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

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

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**Stocks and Their Valuation(Ref: Brigham, E.F., and J.F.**Houston. 2001. Fundamentals of Financial Management, 9th Ed, Harcourt College Publishers, Ch. 9) • 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. • Management’s goal: Maximize the stock price.**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.**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.**Biggest IPOs of 2000 in the USA**Issuer Proceeds from sale AT&T Wireless $9.03 billion Infineon Technologies $2.72 billion Metropolitan Life Ins. Co. $2.50 billion TyCom $2.88 billion Genuity $1.91 billion**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**1. Dividend growth model: - Constant Growth (Gordon) Model - Supernormal (Non-constant) Growth Stock - Erratic Growth Stock 2. Free cash flow method 3. Using the multiples of comparable firms**When to use the models?**• Constant growth model: most appropriate for mature companies w stable history of growth, and stable future dividends. • Free cash flow method: good for the large number of companies that don’t pay a dividend, or for whom it is hard to forecast dividends.**Definitions of Terms**Dt= Dividend the stockholder expects to receive at the end of Year t. D0 is the most recent dividend, which has already been paid; D1 is the first dividend expected, and will be paid at the end of this year; D2 is the dividend expected at the end of two years, and so forth. D1 represents the first cash flow a new purchaser of the stock will receive. Note that D0, the dividend that has been paid, is known with certainty. But all future dividends are expected values, so the estimate of Dt may differ among investors. P0 = Actual market price of the stock today**P0 = Expected price of the stock at the end of Year t**(pronounced “P hat t”). P0 is the intrinsic, or theoretical, value of the stock today as seen by the particular investor doing the analysis; P1 is the price expected at the end of one year; and so on. Note that P0 is the intrinsic value of the stock today based on a particular investor’s estimate of the stock’s expected dividend stream and the riskiness of that stream. Hence, whereas the market price P0 is fixed and is identical for all investors, P0 could differ among investors depending on how optimistic they are about the company. The caret, or “hat” is used to indicate that Pt is an estimated value. cont…**cont…**P0, the individual investor’s estimate of the intrinsic value today, could be above or below P0, the current stock price, but an investor would buy the stock only if his/her estimate of P0 were equal or greater than P0. Since they are many investors in the market, there can be many values for P0. However, we can think of an “average” or “marginal” investors whose actions actually determine the market price. For these marginal investors, P0 must = P0; otherwise a disequilibrium would exist, and buying and selling in the market would change P0, until P0= P0 for the marginal investor.**Market Price, P0 = the price at which the stock sell in the**market Intrinsic Value, P0 = the value of an asset that, in the mind of a particular investor, is justified by the facts; P0 may be different from the asset’s current market price. Growth Rate, g = The expected rate of growth in dividends per share.**g = expected growth rate in dividends as predicted by a**marginal investor. If dividends are expected to grow at a constant rate, g is also equal to the expected rate of growth in earnings and in the stock’s price. Different investors may use different g’s to evaluate a firm’s stock, but the market price, P0, is set on the basis of the g estimated by marginal investors.**Required Rate of Return, ks = The minimum rate of return on**a common stock that a stockholder considers acceptable. ks = minimum acceptable, or required, rate of return on the stock, considering both its riskiness and the returns available on other investments. Again, this term generally relates to marginal investors. The determinants of ks include the real rate of return, expected inflation, and risk.**Expected Rate of Return, ks = The rate of return on a common**stock that a stockholder expects to receive in the future. ks = Expected rate of return that an investor who buys the stock expects to receive in the future. Ks (pronounced “k hat s”) could be above or below ks, but one would buy the stock only if ks were equal or greater than ks.**Actual, Realized Rate of Return, ks = The rate of return on**a common stock actually received by stockholders in some past period. Ks may be greater, or less than, and/or ks. ks = actual, or realized, after-the factrate of return (pronounce “k bar s”). You may expect to obtain a return of ks= 15% if you buy Exxon today, but if the market goes down, you may end up next year with an actual realized return that is much lower, perhaps even negative.**Dividend Yield = The expected dividend divided by the**current price of a share of stock. D1/P0 = Expected dividend yield on the stock during the coming year. If the stock is expected to pay a dividend of D1 = $1 during the next 12 months, and its current price is P0 = $10, then the expected dividend yield is $1/$10 = 0.10 = 10%**Capital Gains Yield = The capital gain during a given year**divided by the beginning price. (P1-P0)/P0 = Expected capital gains yield on the stock during the coming year. If the stock sells for $10 today, and if it is expected to rise to $10.50 at the end of one year, the expected capital gain is P1- P0 = $0.50. Expected capital gain yield = $0.50/$10 = 5%**Expected Total Return = The sum of the dividend yield and**the expected capital gains yield. Expected total return = ks = Expected dividend yield (D1/P0) + expected capital gains yield (P1-P0)/P0. In our example, the expected total return is 10% + 5% = 15%**Stock Value = PV of Dividends**. What is a constant growth stock? A stock whose dividends are expected to grow forever at a constant rate, g.