13.0 (6.0) 19. D/P and cap. gains yield
are constant, with high dividend yield (19)
offsetting negative capital gains yield.
27Free Cash Flow Method
 The free cash flow method suggests that the value
of the entire firm equals the present value of
the firms free cash flows (calculated on an
aftertax basis).  Recall that the free cash flow in any given year
can be calculated as  NOPAT Net capital investment.
28Using the Free Cash Flow Method
 Once the value of the firm is estimated, an
estimate of the stock price can be found as
follows  MV of common stock (market capitalization) MV
of firm MV of debt and preferred stock.  P MV of common stock/ of shares.
29Issues Regarding the Free Cash Flow Method
 Free cash flow method is often preferred to the
dividend growth modelparticularly for the large
number of companies that dont pay a dividend, or
for whom it is hard to forecast dividends.
(More...)
30FCF Method Issues Continued
 Similar to the dividend growth model, the free
cash flow method generally assumes that at some
point in time, the growth rate in free cash flow
will become constant.  Terminal value represents the value of the firm
at the point in which growth becomes constant.
31FCF estimates for the next 3 years are 5, 10,
and 20 million, after which the FCF is expected
to grow at 6. The overall firm cost of capital
is 10.
0
1
2
3
4
...
k 10
g 6
5 10 20 21.20
4.545
8.264
15.026
21.20 0.04
530 TV3
398.197
416.942
TV3 represents the terminal value of the firm,
at t 3.
32If the firm has 40 million in debt and has 10
million shares of stock, what is the price per
share?
Value of equity Total value Value of debt
416.94 40
376.94 million.
Price per share Value of equity/ of shares
376.94/10
37.69.
33Using the Multiples of Comparable Firms to
Estimate Stock Price
 Analysts often use the following multiples to
value stocks  P/E
 P/CF
 P/Sales
 P/Customer
 Example Based on comparable firms, estimate the
appropriate P/E. Multiply this by expected
earnings to back out an estimate of the stock
price.
34What is market equilibrium?
In equilibrium, stock prices are stable. There is
no general tendency for people to buy versus to
sell. In equilibrium, expected returns
must equal required returns
ks D1/P0 g ks kRF (kM kRF)b.
35Expected returns are obtained by estimating
dividends and expected capital gains (which can
be found using any of the three common stock
valuation approaches). Required returns are
obtained from the CAPM.
ks D1/P0 g ks kRF (kM kRF)b.
36How is equilibrium established?
D1 P0
If ks g gt ks, then P0 is too low (a
bargain). Buy orders gt sell orders P0 bid up
D1/P0 falls until D1/P0 g ks ks.
37Why do stock prices change?
D1 ki g
P0
1. ki could change ki kRF (kM kRF
)bi. kRF k IP. 2. g could change due
to economic or firm situation.
38Whats the Efficient Market Hypothesis?
EMH Securities are normally in equilibrium and
are fairly priced. One cannot beat the
market except through good luck or better
information.
391. Weakform 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 weakform EMH, but technical
analysis is still used.
402. Semistrongform EMH All publicly available
information is reflected in stock prices, so
doesnt pay to pore over annual reports looking
for undervalued stocks. Largely true, but
superior analysts can still profit by finding and
using new information.
413. Strongform EMH All information, even inside
information, is embedded in stock prices. Not
trueinsiders can gain by trading on the basis
of insider information, but thats illegal.
42Markets are generally efficient because
1. 15,000 or so trained analysts MBAs, CFAs,
Technical PhDs. 2. Work for firms like Merrill,
Morgan, Prudential, which have a lot of
money. 3. Have similar access to data. 4. Thus,
news is reflected in P0 almost instantaneously.
43Preferred Stock
 Hybrid security.
 Similar to bonds in that preferred stockholders
receive a fixed dividend that must be paid before
dividends can be paid on common stock.  However, unlike interest payments on bonds,
companies can omit dividend payments on preferred
stock without fear of pushing the firm into
bankruptcy.
44Whats the expected return of preferred stock
with Vp 50 and annual dividend 5?