TOPIC 7 Stocks and Their Valuation

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TOPIC 7Stocks and Their Valuation

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

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Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Managements goal Maximize the stock price

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METHODS OF VALUING COMMON STOCK
DIVIDEND VALUATION METHODS 1. NO GROWTH
2. NORMAL GROWTH 3. SUPER GROWTH OTHER
METHODS 1. FIRM MULTIPLES 2. REDUCED
P/E RATIO 3. GROSS MULTIPLIER
4. EXCESS EARNINGS
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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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NO GROWTH WHAT IS THE VALUE OF A SECURITY
THAT PAYS A 2 DIVIDEND IF THE INVESTORS
REQUIRED RATE OF RETURN IS 13?
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What would the expected price(value) today be,
if g 0?

• The dividend stream would be a perpetuity.

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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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WHAT IS THE VALUE OF A STOCK THAT PAYS A
10 DIVIDEND EVERY YEAR IF THE REQUIRED RETURN
IS 20 AND THE GROWTH RATE IS 5? 10 / .15
66.67
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What happens if g gt ks?

• If g gt 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 gt g
• g is expected to be constant forever

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If kRF 7, kM 12, and ß 1.2, what is the
required rate of return on the firms stock?

• Use the SML to calculate the required rate of
  return (ks)
• ks kRF (kM kRF)ß
• 7 (12 - 7)1.2
• 13

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SUPER GROWTH

• EXAMPLE
• DIVIDEND JUST PAID 1.00
• GROWTH RATE FOR 2 YEARS 30
• GROWTH RATE THEREAFTER 8
• REQUIRED RATE OF RETURN 15

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D0 1 PV D1 1.30 1.13 D2
1.69 1.28 TOTAL 2.41
D3 / k g 1.83 / .07 26.14
PV OF 26.14 FOR 2 YEARS IS 19.77
2.41 PLUS 19.77 22.18
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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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REDUCED P/E RATIO METHOD ASSUME PEs OF
SIMILAR COMPANIES ARE 8x, 10x, AND 12x, THE
DISCOUNT IS 20 AND TRUE EARNINGS ARE
100,000. 8 10 12 30 and the average P/E
is 10X. A discount of 20 means the P/E ratio to
be used is 8X. 8X 100,000 800,000
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EXCESS EARNINGS METHOD

• ASSUME
• HARD ASSETS 200,000
• FAIR RETURN 20
• TRUE EARNINGS 70,000
• CAP RATE FOR
• GOODWILL 35
• WHAT IS THE VALUE OF THE COMPANY?

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EXPECTED EARNINGS 200,000 x .20 OR
40,000 TRUE EARNINGS 70,000 EXCESS EARNINGS
30,000 (that is, 70,000 minus 40,000) VALUE
OF THE GOODWILL 30,000 / .35 85,714 VALUE
OF COMPANY 200,000 85.714
or 285,714 HOW GOOD IS THIS METHOD?
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PREFERRED STOCK

• PAR VALUE Often 25 or 100
• DIVIDEND or
• Not required if not earned
• Usually cumulative
• MATURITY
• VOTING RIGHTS
• MAY BE CONVERTIBLE, CALLABLE, AND/OR
  PARTICIPATING

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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.

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A company has decided to raise money by selling
either bonds or preferred stock. Will financial
leverage be provided by Bonds? Preferred
stocks? Is bond interest tax deductible? Are
preferred dividends tax deductible?
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If preferred stock with an annual dividend of 5
sells for 50, what is the preferred stocks
expected return?

• Vp D / kp
• 50 5 / kp
• kp 5 / 50
• 0.10 10

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FROM AN INVESTORS POINT OF VIEW--
P.S. BONDS RISK Which is
safer? RETURN Which has a higher return?
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WHICH IS RISKER TO INVESTORSPREFERRED STOCK OR
BONDS?

