CHAPTER 5

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## CHAPTER 5

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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 Dividends 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 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**0**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%)**Constant growth model:**^ 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:**0**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**At t = 0:**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%.**$46.11**= 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.**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 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.