**For a Constant Growth Stock**D1 = D0(1 + g)1 D2 = D0(1 + g)2 =D1(1+g)1 Dt = D0(1 + g)t If g is constant, then: P0 = = D0(1 + g) ks – g D1 ks – g ^**$**0.25 0 Years (t)**D1**ks – g = requires ks > g 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, kRF = 7%, and kM = 12%. What is the**required rate of return (ks) on the firm’s stock? Use the SML to calculate ks: ks= kRF + (kM – kRF) βFirm = 7% + (12% – 7%) (1.2) = 13%**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? 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, P1?**^ • D1 will have been paid, so expected dividends are D2,D3, D4 and so on. With P0= $30.29, D2=D1(1+g)=$2.12(1.06)=$2.247; Could also find P1 as follows: D2 $2.247 ^ P1 = = ks – g 0.13 – 0.06 = $32.10 ^ P1= P0(1.06)=30.29(1.06)=$32.10**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%**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 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**If we have supernormal growth of 30% for 3 years, then a**long-run constant g = 6%, what is P0? ks is still 13%. ^ • Can no longer use constant growth model. • However, growth becomes constant after 3 years.**Valuing a Supernormal/Non-constant Growth Stock**Supernormal/non-constant growth is that part of the firm’s life cycle in which it grows faster than the economy as a whole. Steps to Value Supernormal Growth Stock: • Compute the expected future cash dividends cont….**2. Compute the stock’s price at a future point in time,**using constant growth model Pt = Dt+1/(r-g). (You must pick a point after the dividend growth rate has become constant) 3. Compute the PV of the expected future sale price and add that to the PV of all the expected cash dividends between now and then. (Source: Emery, D.R., J.D. Finnerty and J.D. Stowe.1998. Principles of Financial Management. Prentice Hall, pp 172-173)**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 46.114 3 . 13 - 0 . 06 0 ^ 54.107 = P0**What is the expected dividend yield and capital gains yield**at t = 0? At t = 4? (Div yield0=Div1/Price) $2.60 $54.11 Div. yield0 = = 4.81%. Cap. gain0 = (ks- div yield) =13.00% – 4.81% = 8.19%.**During nonconstant growth, dividend yield (D/P) and capital**gains yield are not constant, and capital gains yield is not equal to g. • After t = 3, g = constant = 6% = capital gains yield; ks = 13%; so D/P = 13% – 6% = 7%.**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?**D1 $2.00 $25.72 = = 7.78% (D/P=div yield) 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%. (CGY=capital gain yield)**What is the annual dividend yield (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.**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.**Further Example of Supernormal Growth Stock**• Netscape is operating in a new industry that has recently caught on with the public. Sales are growing at 80% per year. This high sales growth is expected to translate into a 25% growth rate in cash dividends for each of the next 4 years. After that, the dividend growth rate is expected to be 5% forever. Annual dividend paid yesterday is $0.75. The stock’s required return is 22%. What is Netscape’s stock’s price? (Source: Emery et al, Principles of Financial Management. 1998. pp 172-173) cont….**i) Compute the expected future cash dividends:**Time 0 1 2 3 4 5 6 ... Div($) 0.75 0.938 1.172 1.465 1.831 1.923 2.019 … g(%) 25% 25% 25% 25% 5% 5% 5% … ii) Find the stock price at a future time, a point after which the dividend growth rate has become constant forever. That point is at year 5, thus: P5 = D6/(r-g) = $2.019/(0.22-0.05) = $11.876 iii) Compute the PVs of all the future expected cash dividends found in step (i) and add to the PV of the expected future sale price (P5) calculated in step (ii): P0 = 0.938/1.221 + 1.172/1.222 + 1.465/1.223 + 1.831/1.224 + 1.923/1.225 + 11.876/1.225 = $(0.768 + 0.787 + 0.807 + 0.827 + 0.711 + 4.394) = $8.295**Valuing An Erratic-Growth Stock (EGS)**• Definition: An EGS is a stock which is expected to have an erratic dividend growth for some finite time, followed by a normal rate forever into the future. P0=D1/( 1+r)1 + D2/(1+r)2 +…Dn/(1+r)n + {(1+g)Dn)/[(1+r)n(r-g)]} (Source: Emery et al., Principles of Financial Management. 1998. pp 173-174) cont…..**Example:**Novell’s dividend was $1 last year and is to be $1 for each of the next 3 years. After its projects have been developed, earnings are expected to grow at a high rate for 2 years as sales resulting from new projects are realized. The higher earnings are expected to result in 40% increase in dividends for 2 years. After these 2extraordinary increases in dividends, the dividend growth rate is expected to be 3% per year forever. Novell’s required rate of return is 12%. What is the worth of its share today? (i) First compute the expected future dividends: Time 0 1 2 3 4 5 6 7 ….. Div($) 1.00 1.00 1.00 1.00 1.40 1.96 2.019 2.079 … Growth 0% 0% 0% 40% 40% 3% 3% 3% …. cont…**(ii) D5 is where the growth rate in dividends is expected to**become constant forever and is the earliest point that satisfies the constant-growth assumption. With D5 =$1.96, g=3%, and r = 12%, P0 =D1/( 1+r)1 + D2/(1+r)2 +…Dn/(1+r)n + (1+g)Dn/{(1+r)n(r-g)} P0 = 1.00/1.121 + 1.00/1.122 + 1.00/1.123 +1.40/1.124 + 1.96/1.125 + (1+0.03)1.96/{(1.12)5(0.12-0.03)} = $17.13**Free Cash Flow Method/Total Company or Corporate Valuation**Model • 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 (NOPAT= Net operating profit after taxes)**The Corporate Valuation Model (Text,pg 306)**Market Value=Vcompany= PV of expected future Free cash flows of company = FCF1/(1+r)1 +FCF2/(1+r)2+…FCFn/(1+r)n FCF = (EBIT(1-T) + Dep + Amort) - (Cap Exp + Change in NOWC); or FCF = NOPAT – New Investment in Operating Cap**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**• 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. Cont..**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.