CHAPTER 8 Stocks and Their Valuation

1
CHAPTER 8Stocks and Their Valuation

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

2
Facts about common stock

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

3
Social/Ethical Question

• Should management be equally concerned about
  employees, customers, suppliers, and the
  public, or just the stockholders?
• In an enterprise economy, management should work
  for stockholders subject to constraints
  (environmental, fair hiring, etc.) and
  competition.

4
Types of stock market transactions

• Secondary market
• Primary market
• Initial public offering market (going public)

5
Different approaches for valuing common stock

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

6
Dividend growth model

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

7
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

8
Future dividends and their present values
9
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

10
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

11
If D0 2 and g is a constant 6, find the
expected dividend stream for the next 3 years,
and their PVs.
12
What is the stocks market value?

• Using the constant growth model

13
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

14
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

15
What would the expected price today be, if g 0?

• The dividend stream would be a perpetuity.

16
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.

17
Valuing common stock with nonconstant growth

P

18
Find expected dividend and capital gains yields
during the first and fourth years.

• Dividend yield (first year)
• 2.60 / 54.11 4.81
• Capital gains yield (first year)
• 13.00 - 4.81 8.19
• During nonconstant growth, dividend yield and
  capital gains yield are not constant, and capital
  gains yield ? g.
• After t 3, the stock has constant growth and
  dividend yield 7, while capital gains yield
  6.

19
Nonconstant growthWhat if g 0 for 3 years
before long-run growth of 6?
20
Find expected dividend and capital gains yields
during the first and fourth years.

• Dividend yield (first year)
• 2.00 / 25.72 7.78
• Capital gains yield (first year)
• 13.00 - 7.78 5.22
• After t 3, the stock has constant growth and
  dividend yield 7, while capital gains yield
  6.

21
If the stock was expected to have negative growth
(g -6), would anyone buy the stock, and what
is its value?

• The firm still has earnings and pays dividends,
  even though they may be declining, they still
  have value.

22
Find expected annual dividend and capital gains
yields.

• Capital gains yield
• g -6.00
• Dividend yield
• 13.00 - (-6.00) 19.00
• Since the stock is experiencing constant growth,
  dividend yield and capital gains yield are
  constant. Dividend yield is sufficiently large
  (19) to offset a negative capital gains.

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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.

25
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

27
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.

31
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.

33
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