Emgt 452 Advanced Financial Management

1
Emgt 452 Advanced Financial Management

• Chapter 10
• Stocks and their Valuation

2
Rights of a Stockholder

• Common Stockholders are the owners of the
  company.
• Stockholders elect Directors
• Directors hire officers to manage the business.
• Corporations hold an election of directors
  periodically, usually once a year, with votes
  taken at the annual meeting. 1/3 of the
  directors are elected every year for a 3 year
  term.
• As a shareholder, you can appear at the meeting
  and vote in person, or transfer vote by proxy.
• Management always solicit shareholders proxies.
• Stockholders often have the right (preemptive
  right) to purchase any additional shares sold by
  the firm.
• Prevents dilution of control and a dilution of
  value

3
Types of Common Stock

• Most firms have only one type of stock.
• However, companies may also have classified stock
  (Class A, Class B, and so forth).
• If the companys stock is not actively traded, it
  is referred to as a privately owned, or closely
  held, corporations.
• If the companys stock is actively traded, it is
  referred to as a publicly owned corporation.
• The three types of transactions are stocks sold
  in the secondary market, new shares issued in the
  primary market, and IPOs.

4
Common Stock Valuation

• Dt Dividend shareholders expect to receive at
  the end of period t. D0 is the most recent
  dividend, which has already been paid. D1 is the
  first dividend expected.
• P0 actual market price of the stock today.
• P(hat)t is the expected price of the stock at
  the end of period t.
• g expected growth rate in dividends
• ks required rate of return on the stock
• k(hat)s expected rate of return on the stock
• k(bar)s actual or realized rate of return on
  the stock
• D1/P0 expected dividend yield on the stock
  during the year if D1 is is the dividend received
  per year.
• (P(hat)1 P0) / P0 expected capital gains
  yield
• Expected total return k(hat)t expected
  dividend yield plus expected capital gain yield

5
Stock valuation Formulas

• Zero Growth Stocks
• P(hat)0 D/ks
• Normal Growth Stocks
• P(hat)0 D1 / (ks g)
• Gordon growth model
• Expected Rate of Return under normal growth
• k(hat)s (D1/P0) g
• Expected rate of return expected dividend yield
  plus expected growth rate (capital gains yield)
• For supernormal growth just calculate the present
  value of future cash flows.

6
Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
7
For a constant growth stock,
If g is constant, then
8

0.25
0
Years (t)
9
What happens if g gt ks?

• If kslt g, get negative stock price, which is
  nonsense.
• We cant use model unless (1) g lt ks and (2) g is
  expected to be constant forever. Because g must
  be a long-term growth rate, it cannot be gt ks.

10
Assume beta 1.2, kRF 7, and kM 12. What
is the required rate of return on the firms
stock?
Use the SML to calculate ks
ks kRF (kM - kRF)bFirm 7 (12 - 7)
(1.2) 13.
11
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
4
g6
2.2472
2.3820
D02.00
2.12
13
1.8761
1.7599
1.6508
12
Whats the stocks market value? D0 2.00, ks
13, g 6.
Constant growth model
2.12
2.12
30.29.
0.13 - 0.06
0.07
13
What is the stocks market value one year from
now, P1?

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

14
Find the expected dividend yield and capital
gains yield during the first year.
2.12
D1
Dividend yield 7.0.
30.29
P0

P1 - P0
32.10 - 30.29
CG Yield
P0
30.29
6.0.
15
Find the total return during the first year.

• Total return Dividend yield Capital gains
  yield.
• Total return 7 6 13.
• Total return 13 ks.
• For constant growth stock
• Capital gains yield 6 g.

16
Rearrange model to rate of return form

Then, ks 2.12/30.29 0.06 0.07 0.06
13.
17
What would P0 be if g 0?
The dividend stream would be a perpetuity.
0
1
2
3
ks13
2.00
2.00
2.00
PMT
2.00

P0 15.38.
k
0.13
18
If we have supernormal growth of 30 for 3
years, then a long-run constant g 6, what is
P0? k is still 13.

• Can no longer use constant growth model.
• However, growth becomes constant after 3 years.

19
Nonconstant growth followed by constant growth
0
1
2
3
4
ks13
g 30
g 30
g 30
g 6
D0 2.00 2.60 3.38 4.394
4.6576
2.3009
2.6470
3.0453
46.1135

54.1067 P0
20
What is the expected dividend yield and capital
gains yield at t 0? At t 4?
At t 0
2.60
D1
Dividend yield 4.8.
54.11
P0
CG Yield 13.0 - 4.8 8.2.
(More)
21
Nonconstant Growth

• 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 t 4
  capital gains gains yield 6.
• Because ks 13, the t 4 dividend yield 13
  - 6 7.

22
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

23
If most of a stocks value is due to long-term
cash flows, why do so many managers focus on
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.

24
Suppose g 0 for t 1 to 3, and then g is a
constant 6. What is P0?

0
1
2
3
4
ks13
...
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
25
What is dividend yield and capital gains yield at
t 0 and at t 3?
D1
2.00


7.8.

t 0
P0
25.72
CGY 13.0 - 7.8 5.2.
t 3 Now have constant growth with g capital
gains yield 6 and dividend yield 7.
26
If g -6, would anyone buy the stock? If so,
at what price?
Firm still has earnings and still pays dividends,
so P0 gt 0

2.00(0.94)
1.88
9.89.
0.13 - (-0.06)
0.19
27
What are the annual dividendand capital gains
yield?
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.
28
What is market equilibrium?
In equilibrium, stock prices are stable. There is
no general tendency for people to buy versus to
sell. The expected price, P, must equal the
actual price, P. In other words, the fundamental
value must be the same as the price.

29
Market Equilibrium
In equilibrium, expected returns must equal
required returns

ks D1/P0 g ks kRF (kM - kRF)b.
30
How is equilibrium established?

D1 P0

If ks g gt ks, 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, and
D1/P0 falls until D1/P0 g ks ks.

31
Why do stock prices change?

• ki kRF (kM - kRF )bi could change.
• Inflation expectations
• Risk aversion
• Company risk
• g could change.

32
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.

33
Whats the expected return on preferred stock
with Vps 50 and annual dividend 5?
34
Whats 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.
35
Efficient Market Hypothesis

• Weak-form Efficiency All information contained
  in past price movements is fully reflected in
  current market prices
• Semistrong-form Efficiency Current market
  prices reflect all publicly available
  information. It is the degree of efficiency that
  is tested. How fast do stock prices react to new
  public information (seconds)
• Strong-form Efficiency Current market prices
  reflect all information, whether public or
  private.

36
Markets are generally efficient because
1. 100,000 or so trained analysts--MBAs, CFAs,
and PhDs--work for firms like Fidelity, Merrill,
Morgan, and Prudential. 2. These analysts have
similar access to data and megabucks to
invest. 3. Thus, news is reflected in P0 almost
instantaneously.