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### CHAPTER 5

Basic Stock Valuation

Topics in Chapter

- 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.
- Directors hire management.
- Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

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.

Tracking Stock

- 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.

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

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.

Different Approaches for Valuing Common Stock

- Dividend growth model
- Using the multiples of comparable firms
- Free cash flow method (covered in Chapter 11)

D1 D2 D3 D∞

P0 =

+

+…+

+

(1+rs)1 (1+rs)2 (1+rs)3 (1+rs)∞

Stock Value = PV of DividendsWhat is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.

D1 = D0(1+g)1

D2 = D0(1+g)2

Dt = D0(1+g)t

If g is constant and less than rs, then:

^

D0(1+g)

D1

P0 =

=

rs - g

rs - g

For a constant growth stock:Dt = D0(1 + g)t

Dt

0.25

PV of Dt =

(1 + r)t

If g > r, P0 = ∞ !

Years (t)

Dividend Growth and PV of Dividends: P0 = ∑(PVof Dt)D0(1+g)1 D0(1+g)2 D0(1+rs)∞

P0 =

+…+

+

(1+rs)1 (1+rs)2 (1+rs)∞

(1+g)t

^

If g > rs, then

> 1, and

P0 = ∞

(1+rs)t

So g must be less than rs to use the constant growth model.

What happens if g > rs?Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%.

Use the SML to calculate rs:

rs = rRF + (RPM)bFirm

= 7% + (5%) (1.2)

= 13%.

Projected Dividends

- D0 = 2 and constant g = 6%
- D1 = D0(1+g) = 2(1.06) = 2.12
- D2 = D1(1+g) = 2.12(1.06) = 2.2472
- D3 = D2(1+g) = 2.2472(1.06) = 2.3820

1

2

3

4

g=6%

2.12

2.2472

2.3820

1.8761

13%

1.7599

1.6508

Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)^

D0(1+g)

D1

P0 =

=

rs - g

rs - g

$2.12

$2.12

= = = $30.29.

0.13 - 0.06

0.07

Intrinsic Stock Value: D0 = 2.00, rs = 13%, g = 6%.D2

^

$2.2427

P1 =

=

= $32.10

rs - g

0.07

Expected value one year from now:- D1 will have been paid, so expected dividends are D2, D3, D4 and so on.

D1

$2.12

Dividend yield = = = 7.0%.

P0

$30.29

^

P1 - P0

$32.10 - $30.29

CG Yield = =

P0

$30.29

= 6.0%.

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

D1

^

^

D1

P0 =

to

rs

+ g.

=

rs - g

P0

^

Then, rs = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.

Rearrange model to rate of return form:1

2

3

rs=13%

2.00

2.00

2.00

PMT

$2.00

^

P0 = = = $15.38.

r

0.13

If g = 0, the dividend stream is a perpetuity.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.

Nonconstant growth followed by constant growth (D0 = $2):

rs=13%

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

D1

$2.60

Dividend yield = = = 4.8%.

P0

$54.11

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

(More…)

Expected Dividend Yield and Capital Gains Yield (t = 0)Expected Dividend Yield and Capital Gains Yield (t = 4)

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

= 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:

Intrinsic Stock Value vs. Quarterly Earnings

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

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.

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

Suppose g = 0 for t = 1 to 3, and then g is a constant 6%.Dividend Yield and Capital Gains Yield (t = 0)

- Dividend Yield = D1 / P0
- Dividend Yield = $2.00 / $25.72
- Dividend Yield = 7.8%
- CGY = 13.0% - 7.8% = 5.2%.

Dividend Yield and Capital Gains Yield (t = 3)

- Now have constant growth, so:
- Capital gains yield = g = 6%
- Dividend yield = rs – g
- Dividend yield = 13% - 6% = 7%

Firm still has earnings and still pays

dividends, so P0 > 0:

^

D0(1+g)

D1

^

P0 =

=

rs - g

rs - g

$2.00(0.94)

$1.88

= = = $9.89.

0.13 - (-0.06)

0.19

If g = -6%, would anyone buy the stock? If so, at what price?Annual Dividend and Capital Gains Yields

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 Stock Price Multiples to Estimate Stock Price

- Analysts often use the P/E multiple (the price per share divided by the earnings per share).
- 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

- 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)

- 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

- 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?

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.

Expected return, given Vps = $50 and annual dividend = $5

$5

Vps

= $50 =

^

rps

$5

^

rps

= 0.10 = 10.0%

=

$50

D1

^

P0 =

rs - g

Why are stock prices volatile?- rs = rRF + (RPM)bi could change.
- Inflation expectations
- Risk aversion
- Company risk

- g could change.

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?

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

What is market equilibrium?

- In equilibrium, the expected price must equal the actual price. In other words, the fundamental (or intrinsic) value must be the same as the actual price.
- If the actual price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the actual price will be bid up. The opposite occurs if the actual price is higher than the fundamental value.

(More…)

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

In equilibrium, expected returns must equal required returns:D1

^

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 until:

D1/P0 + g = rs = rs.

P0

^

How is equilibrium established?What’s 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…)

Weak-form EMH

- 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.

Semistrong-form EMH

- 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.

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 that’s illegal.

Markets are generally efficient because:

- 100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential.
- These analysts have similar access to data and megabucks to invest.
- Thus, news is reflected in P0 almost instantaneously.

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