CHAPTER 8 Stocks and Their Valuation

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CHAPTER 8Stocks 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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Different approaches for valuing common stock

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

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What determines a stock's value?

• P0 div1 div2 div3 div4 .
  divn Pn
• (1r) (1r)2 (1r)3 (1r)4
  (1r)n (1r)n
• Need to estimate the future dividends and capital
  gains (selling price)
• Also need the discount rate to price these cash
  flows

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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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• Where we can make some simplifying assumptions
  about the growth pattern of future dividends
• No growth
• Constant dividends div1div2.......D
  iv
• Ex utility stocks, preferred stocks
• P0 D
• ks

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Constant Growth Stock

• One whose dividends are expected to
• grow forever at a constant rate, g.
• Growing perpetuity
• P0 DIV1
• (ks-g)
• ks DIV1 g
• P0
• Market capitalization rate Dividend yield
  (DIV1/P0) expected rate of growth in dividends,
  g

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

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What would the expected price today be, if g 0?

• The dividend stream would be a perpetuity.

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If D0 2 and g is a constant 6, what is the
stocks market value?

• Using the constant growth model

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

• D1 will have been paid out already. So, P1 is
  the present value (as of year 1) of D2, D3, D4,
  etc.
• Could also find expected P1 as

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

• Dividend yield
• D1 / P0 2.12 / 30.29 7.0
• Capital gains yield
• (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

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Rearrange model to rate of return form

Then, ks 2.12/30.29 0.06 0.07 0.06
13.
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• World Wide Inc. is expected to pay a per-share
  dividend of 3 next year. It also expects that
  this dividend will grow at a rate of 8 in
  perpetuity. What price would you expect to see
  for World Wide stock if the appropriate discount
  rate is 12?

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• Brown Inc. has just paid a 3 dividend per
  share of common stock. The stock is currently
  being sold at 40. Investors expect that Browns
  dividend will grow at a constant rate
  indefinitely. What growth rate is expected by
  investors if they require 8 return on the stock?

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• Consider the stock of Davidson Company that
  will pay an annual dividend of 2 in the coming
  year. This dividend is expected to grow at a
  constant rate of 5 permanently. The market
  requires a 12 return on the company.
• What is the current price of the stock?
• What will the stock price be 10 years from now?

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Supernormal growthWhat if g 30 for 3 years
before achieving long-run growth of 6?

• Can no longer use just the constant growth model
  to find stock value.
• However, the growth does become constant after 3
  years.

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Valuing common stock with nonconstant growth

P

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• Whizkids Inc. is experiencing a period of rapid
  growth. Earnings and dividends are expected to
  grow at 18 during the next two years, 15 in the
  third year and a constant rate of 6 thereafter.
  Their last dividend which has already been paid
  was 1.15. If the required rate of return on the
  stock is 12, what should the price of the stock
  be today?

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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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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.

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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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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