Chapter 7 stocks and their valuation
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CHAPTER 7 Stocks and Their Valuation. Features of common stock Determining common stock values Efficient markets Preferred stock. Common Stock: Owners, Directors, and Managers. Represents ownership . Ownership implies control . Stockholders elect directors .

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Chapter 7 stocks and their valuation
CHAPTER 7Stocks and Their Valuation

  • Features of common stock

  • Determining common stock values

  • Efficient markets

  • Preferred stock


Common stock owners directors and managers
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.


What s classified stock how might classified stock be used
What’s 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.


What is tracking stock
What is tracking stock? used?

  • 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.


When is a stock sale an initial public offering ipo
When is a stock sale an initial public offering (IPO)? used?

  • 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 firm’s managers, key employees, and, in many situations, venture capital providers.


What is a seasoned equity offering seo
What is a seasoned equity offering (SEO)? used?

  • 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.


Different approaches for valuing common stock
Different Approaches for Valuing Common Stock used?

  • Dividend growth model

  • Using the multiples of comparable firms

  • Free cash flow method (covered in Chapter 15)


Stock Value = PV of Dividends used?

What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.


For a constant growth stock
For a constant growth stock, used?

If g is constant, then:


$ used?

0.25

0

Years (t)


What happens if g r s
What happens if g > r used?s?

  • If rs< g, get negative stock price, which is nonsense.

  • We can’t use model unless (1) g  rs and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be  rs.


Assume beta 1 2 r rf 7 and rp m 5 what is the required rate of return on the firm s stock
Assume beta = used?1.2, rRF = 7%, and RPM = 5%. What is the required rate of return on the firm’s stock?

Use the SML to calculate rs:

rs = rRF + (RPM)bFirm

= 7% + (5%) (1.2)

= 13%.


D used?0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. rs = 13%.

0

1

2

3

4

g=6%

D0=2.00

2.12

2.2472

2.3820

13%

1.8761

1.7599

1.6508


What s the stock s market value d 0 2 00 r s 13 g 6
What’s the stock’s market value? used?D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:

$2.12

$2.12

= = $30.29.

0.13 - 0.06

0.07


What is the stock s market value one year from now p 1
What is the stock’s market value one year from now, P used?1?

^

  • D1 will have been paid, so expected dividends are D2,D3, D4 and so on. Thus,


Find the expected dividend yield and capital gains yield during the first year
Find the expected dividend yield and capital gains yield during the first year.

D1

$2.12

Dividend yield = = = 7.0%.

P0

$30.29

^

P1 - P0

$32.10 - $30.29

CG Yield = =

P0

$30.29

= 6.0%.


Find the total return during the first year
Find the total return during the during the first year.first year.

  • 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.


Rearrange model to rate of return form: during the first year.

^

Then, rs = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.


What would p 0 be if g 0
What would P during the first year.0 be if g = 0?

The dividend stream would be a perpetuity.

0

1

2

3

rs=13%

2.00

2.00

2.00

PMT

$2.00

^

P0 = = = $15.38.

r

0.13


If we have supernormal growth of during the first year.30% for 3 years, then a long-run constant g = 6%, what is P0? r isstill 13%.

^

  • Can no longer use constant growth model.

  • However, growth becomes constant after 3 years.


Nonconstant growth followed by constant during the first year.

growth:

0

1

2

3

4

rs=13%

g = 30%

g = 30%

g = 30%

g = 6%

D0 = 2.00 2.60 3.38 4.394 4.6576

2.3009

2.6470

3.0453

46.1135

^

54.1067 = P0


What is the expected dividend yield and capital gains yield at t 0 at t 4
What is the expected dividend yield and capital gains yield at t = 0? At t = 4?

At t = 0:

D1

$2.60

Dividend yield = = = 4.8%.

P0

$54.11

CG Yield = 13.0% - 4.8% = 8.2%.

(More…)


  • 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 t = 4 capital gains gains yield = 6%.

  • Because rs = 13%, the t = 4 dividend yield = 13% - 6% = 7%.


