chap 4c-stock and their valuation [compatibility mode]

7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]

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CHAPTER 4

Stocks and Their Valuation

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

Facts about common stock

Represents ownership

Ownership implies control

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oc o ers e ec rec ors

Directors elect management

Managements goal: Maximize thestock price

Social/Ethical Question

Should management be equally concernedabout employees, customers, suppliers,

and the public, or just the stockholders?

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In an enterprise economy, managementshould work for stockholders subject toconstraints (environmental, fair hiring,etc.) and competition.


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Types of stock markettransactions

Secondary market Primary market

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(going public)

Different approaches forvaluing common stock

Dividend growth model

Corporate value model

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s ng e mu p es o compara efirms

Dividend growth model

Value of a stock is the present value of thefuture dividends expected to be generated

by the stock.

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+++

++

++

+=

)k(1

D...

)k(1

D

)k(1

D

)k(1

DP

s3

s

3

2s

2

1s

10

^


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Constant growth stock

A stock whose dividends are expected to

grow forever at a constant rate, g.

D1 = D0 (1+g)1

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D2 = D0 (1+g)2

Dt = D0 (1+g)t

If g is constant, the dividend growth formulaconverges to:

g-k

D

g-k

g)(1DP

s

1

s

00

^

=+

=

Future dividends and theirpresent values

t0t )g1(DD +=

$

8-8

t

tt

)k1(

DPVD

+=

t0 PVDP =

0.25

Years (t)0

What happens if g > ks?

If g > ks, the constant growth formulaleads to a negative stock price, which

does not make sense.

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The constant growth model can only

be used if:

ks > g

g is expected to be constant forever


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If kRF = 7%, kM = 12%, and = 1.2,what is the required rate of return onthe firms stock?

Use the SML to calculate the requiredrate of return (ks):

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ks = kRF + (kM kRF)

= 7% + (12% - 7%)1.2

= 13%

If D0 = $2 and g is a constant 6%,find the expected dividend stream forthe next 3 years, and their PVs.

g = 6%0 1 2 3

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1.8761

1.7599

D0 = 2.00

1.6509

ks = 13%

2.247 2.3822.12

What is the stocks marketvalue?

Using the constant growth model:

$2.12

DP ==

1

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$30.29

0.07

$2.12

.-.g-s

=

=


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What is the expected market priceof the stock, one year from now?

D1 will have been paid out already. So,P1 is the present value (as of year 1) ofD2, D3, D4, etc.

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Could also find expected P1 as:

$32.10

0.06-0.13

$2.247

g-k

DP

s

2^

1

=

==

$32.10(1.06)PP 0^

1 ==

What is the expected dividend yield,capital gains yield, and total returnduring the first year?

Dividend yield= D1/ P0 = $2.12 / $30.29 = 7.0%

Ca ital ains ield

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= (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%

What would the expected pricetoday be, if g = 0?

The dividend stream would be aperpetuity.

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2.00 2.002.00

ks = 13% ...

$15.380.13

$2.00

k

PMTP

^

0 ===


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Supernormal growth:What if g = 30% for 3 years beforeachieving long-run growth of 6%?

Can no longer use just the constantgrowth model to find stock value.

However, the growth does become

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constant after 3 years.

Valuing common stock withnonconstant growth

ks = 13%

g = 30% g = 30% g = 30% g = 6%

0 1 2 3 4...

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P =

0.06

$66.5434.658

0.13

=

2.301

2.647

3.045

46.114

54.107 = P0^

0 = . . . . .

Find expected dividend and capital gainsyields during the first and fourth years.

Dividend yield (first year)

= $2.60 / $54.11 = 4.81%

Capital gains yield (first year)

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= 13.00% - 4.81% = 8.19%

During nonconstant growth, dividend yieldand capital gains yield are not constant,and capital gains yield g.

After t = 3, the stock has constant growthand dividend yield = 7%, while capitalgains yield = 6%.


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Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?

ks = 13%

g = 0% g = 0% g = 0% g = 6%

0 1 2 3 4...

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0.06

$30.29P32.12

0.13=

=

1.77

1.57

1.39

20.99

25.72 = P0^

0 = . . . . .

Find expected dividend and capital gainsyields during the first and fourth years.

Dividend yield (first year)

= $2.00 / $25.72 = 7.78%

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= 13.00% - 7.78% = 5.22%

After t = 3, the stock has constantgrowth and dividend yield = 7%,while capital gains yield = 6%.

negative growth (g = -6%), wouldanyone buy the stock, and what is itsvalue?

The firm still has earnings and paysdividends, even though they may be

declining, they still have value.

