CHAPTER 5 Stocks and Their Valuation

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CHAPTER 5Stocks and Their Valuation

• Features of common stock
• Determining common stock values
• Preferred stock

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Common Stock

• Stockholders are owners of the firm.
• Stockholders are residual claimants.
• Stockholders have the right to
• vote at company meetings
• dividends and other distributions
• sell their shares
• Stockholders benefit in two ways
• dividends
• capital gains
• Stock is issued by public corporations to finance
  investments.
• Stock is initially issued in the primary market
  (IPOs and secondary offerings).
• Stock is traded in the secondary market on
  organized exchanges.

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Steps in raising equity

• Founders equity Friends Family
• Angel Investors
• Venture capitalists
• Private financing
• Public offering (IPO)

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U. S. Stock Markets

• Major U. S. Stock Exchanges
• New York Stock Exchange (NYSE)
• National Association of Securities Dealers
  (NASDAQ)

U. S. Stock Market

• Other Indices
• NYSE Composite
• Russell 2000
• Wilshire 5000
• Value Line

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World Stock Markets

• Sydney
• Switzerland
• Hong Kong

• New York
• Tokyo
• London
• Frankfurt
• Paris

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International Stock Market Indices
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Reading Stock Quotes
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Transactions Involving Stocks

• Buy
• Savings motive
• Expect stock to appreciate in value
• Long position
• Sell
• Liquidity needs
• Expect stock to decline in value

• Short Sell
• Sell stock without first owning it.
• Borrow stock from your broker with the promise to
  repay it at some later date.
• Sell the borrowed stock.
• Repurchase it at a later date to repay your
  broker.
• Responsible for all dividends and other
  distributions while short the stock.

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Basic Valuation

• From The Time Value of Money we realize that
  the value of anything is based on the present
  value of the cash flows the asset is expected to
  produce in the future.

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Basic Valuation

• k the return investors consider appropriate for
  holding such an asset--usually referred to as the
  required return-- based on riskiness and economic
  conditions.

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Different approaches for estimating the intrinsic
value of a common stock

• Dividend growth model
• Corporate value model
• Using the multiples of comparable firms

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Dividend growth model

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

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Stock Valuation Models

• Terms Expected Dividends

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Stock Valuation Models
Terms Market Price
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Stock Valuation Models
Terms Intrinsic Value
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Stock Valuation Models
Terms Growth Rate
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Stock Valuation Models
Terms Required Rate of Return
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Stock Valuation Models
Terms Dividend Yield
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Example Dividend yield

• If a firm is expected to pay a dividend of 2 (D1
  2). The current stock price is 40, what is
  the dividend yield?
• Dividend yield D1/ P0 2 / 40 5

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Practice Dividend yield

• If a firm is expected to pay a dividend of 4 (D1
  4). The current stock price is 60, what is
  the dividend yield?
• Dividend yield D1/ P0 ?

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Constant growth stock

• A stock whose dividends are expected to grow
  forever at a constant rate, g.
• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• If g is constant, the dividend growth formula
  converges to

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Example Constant growth

• If a firm just paid a dividend of 2 (D0 2).
  The growth rate is expected to be constant at 10
  . If the cost of equity is 15, what is the
  value of this stock?
• P0 D0(1g) / (Ks g) 2(1.10)/(0.15-0.1) 44

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Practice Constant growth

• If a firm just paid a dividend of 5 (D0 5).
  The growth rate is expected to be constant at 20
  . If the cost of equity is 25, what is the
  value of this stock?
• P0 ???

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ExampleConstant growth

• ABC Inc. is expected to pay a dividend of 5 (D1
  5) next year. The dividend is expected to
  grow at a constant rate of 6 . If the cost of
  equity is 10, what is the value of this stock?
• P0 D1 / (Ks g) 5 / (0.10-0.06) 125

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Practice Constant growth

• ABC Inc. is expected to pay a dividend of 2 (D1
  2) next year. The dividend is expected to
  grow at a constant rate of 10 . If the cost of
  equity is 14, what is the value of this stock?
• P0 ?

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Example Non-constant growth

• A share just paid a dividend of 10. The
  dividend is expected to grow at 40 percent for
  the next three years. After that, dividend is
  expected to grow at a constant rate of 10 percent
  forever. The required rate of return is 20
  percent. Calculate the value of this stock.

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Practice Non-constant growth
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Corporate value model

• Also called the free cash flow method. Suggests
  the value of the entire firm equals the present
  value of the firms free cash flows.
• Find the market value (MV) of the firm, by
  finding the PV of the firms future FCFs.
• Subtract MV of firms debt to get MV of common
  stock.
• Divide MV of common stock by the number of shares
  outstanding to get intrinsic stock price (value).

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Applying the corporate value model
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Example Corporate Value model
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Firm multiples method

• Analysts often use the following multiples to
  value stocks.
• P / E
• P / CF
• P / Sales
• EXAMPLE Based on comparable firms, estimate the
  appropriate P/E. Multiply this by expected
  earnings to back out an estimate of the stock
  price.

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Practice Multiples method

• Lowell Inc. is going public soon. It is expected
  to earn 5 per share this year (EPS 5). If a
  similar firm has a P/E ratio of 10, what should
  the value of Lowell Inc.s stock?
• P0 5 10 50

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Practice Multiples method

• Lowell Inc. is going public soon. It is expected
  to earn 6 cash per share this year (CF 6).
  If a similar firm has a P/CF ratio of 15, what
  should the value of Lowell Inc.s stock?
• P0 ?

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Firm multiples method

• Lowell Inc. is going public soon. It is expected
  to have a sales of 10 million this year. It has
  1 million shares outstanding. If a similar firm
  has a P/Sales ratio of 5, what should the value
  of Lowell Inc.s stock?
• P0 ?

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Changes in Stock Prices

• Investors change the rates of return required to
  invest in stocks.
• Expectations change about the cash flows
  associated with particular stocks.

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The Efficient Markets Hypothesis

• The weak form of the EMH states that all
  information contained in the past price movements
  is fully reflected in current market prices.
• The semistrong form states that current market
  prices reflect all publicly available
  information.
• The strong form states that current market prices
  reflect all pertinent information, whether
  publicly available or privately held.