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CHAPTER 8 Stocks and Their Valuation

CHAPTER 8 Stocks and Their Valuation. Features of common stock Determining common stock values Efficient markets Preferred stock. Facts about common stock. Represents ownership Ownership implies control Stockholders elect directors Directors elect management

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CHAPTER 8 Stocks and Their Valuation

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  1. CHAPTER 8Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock

  2. Facts about common stock • Represents ownership • Ownership implies control • Stockholders elect directors • Directors elect management • Management’s goal: Maximize the stock price

  3. Social/Ethical Question • Should management be equally concerned about employees, customers, suppliers, and “the public,” or just the stockholders? • In an enterprise economy, management should work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition.

  4. Types of stock market transactions • Secondary market • Primary market • Initial public offering market (“going public”)

  5. Different approaches for valuing common stock • If you buy a stock, you can receive cash in future in two ways :- • Dividend expected in each year • the price investors expect to receive when they sell the stocks • As with bonds, the price of the stock is the PV these expected CF • How do stock CF differ from bond CF • Stock CF are neither guaranteed nor constant • Stock CF never cease

  6. Different approaches for valuing common stock • How do we value the stock CF? • the value/price of the stock is the PV these expected CF • Method Value the Common stocks • Dividend growth model • Corporate value model • Using the multiples of comparable firms

  7. Dividend growth model • Dividend can be rising, falling, fluctuating randomly or it can even be zero for several years. • In many cases, the stream of dividend is expected to grow at a constant rate, g. D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t

  8. Dividend growth model • TNB just paid a dividend of RM1.15. The dividend is expected to grow at 8 % per year in future. What would you be willing pay if our required return TNB stock is 13.4%n

  9. $ 1.15 0 Years (t) Future dividends and their present values if ks >g Dividend is growing D1 = 1.15 (1.08)1 = 1.242 D2 = 1.242 (1.08)2 = 1.341 PV D1 =1.10 But the PV of Dividend is declining PV(D1) = 1.242/(1.1.34)1 = 1.095, PV(D2) = 1.341/(1.1.34)2 = 1.043

  10. What happens if g > ks? • If g > ks, the constant growth formula leads to a negative stock price, which does not make sense. • The constant growth model can only be used if: • ks > g • g is expected to be constant forever

  11. Dividend and Earning Growth • Growth in dividend result from the growth of EPS • While EPS growth depend on number of factor such as : • The amount of earning of the company retain and reinvest ( co. pay higher current dividend will have less retain and reinvest in the business, thus reduce the future earning and dividend- the issues whether s/h prefer higher current dividend and lower future dividend of conversely?) • Rate of return company earn on it equity (ROE) • inflation

  12. 0 1 2 3 g = 6% 2.12 2.247 2.382 D0 = 2.00 1.8761 ks = 13% 1.7599 1.6509 If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

  13. What is the stock’s market value? • Using the constant growth model:

  14. What is the expected market price of the stock, one year from now? • D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc. • Could also find expected P1 as:

  15. D 1 P0 = k - g s Expected Rate of Return on A Constant Growth Stock Just adjust the valuation model ^ks = ( D1 /Po ) + g Expected growth rate, Or capital gains yield Expected rate Of return Expected dividend yield

  16. 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%

  17. Zero Growth Stock • Where the dividend is expected to remain constant over time, g=0

  18. 0 1 2 3 ks = 13% ... 2.00 2.00 2.00 What would the expected price today be, if g = 0? • The dividend stream would be a perpetuity.

  19. A Non Constant Growth or Supernormal growth: • Firm will go thoroughly life cycles. • Life cycles in firms: • Early part of co life's their growth is much faster than the eco. as a whole. Thus this part known a supernormal or non constant growth firms. • Finally their growth is slower than that of the economy and become constant growth.

  20. Valuing Stock that have A Non Constant Growth Rate • Can no longer use just the constant growth model to find stock value. PV of dividend during nonconstant period PV of dividend during constant period

  21. Valuing Stock that have A Non Constant Growth Rate To implement the equation, 3 step involves: • Find the PV of dividend during the period of non constant • Find the PRICE of the stock at the END of non constant growth (at which it has become a constant growth stock) then discount this price to present • Add (1) and (2) to find the value of stock at P0

  22. 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 46.114 3 - 0.13 0.06 54.107 = P0 Valuing common stock with nonconstant growth 1.PV of dividend during the period of non constant 2.discount this price to present $ P ^ 2.PRICE of the stock at the END of non constant growth 3.Add all to find the value of stock at P0

  23. Find expected dividend and capital gains yields during the first and fourth years. • Dividend yield (first year) = $2.60 / $54.11 = 4.81% • Capital gains yield (first year) = 13.00% - 4.81% = 8.19% • During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ≠ g. • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

  24. 0 1 2 3 4 ks = 13% ... g = 0% g = 0% g = 0% g = 6% D0 = 2.00 2.00 2.00 2.00 2.12 1.77 1.57 1.39 2.12 $ P = = $30.29 20.99 3 - 0.13 0.06 ^ 25.72 = P0 Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?

