The Valuation of Common Stock

Ch7 & 8

Chapter 7The Valuation of

Common Stock

Acquiring ownership in a corporation

Investing in Stock

Formed by a state: A corporation is an artificial legal economic unit established (i.e., chartered) by a stat

Certificate of incorporation: A document creating a corporation.

Corporations

Charter – A document specifying the relationship between a firm and the state in which it is incorporated

Bylaws - specifies the relationship with stockholders

Corporations

Director: A person who is elected by stockholders to determine the goals and policies of the firm.

The Board of Directors

Right of stockholde

r

Preemptive rights

Cumulative voting

Voting authority

Rights offering

Right of stockholder

Voting authority to elect a board of directors

Cumulative voting: The alternative system, cumulative voting, gives minority stockholders a means to obtain representation on the firm’s board.

Rights of Stockholders

Preemptive rights: The right of current stockholders to maintain their proportionate ownership in the firm.

Rights offering: Sale of new securities to existing stockholders.

Rights of Stockholders

Dividends/earnings

Stability of the payout ratio

Stability of dividend payments

Payout Ratio

Dividends

Stock Dividends

Cash Dividends

Kind of Dividends

Distribution from earnings Regular quarterly dividends Extra dividends Irregular dividends Dividends paid in property

Cash Dividends

Date of recordStock trading ex dividendEx-dividend dateDistribution date

Distribution of Dividends

The retention ratio:earnings retained/earnings

or1 - payout ratio

Payout Ratio

Date of record: The day on which an investor must own shares in order to receive the dividend payment.Stock trading ex dividend:

Stock that trades exclusive of any dividend payment.

Distribution of Dividends

Ex-dividend date is two trading days prior to the date of record

Distribution date: The date on which a dividend is paid to stockholders.

Distribution of Dividends

Some firms pay stock dividends in addition to or in lieu of cash dividends.

Stock dividends are a form recapitalization and do not affect the assets or liabilities of the

firm.

The Stock Dividend

Does not affect proportionate ownership

Does not affect assetsDoes not affect liabilitiesDoes not affect total equity

The Stock Dividend

Dilution of existing shares: A reduction in earnings per share due to the issuing of new securities.

Price adjusts for a stock dividendA 10% stock dividendCauses a $20 stock price to fall to $18.18 ($20/1.1)

The Stock Dividend

Does not affect proportionate ownership

Does not affect assetsDoes not affect liabilitiesDoes not affect total equity

The Stock Split

Does affect the stock's priceA 2 for 1 stock splitCauses a $80 stock price to decline to $40 ($80/2)

The Stock Split

Cash dividends used to purchase additional shares

Additional cash contributions may be allowed

Expenses often paid by the firmAre automatic; an easy means to save

Dividend Reinvestment Plans

Corporations with cash may reduce the number of existing shares through buy back programs

The decrease in outstanding shares may◦Increase earnings per share◦Increase the price of the stock

Stock Repurchases

Stockholders do not have to sell their shares

Sales are◦Realized capital gains◦Subject to capital gains taxation

Stock Repurchases and Capital Gains

25

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.

The dividends is % of the par value

26

Expected return, given Vps = $50 and annual dividend = $5

Vps = $50 = $5rps^

rps$5

$50^ = = 0.10 = 10.0%

Corporate liquidations are rareCompany◦Ceases operations◦Pays off its liabilities◦Distributes its remaining assets to stockholders

Corporate Liquidations

THE LOGICAL PROCESS OF SECURITIES VALUATION

Ch8

1. Evaluate the economic environment Including estimates of economic growth, employment, inflation, and the geopolitical environment in which firms operate.

The valuation of a stock includes:

2. Evaluate regulatory issues and the impact of government policy and intervention.

The valuation of a stock includes:

3. Analyst then moves to the various sectors of the economy.

Within each industry the analyst needs to be aware of the degree of competition, cost structures, the pricing environment, and anticipated growth. Such background is necessary prior to analyzing an individual firm.

The valuation of a stock includes:

4. The securities analyst progresses to consider specific firms.

Ultimately the purpose of the analysis is to determine if the firm’s securities (i.e., its stocks and bonds) are undervalued and should be purchased for inclusion in an individual’s or investment company’s portfolio.

The valuation of a stock includes:

Investors purchase stock with the anticipation of a total return consisting of a dividend yield and a capital gain.

If a firm’s $0.93 dividend is expected to grow at 7 percent to $1.00 and the price of the stock is $25, the anticipated annual return on an investment in the stock is:

The investor expected return

R(E) = E(D) /P + E(g)

An estimate of the firm's dividend growth rate is used in the dividend-growth model

Estimates often based on accounting data

Historical earnings or dividend payments

Estimation of Growth Rates

Increased growth should increase a stock’s price

Increased growth at the expense of dividends may reduce a stock’s price

Impact of Increased Growth on Stock Prices

Growth or income

Question of what is the best use of the funds - retention versus distribution

What Do Investors Want?

Dividends: Regular, extra, and irregular.

Payout: The ratio of dividends to earnings.

Retention ratio: The ratio of earnings not distributed to earnings.

