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CHAPTER 5

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CHAPTER 5

Basic Stock Valuation

- Features of common stock
- Determining common stock values
- Efficient markets
- Preferred stock

- 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 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.

- 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.

- 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.

- 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.

- 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)∞

What 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

$

Dt = D0(1 + g)t

Dt

0.25

PV of Dt =

(1 + r)t

If g > r, P0 = ∞ !

Years (t)

^

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.

Use the SML to calculate rs:

rs= rRF + (RPM)bFirm

= 7% + (5%) (1.2)

= 13%.

- 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

0

1

2

3

4

g=6%

2.12

2.2472

2.3820

1.8761

13%

1.7599

1.6508

Constant growth model:

^

D0(1+g)

D1

P0 =

=

rs - g

rs - g

$2.12

$2.12

= = = $30.29.

0.13 - 0.06

0.07

D2

^

$2.2427

P1 =

=

= $32.10

rs - g

0.07

- 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%.

- 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%.

0

1

2

3

rs=13%

2.00

2.00

2.00

PMT

$2.00

^

P0 = = = $15.38.

r

0.13

- 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.

rs=13%

0

1

2

3

4

g = 30%

g = 30%

g = 30%

g = 6%

2.603.38 4.394 4.6576

2.3009

2.6470

3.0453

^

$4.6576

46.1135

P3 =

= $66.5371

0.13 – 0.06

^

54.1067 = P0

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

$46.11

= 85.2%.

$54.11

- 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?
- See next slide.

- 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.

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

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

- 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

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.

- 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.

- 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

- 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.

- 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?

- 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.

$5

Vps

= $50 =

^

rps

$5

^

rps

= 0.10 = 10.0%

=

$50

D1

^

P0 =

rs - g

- rs = rRF + (RPM)bi could change.
- Inflation expectations
- Risk aversion
- Company risk

- g could change.

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

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

What happens if rs or g change?

- 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.

- 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.

^

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

^

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

(More…)

- 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.

- 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.

- 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.

- 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.