  25. Find expected dividend and capital gains yields during the first and fourth years. • Dividend yield (first year) = $2.00 / $25.72 = 7.78% • Capital gains yield (first year) = 13.00% - 7.78% = 5.22% • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

  26. If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? • The firm still has earnings and pays dividends, even though they may be declining, they still have value.

  27. Find expected annual dividend and capital gains yields. • Capital gains yield = g = -6.00% • Dividend yield = 13.00% - (-6.00%) = 19.00% • Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.

  28. Corporate value model • Firm value is determined by it ability to generate CF in current and future period. • Thus, the value of the entire firm equals the present value of the firm’s free cash flows. • Remember, free cash flow is the firm’s after-tax operating income less the net capital investment • FCF = NOPAT – Net capital investment • Also called the free cash flow method.

  29. Corporate value model • FCF is generated before making any payment to common or preferred shareholder or to bondholder. Thus it is the CF that is available to all investor • Therefore the FCF is discounted at the co. weighted average cost of debt, preferred and common stock -WACC

  30. Applying the corporate value model • Find the market value (MV) of the firm. • Find PV of firm’s future FCFs • Subtract MV of firm’s 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

  31. Issues regarding the corporate value model • Often preferred to the dividend growth model, especially when considering number of firms that don’t 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.

  32. 0 1 2 3 4 k = 10% ... g = 6% -5 10 20 21.20 -4.545 8.264 15.026 21.20 398.197 530 = = TV3 0.10 - 0.06 416.942 Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value.

  33. If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s 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

  34. 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.

  35. If kRF = 7%, kM = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? • Required rate of return can be calculated using Security Market Line equation (ks): ks = kRF + (kM – kRF)β = 7% + (12% - 7%)1.2 = 13% Km = required rate of return of an average stock kRF = risk-free of return β = beta

  36. 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. *Beta – measure the volatility of return on individual stock relative to the stock market

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

  38. If kRF =8%, kM = 12%, and β = 2, what is the required rate of return on the firm’s stock? • Required rate of return can be calculated using Security Market Line equation (ks): ks = kRF + (kM – kRF)β = 8% + (12% - 8%)2 = 16% • The investor will buy the stock if its expected rate of return is >16% • The investor will sell the stock if its expected rate of return is <16%

  39. If D0= $2.8571 , D1= $2.8571 (1.05) =$3 and the P0 = $30 • The expected rate of return (15%) is less than required of return(16%), investor want to sell the stock.(at P0=$30 the expected return only 15%, which below the market) • But few people would want to buy the stock at $30, thus the owner would be unable to find buyer unless they cut the price. • Therefore, the price would decline at point which the market achieve market equilibrium. Investor will buy the stock is less than $30 in order to make the expected required rate of return = required return.

  40. If kRF = 7%, kM = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? Rate of Return SML Kx = 16 16% - required rate of return 15% - expected rate of return The investor will buy the stock if its expected rate of return is >16% Current Price is low and offer a bargain Buy orders will be greater than sell orders The current price will bid up until expected return =required return The investor will sell the stock if its expected rate of return is <16% Kx= 15 Km = 12 Krf = 8 Risk (B) 0 1.0 2.0

  41. Factors that affect stock price(Stock Price certainly change) • Required return (ks) could change • Changing inflation could cause kRF to change • Market risk premium or exposure to market risk (β) could change • Growth rate (g) could change • Due to economic (market) conditions • Due to firm conditions

  42. What is the Efficient Market Hypothesis (EMH)? • Efficient Market Hypothesis (EMH)? Theory mentioned that stocks are always in equilibrium and impossible for an investor to consistently “beat the market”. • Thus, 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 • Semi strong-form efficiency • Strong-form efficiency

  43. What is the Efficient Market Hypothesis (EMH)? • Market in general are efficient when :- • Price adjust rapidly to new information (financial,politic, economic and social event) • There is a continuous market, in which each successive trade is made a price to close to the previous price (the faster that the price respond to new information and the smaller the differences in prices changes, the more efficient without destabilizing the price. • Levels of market efficiency • Weak-form efficiency • Semi strong-form efficiency • Strong-form efficiency

  44. Weak-form efficiency • Can’t 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.

  45. Semistrong-form efficiency • All publicly available information is reflected in stock prices. • Changes in public information • effect the price • how rapidly the price is converge to new equilibrium after a new information has been released. • Investor should expect to earn a return predicted in SML, but they should not expect to do any better unless they have information is not public available (the insider/ president of co. who have the information and can earn abnormal return) • Whenever information is released to the public, stock price will respond only if the information is different from what had been expected.

  46. Strong-form efficiency • All information, even inside information, is embedded in stock prices.(insider would find it impossible to earn abnormal return in the stock market) • Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

  47. 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 (irrational factor) to better understand how individuals and markets respond to different situations.

  48. 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.

  49. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? A preferred stock entitles its owner to regular, fixed dividend payments. If the payments last forever, the issuing is a perpetuity whose value as follows:- Vp = D / kp Thus the preferred stock’s expected return :- $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%

  50. 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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