Source of Return

Difference in short and long-term capital gains taxation favor capital gains

Transaction costs (e.g., commissions) favor dividend income

Sources of Return

Capital gain Dividends'

Low taxation Higher taxation

Long term Short term

Pay commission for selling and buying

No commission for selling and buying

Difference between capital gain and dividends

40

Different Approaches for Valuing Common Stock Dividend growth model

◦ Constant growth stocks◦ Nonconstant growth stocks

Free cash flow method. Using the multiples of comparable firms

41

Stock Value = PV of Dividends

What is a constant growth stock?

One whose dividends are expected to grow forever at a constant rate, g.

P0 =^

(1 + ks)1 (1 + ks)2 (1 + ks)3 (1 +ks)∞

D1 D2 D3 D∞+ + + … +

42

For a constant growth stock:

D1 = D0(1 + g)1

D2 = D0(1 + g)2

Dt = D0(1 + g)t

If g is constant and less than rs, then:

P0 = ^ D0(1 + g)ks – g

=D1

ks – g

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Dividend Growth and PV of Dividends: P0 = ∑(PV of Dt)

$

0.25

Years (t)

Dt = D0(1 + g)t

PV of Dt =

Dt

(1 + r)t

If g > r, P0 = ∞ !

Valuation is

V=D/k If a stock pays a dividend of $1 and the investor’s required rate of return is 12 percent, then the valuation is = 1/12%= 8.33$

If the Dividend Is Fixed

Valuation is

V=D0 (1+g)/(k - g)

If the Dividend Grows at a Constant Rate

46

Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6%

Constant growth model:

= = = $30.29.0.13 – 0.06

$2.12

P0 = ^ D0(1 + g)

ks – g=

D1

ks – g

47

Expected value one year from now:

P1 = ^ D2

ks – g=

$2.2472

0.07= $32.10

D1 will have been paid, so expected dividends are D2, D3, D4 and so on.

Value depends on the◦the required return◦the dividend◦the growth in the dividend

The Dividend Growth Model

value

the required return

the dividend

the growth in the

dividend

Value depends on the

Depends on◦the risk-free rate (rf)

◦the return on the market (rm)◦the stock's beta

The Required Return (k)

The Required Return

(k)

the stock's beta

the risk-free rate

(rf)

the return on the

market (rm)

Depend on The Required Return (k)

Risk and Required Rate of Return

P/E ratio is a price-earnings multiple times earnings

P=(m)(EPS) if the analyst determines that the appropriate P/E is 10 and the firm’s per-share earnings are $4.50, the value of the stock is 45

Alternative Valuation Techniques

Different definitions of earnings

Differences in estimated earnings

Question of the appropriate multiple

Weakness in the Use of P/E Ratios

Conceptually the same as using P/E ratios

Same weaknesses apply

Price to Book Value and Price to Sales

Standardizes the P/E ratio for growth

P/EEarnings growth

Low PEG ratios (below 1.0) suggest undervaluation

The PEG Ratio

Emphasis on firm’s ability to generate cash

May be applied when firm does not pay a dividend

Substitution of Cash Flow for Earnings and Dividends

May be applied if firm operates at a loss

Value investing employs all of the alternative methods

Substitution of Cash Flow for Earnings and Dividends

Hard to beat the market on a risk-adjusted basis consistently

Earning a higher return is not necessarily outperforming the market

Considering risk is also important

The Efficient Market Hypothesis

Large number of competing participants

Information is readily available

Transaction costs are small

Assumptions Concerning Efficient Markets

Another term for efficient markets

Does not imply security prices are randomly determined

Implies day-to-day price changes are random

Random Walk

Successive prices changes are independent

Today's price does not forecast tomorrow's price

Current price embodies all known information

Random Walk

New information must be random

IF NOT

An opportunity to earn an excess return would exist

Random Walk

Undervaluationdrives prices up

returns decline

Overvaluationdrives prices down

returns increase

Undervaluation and Overvaluation

Undervaluation and Overvaluation

Prices change quickly to new information

By the time most investors know the information the price change has already occurred

Random Walk

Price Adjustments to New Information

The forms of the efficient market hypothesis:◦the weak form◦the semi-strong form◦the strong form

Degree of Market Efficiency

Even if financial markets are efficient, that does not answer the question "How efficient?”

Degree of Market Efficiency

Studying past price and volume data will not lead to superior investment results

While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior returns

The Weak Form

Studying economic and accounting data will not lead to superior investment returns

Studying inside information may lend to superior returns

The Semi-Strong Form

Using inside information will not lead to superior investment returns

The Strong Form

The Strong Form

The Semi-Strong Form

The Weak Form

Empirical results generally support◦the weak form◦the semi-strong form

Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist

Anomalies

Low P/E stocksThe small firm effectThe January effectThe neglected firm effect

Examples of Anomalies

The day-of-the-week effect

The Value Line effect

The overreaction effect

Drifts in security prices

Examples of Anomalies

Empirical evidence of the existence of an anomaly, however, does not mean the individual can take advantage of the anomaly

The anomaly can still exist and the market be effectively efficient from the individual investor's perspective

Anomalies and Returns

Security prices embody known information

The playing field is levelSpecifying financial goals may be more important than seeking undervalued stocks

Implications of Efficient Markets

Other markets may not be efficient

Importance of reducing transactions costs: the argument for a buy-and-hold strategy

Implications of Efficient Markets