• PS IS RISKIER COMPANY IS NOT REQUIRED TO PAY
  DIVIDENDS
• Therefore, the return to the investor
• should be higher on the preferred stock
• than the return available on the bonds.
• HOWEVER, FIRMS TRY TO PAY DIVIDENDS. OTHERWISE,
  (1) CANNOT PAY COMMON DIVIDEND, (2) DIFFICULT TO
  RAISE MORE MONEY, AND (3) PREFERRED STOCKHOLDERS
  MAY GAIN CONTROL OF COMPANY.

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WHY IS THE YIELD ON BONDS HIGHER THAN THE RETURN
ON PREFERRED STOCK?

• CORPORATIONS OWN MOST PS BECAUSE 70 OF PREFERRED
  DIVIDENDS ARE NONTAXABLE.
• PS USUALLY HAS A LOWER BT YIELD THAN THE BT YIELD
  ON BONDS
• THE AT YIELD TO AN INDIVIDUAL INVESTOR ARE LOWER
  ON PS THAN ON BONDS.

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EXAMPLE

• ASSUME BOTH CORPORATE AND INDIVIDUAL INVESTORS
  ARE IN THE 40 TAX BRACKET.
• BONDS PS
• BT 10 8
• AT 6 7.04 CORP.
• 4.8 IND.
• 8.00 X 30 2.40 WILL BE TAXED
• 2.40 X .40 .9600
• 8.00 - .96 7.04

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WHICH IS RISKER TO INVESTORSPREFERRED STOCK OR
BONDS?

• PS IS RISKIER COMPANY IS NOT REQUIRED TO PAY
  DIVIDENDS
• HOWEVER, FIRMS TRY TO PAY DIVIDENDS. OTHERWISE,
  (1) CANNOT PAY COMMON DIVIDEND, (2) DIFFICULT TO
  RAISE MORE MONEY, AND (3) PREFERRED STOCKHOLDERS
  MAY GAIN CONTROL OF COMPANY.

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WHY IS THE YIELD ON PREFERRED STOCK LOWER THAN
DEBT?

• CORPORATIONS OWN MOST PS BECAUSE 70 OF PREFERRED
  DIVIDENDS ARE NONTAXABLE.
• PS USUALLY HAS A LOWER BT YIELD THAN THE BT YIELD
  ON BONDS
• THE AT YIELD TO AN INVESTOR ARE HIGHER ON PS THAN
  ON BONDS. CONSISTENT WITH HIGHER RISK OF PS.

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EXAMPLE

• ASSUME BOTH CORPORATE AND INDIVIDUAL INVESTORS
  ARE IN THE 40 TAX BRACKET.
• BONDS PS
• BT 10 8
• AT 6 7.04 CORP.
• 4.8 IND.

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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.

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Market equilibrium

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

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How is market equilibrium established?

• If expected return exceeds required return
• The current price (P0) is too low and offers a
  bargain.
• Buy orders will be greater than sell orders.
• P0 will be bid up until expected return equals
  required return

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Factors that affect stock price

• Required return (ks) could change
• Changing inflation could cause kRF to change
• Market risk premium or exposure to market risk
  (ß) could change
• Growth rate (g) could change
• Due to economic (market) conditions
• Due to firm conditions

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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

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Weak-form efficiency

• Cant profit by looking at past trends. A recent
  decline is no reason to think stocks will go up
  (or down) in the future.
• Evidence supports weak-form EMH, but technical
  analysis is still used.

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Semistrong-form efficiency

• All publicly available information is reflected
  in stock prices, so it doesnt pay to over
  analyze annual reports looking for undervalued
  stocks.
• Largely true, but superior analysts can still
  profit by finding and using new information

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Strong-form efficiency

• All information, even inside information, is
  embedded in stock prices.
• Not true--insiders can gain by trading on the
  basis of insider information, 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 of which suggest
  the stock market was
• Highly efficient in the weak form.
• Reasonably efficient in the semistrong form.
• Not efficient in the strong form. Insiders could
  and did make abnormal (and sometimes illegal)
  profits.
• Behavioral finance incorporates elements of
  cognitive psychology to better understand how
  individuals and markets respond to different
  situations.