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$9.890.19

$1.88

(-0.06)-0.13

(0.94)$2.00

g-k

)g1(D

g-k

DP

s

0

s

1^

0

===

+==


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Find expected annual dividend andcapital gains yields.

Capital gains yield= g = -6.00%

Dividend yield

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= 13.00% - (-6.00%) = 19.00%

Since the stock is experiencing constantgrowth, dividend yield and capital gainsyield are constant. Dividend yield issufficiently large (19%) to offset anegative capital gains.

Corporate value model

Also called the free cash flow method.Suggests the value of the entire firme uals the resent value of the firms

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free cash flows.

Remember, free cash flow is the firmsafter-tax operating income less the netcapital investment

FCF = NOPAT Net capital investment

Applying the corporate value model

Find the market value (MV) of the firm. Find PV of firms future FCFs

Subtract MV of firms debt and preferred stock to

8-24

ge o common s oc . MV of = MV of MV of debt and

common stock firm preferred

Divide MV of common stock by the number ofshares outstanding to get intrinsic stock price(value). P0 = MV of common stock / # of shares


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Issues regarding thecorporate value model

Often preferred to the dividend growthmodel, especially when considering numberof firms that dont pay dividends or when

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ivi en s are ar to orecast.

Similar to dividend growth model, assumesat some point free cash flow will grow at aconstant rate.

Terminal value (TVn) represents value of firmat the point that growth becomes constant.

Given the long-run gFCF = 6%, andWACC of 10%, use the corporate valuemodel to find the firms intrinsic value.

k = 10%0 1 2 3 4

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g = 6%21.20-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20

530 = = TV30.10 0.06-

If the firm has $40 million in debt andhas 10 million shares of stock, what isthe firms intrinsic value per share?

MV of equity = MV of firm MV of debt

= $416.94m - $40m

=

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.

Value per share = MV of equity / # of shares

= $376.94m / 10m

= $37.69


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Firm multiples method

Analysts often use the following multiplesto value stocks.

P / E

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P / CF

P / Sales

EXAMPLE: Based on comparable firms,estimate the appropriate P/E. Multiply thisby expected earnings to back out anestimate of the stock price.

What is market equilibrium?

In equilibrium, stock prices are stable andthere is no general tendency for people tobuy versus to sell.

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n equ r um, expec e re urns mus equarequired returns.

+==+= )k(kkkgP

Dk

RFMRFs

0

1^

s

Market equilibrium

Expected returns are obtained byestimating dividends and expected

ca ital ains.

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Required returns are obtained by

estimating risk and applying the CAPM.


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How is market equilibriumestablished?

If expected return exceeds requiredreturn

The current rice P is too low and

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offers a bargain.

Buy orders will be greater than sellorders.

P0 will be bid up until expected returnequals required return

Factors that affect stock price

Required return (ks) could change

Changing inflation could cause kRF tochan e

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Market risk premium or exposure tomarket risk () could change

Growth rate (g) could change

Due to economic (market) conditions

Due to firm conditions

What is the Efficient MarketHypothesis (EMH)?

Securities are normally in equilibriumand are fairly priced.

Investors cannot beat the market

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except through good luck or betterinformation.

Levels of market efficiency Weak-form efficiency

Semistrong-form efficiency

Strong-form efficiency


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Weak-form efficiency

Cant profit by looking at past trends.A recent decline is no reason to thinkstocks will o u or down in the

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future.

Evidence supports weak-form EMH,but technical analysis is still used.

Semistrong-form efficiency

All publicly available information isreflected in stock prices, so itdoesnt a to over anal ze annual

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reports looking for undervaluedstocks.

Largely true, but superior analystscan still profit by finding and using

new information

Strong-form efficiency

All information, even insideinformation, is embedded in stock

rices.

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Not true--insiders can gain by

trading on the basis of insiderinformation, but thats illegal.


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Is the stock market efficient? Empirical studies have been conducted to

test the three forms of efficiency. Most ofwhich suggest the stock market was: Highly efficient in the weak form.

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Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders

could and did make abnormal (and sometimesillegal) profits.

Behavioral finance incorporateselements of cognitive psychology tobetter understand how individuals andmarkets respond to different situations.

Preferred stock

Hybrid security

Like bonds, preferred stockholdersreceive a fixed dividend that must be

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paid before dividends are paid tocommon stockholders.

However, companies can omitpreferred dividend payments withoutfear of pushing the firm into

bankruptcy.

If preferred stock with an annualdividend of $5 sells for $50, what is thepreferred stocks expected return?

Vp = D / kp$50 = $5 / k

p

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kp = $5 / $50

= 0.10 = 10%

chap 4c-stock and their valuation [compatibility mode]

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