Is the stock price based on short term growth

$46.11 yield are

= 85.2%.

$54.11

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:

^


If most of a stock’s value is due to long-term cash flows, why do so many managers focus on 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.


Suppose g 0 for t 1 to 3 and then g is a constant 6 what is p 0
Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P0?

^

0

1

2

3

4

...

rs=13%

g = 0%

g = 0%

g = 0%

g = 6%

2.00 2.00 2.00 2.12

1.7699

1.5663

2.12

1.3861

P

30.2857

20.9895

3

0

.

07

25.7118


What is dividend yield and capital gains yield at t 0 and at t 3
What is dividend yield and capital gains yield at t = 0 and at t = 3?

D1

2.00

7.8%.

t = 0:

P0

$25.72

CGY = 13.0% - 7.8% = 5.2%.

t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%.


If g 6 would anyone buy the stock if so at what price
If g = at t = 3?-6%, would anyone buy the stock? If so, at what price?

Firm still has earnings and still pays

dividends, so P0 > 0:

^

$2.00(0.94)

$1.88

= = = $9.89.

0.13 - (-0.06)

0.19


What are the annual dividend and capital gains yield
What are the annual dividend at t = 3?and capital gains yield?

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.


Using the stock price multiples to estimate stock price
Using the Stock Price Multiples to Estimate Stock Price at t = 3?

  • Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks.

  • 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.


Using entity multiples
Using Entity Multiples at t = 3?

  • 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


Using entity multiples continued
Using Entity Multiples (Continued) at t = 3?

  • Find the entity value of the firm in question. For example,

    • Multiply the firm’s sales by the V/Sales multiple.

    • Multiply the firm’s # of customers by the V/Customers ratio

  • The result is the total value of the firm.

  • Subtract the firm’s debt to get the total value of equity.

  • Divide by the number of shares to get the price per share.


Problems with market multiple methods
Problems with Market Multiple Methods at t = 3?

  • 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?


Why are stock prices volatile
Why are stock prices volatile? at t = 3?

^

  • rs = rRF + (RPM)bi could change.

    • Inflation expectations

    • Risk aversion

    • Company risk

  • g could change.


Stock value vs changes in r s and g
Stock value vs. changes in r at t = 3?s and g

D1 = $2, rs = 10%, and g = 5%:

P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40.

What if rs or g change?

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


Are volatile stock prices consistent with rational pricing
Are volatile stock prices consistent with rational pricing? at t = 3?

  • 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 aren’t volatile, then this means there isn’t a good flow of information.


What is market equilibrium
What is market equilibrium? at t = 3?

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…)


In equilibrium, expected returns must at t = 3?

equal required returns:

^

rs = D1/P0 + g = rs = rRF + (rM - rRF)b.


How is equilibrium established
How is equilibrium established? at t = 3?

^

D1

P0

^

If rs = + g > rs, then P0 is “too low.”

If the price is lower than the fundamental value, then the stock is a “bargain.”

Buy orders will exceed sell orders, the price will be bid up, and D1/P0 falls until

D1/P0 + g = rs = rs.

^


Why do stock prices change
Why do stock prices change? at t = 3?

^

  • ri = rRF + (rM - rRF )bi could change.

    • Inflation expectations

    • Risk aversion

    • Company risk

  • g could change.


What s the efficient market hypothesis emh
What’s the Efficient Market at t = 3?Hypothesis (EMH)?

Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information.

(More…)


1. Weak-form EMH: at t = 3?

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.


2. Semistrong-form EMH: at t = 3?

All publicly available information is reflected in stock prices, so it doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true.


3. Strong-form EMH: at t = 3?

All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.


Markets are generally efficient because
Markets are generally efficient because: at t = 3?

1. 100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential.

2. These analysts have similar access to data and megabucks to invest.

3. Thus, news is reflected in P0 almost instantaneously.


Preferred stock
Preferred Stock at t = 3?

  • 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.


What s the expected return on preferred stock with v ps 50 and annual dividend 5
What’s the expected return on preferred stock with V at t = 3?ps = $50 and annual dividend = $5?


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