Chapter 9 stocks and their valuation
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CHAPTER 9 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 9 stocks and their valuation

CHAPTER 9Stocks and Their Valuation

  • Features of common stock

  • Determining common stock values

  • Efficient markets

  • Preferred stock


Facts about common stock

Facts about Common Stock

  • Represents ownership.

  • Ownership implies control.

  • Stockholders elect directors.

  • Directors elect management.

  • Management’s goal: Maximize stock price.


Social ethical question

Social/Ethical Question

Should management be equally concerned about employees, customers, suppliers, “the public,” or just the stockholders?

In enterprise economy, work forstockholders subject to constraints (environmental, fair hiring, etc.) and competition.


What s classified stock how might classified stock be used

What’sclassified 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.


When is a stock sale an initial public offering ipo

When is a stock sale aninitial public offering (IPO)?

A firm “goes public” through an IPO when the stock is first offered to the public.


Average initial returns on ipos in various countries

Average Initial Returns on IPOs in Various Countries

100%

75%

50%

25%

Japan

United States

Brazil

Portugal

Sweden

Malaysia

Canada


Different approaches for valuing common stock

Different Approaches for Valuing Common Stock

  • Dividend growth model

  • Free cash flow method

  • Using the multiples of comparable firms


Chapter 9 stocks and their valuation

Stock Value = PV of Dividends

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

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

^


Chapter 9 stocks and their valuation

$

0.25

0

Years (t)


What happens if g k s

What happens if g > ks?

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

  • We can’t use model unless (1) ks> g and (2) g is expected to be constant forever.


Assume beta 1 2 k rf 7 and k m 12 what is the required rate of return on the firm s stock

Assume beta =1.2, kRF =7%, and kM =12%. What is the required rate of return on the firm’s stock?

Use the SML to calculate ks:

ks= kRF + (kM – kRF)bFirm

= 7% + (12% – 7%) (1.2)

= 13%.


Chapter 9 stocks and their valuation

D0 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%

D0 = 2.00

2.12

2.247

2.382

13%

1.8761

1.7599

1.6509


What s the stock s market value d 0 2 00 k s 13 g 6

What’s the stock’s 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


What is the stock s market value one year from now p 1

What is the stock’s 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.


Find the expected dividend yield capital gains yield and total return during the first year

Find 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%.


Chapter 9 stocks and their valuation

D

D

$

$

1

1

=

=

+

P

to

k

g

.

-

0

s

k

g

P

s

0

Rearrange model to rate of return form:

^

Then, ks= $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.


What would p 0 be if g 0

What 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.


Chapter 9 stocks and their valuation

If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P0? k is still 13%.

^

  • Can no longer use constant growth model.

  • However, growth becomes constant after 3 years.


Chapter 9 stocks and their valuation

Nonconstant 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

.

$

P

=

=

$66.54

46.116

3

.

13

-

0

.

06

0

^

54.109 = 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?

$2.60

$54.11

Div. yield0 = = 4.81%.

Cap. gain0 = 13.00% – 4.81% = 8.19%.


Chapter 9 stocks and their valuation

  • 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%.


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

...

ks=13%

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


What is d p and capital gains yield at t 0 and at t 3

What 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%.


If g 6 would anyone buy the stock if so at what price

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

Firm still has earnings and still pays

dividends, so P0 > 0:

(

)

+

D

1

g

D

$

0

1

=

=

P

-

-

0

k

g

k

g

s

s

$2.00(0.94) $1.88

0.13 – (-0.06) 0.19

= = = $9.89.


What is the annual d p and capital gains yield

What 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.


Free cash flow method

Free Cash Flow Method

  • The free cash flow method suggests that the value of the entire firm equals the present value of the firm’s free cash flows (calculated on an after-tax basis).

  • Recall that the free cash flow in any given year can be calculated as:

    NOPAT – Net capital investment.


Using the free cash flow method

Using 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.

^


Issues regarding the free cash flow method

Issues Regarding the Free Cash Flow Method

  • Free cash flow method is often preferred to the dividend growth model--particularly for the large number of companies that don’t pay a dividend, or for whom it is hard to forecast dividends.

(More...)


Fcf method issues continued

FCF 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.


Chapter 9 stocks and their valuation

FCF 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 2021.20

-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.


If the firm has 40 million in debt and has 10 million shares of stock what is the price per share

If 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.


Using the multiples of comparable firms to estimate stock price

Using 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.


What is market equilibrium

What 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.


Chapter 9 stocks and their valuation

Expected 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.


How is equilibrium established

How is equilibrium established?

D1

P0

^

If ks = + g > ks, then

P0 is “too low” (a bargain).

Buy orders > sell orders;

P0 bid up; D1/P0 falls until

D1/P0 + g = ks = ks.

^


Why do stock prices change

Why 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.


What s the efficient market hypothesis

What’s 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.


Chapter 9 stocks and their valuation

1.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.


Chapter 9 stocks and their valuation

2.Semistrong-form EMH:

All publicly available information is reflected in stock prices, so doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information.


Chapter 9 stocks and their valuation

3.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

Markets 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.


Preferred stock

Preferred 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.


What s the expected return of preferred stock with v p 50 and annual dividend 5

What’s the expected return of preferred stock with Vp = $50 and annual dividend = $5?


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