CHAPTER 8 Stocks and Their Valuation

1. CHAPTER 8Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock

2. Facts about common stock • Represents ownership • Ownership implies control • Stockholders elect directors • Directors elect management • Management’s goal: Maximize the stock price

3. Types of stock market transactions • Secondary market • Primary market • Initial public offering market (“going public”)

4. Different approaches for valuing common stock • Dividend growth model • Corporate value model • Using the multiples of comparable firms

5. Terms used in stock valuation • Dt = Dividend expectedto receive at the end of year t. • Po = Actual market price of the stock today • = Expected price of the stock at the end of year t • =Intrinsic or theoretical value

6. Terms used in stock valuation • g= Expected growth rate in dividends. • = Required rate of return • = Expected rate of return • = Actual or realized rate of return • D1/P0 =Dividend Yield during the coming year • (P1-P0)/P0 = Capital Gain Yield.

7. Dividend growth model • Value of a stock is the present value of the future dividends expected to be generated by the stock.

8. Constant growth stock • A stock 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, the dividend growth formula converges to:

9. What happens if g > ks? • If g > ks, the constant growth formula leads to a negative stock price, which does not make sense. • The constant growth model can only be used if: • ks > g • g is expected to be constant forever

10. If kRF = 7%, kM = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? • Use the CAPM to calculate the required rate of return (ks): ks = kRF + (kM – kRF)β = 7% + (12% - 7%)1.2 = 13%

11. 0 1 2 3 g = 6% 2.12 2.247 2.382 D0 = 2.00 1.8761 ks = 13% 1.7599 1.6509 If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

12. What is the stock’s market value? • Using the constant growth model:

13. What is the expected market price of the stock, one year from now? • D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc. • Could also find expected P1 as:

14. What is the expected dividend yield, capital gains yield, and total return during the first year? • Dividend yield = D1 / P0 = $2.12 / $30.29 = 7.0% • Capital gains yield = (P1 – P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0% • Total return (ks) = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

15. 0 1 2 3 ks = 13% ... 2.00 2.00 2.00 What would the expected price today be, if g = 0? • The dividend stream would be a perpetuity.

16. Self testing:1 • Cook company is expected to pay a $0.50 per share dividend at the end of the year. The dividend is expected to grow at a constant rate of 7% per year. The required rate of return on the stock,Ks, is 15%. What is the value per share of the company’s stock?

17. Self testing:2 • Dozier Corporation’s share currently sell for $20 per share. The stock just paid a dividend of $1 per share. The dividend is expected to grow at a constant rate of 10% a year. What stock price is expected 1 year from now? What is the required rate of return on the company’s stock?

18. Supernormal/Nonconstant growth:What if D0 = $2 & g = 30% for 3 years before achieving long-run growth of 6%? • Can no longer use just the constant growth model to find stock value. • However, the growth does become constant after 3 years.

19. 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 = = $66.54 46.114 3 - 0.13 0.06 54.107 = P0 Valuing common stock with nonconstant growth $ P ^

20. Find expected dividend and capital gains yields during the first and fourth years. • Dividend yield (first year) = $2.60 / $54.11 = 4.81% • Capital gains yield (first year) = 13.00% - 4.81% = 8.19% • During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ≠ g. • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

21. 0 1 2 3 4 ks = 13% ... g = 0% g = 0% g = 0% g = 6% D0 = 2.00 2.00 2.00 2.00 2.12 1.77 1.57 1.39 2.12 $ P = = $30.29 20.99 3 - 0.13 0.06 ^ 25.72 = P0 Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?

22. Find expected dividend and capital gains yields during the first and fourth years. • Dividend yield (first year) = $2.00 / $25.72 = 7.78% • Capital gains yield (first year) = 13.00% - 7.78% = 5.22% • After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

23. If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? • The firm still has earnings and pays dividends, even though they may be declining, they still have value.

24. Find expected annual dividend and capital gains yields. • Capital gains yield = g = -6.00% • Dividend yield D1 / P0 = $1.88/$9.89 = 19.00% • Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.

25. Corporate value model • Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. • Free cash flow is the firm’s after-tax operating income less the net capital investment • FCF = NOPAT – Net capital investment

26. Issues regarding the corporate value model • Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast. • Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. • Terminal value (TVn) represents value of firm at the point that growth becomes constant.

27. 0 1 2 3 4 k = 10% ... g = 6% -5 10 20 21.20 -4.545 8.264 15.026 21.20 398.197 530 = = TV3 0.10 - 0.06 416.942 Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value.

28. What is market equilibrium? • In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. • In equilibrium, expected returns must equal required returns.

29. Market equilibrium • Expected returns are obtained by estimating dividends and expected capital gains. • Required returns are obtained by estimating risk and applying the CAPM.

30. What is the Efficient Market Hypothesis (EMH)? • Securities are normally in equilibrium and are “fairly priced.” • Investors cannot “beat the market” except through good luck or better information. • Levels of market efficiency • Weak-form efficiency • Semistrong-form efficiency • Strong-form efficiency

31. Weak-form efficiency • The weak form of the EMH states that all information contained in past price movements is fully reflected in current market prices.

32. Semistrong-form efficiency • The semistrong-form of the EMH states that current market prices reflect all publicly available information.

33. Strong-form efficiency • The strong form of the EMH states that current market prices reflect all related information, whether publicly available or privately held.

34. Preferred stock • Hybrid security • Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. • However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

35. If a preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? Vp = D / kp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%