CHAPTER 9 Stocks and Their Valuation

1
CHAPTER 9Stocks 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 stock price.

3
Social/Ethical Question
Should management be equally concerned about
employees, customers, suppliers, the public, or
just the stockholders? In enterprise economy,
work for stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
4
Whats classified stock? How might classified
stock be used?

• Classified stock has special provisions.
• Could classify existing stock as founders
  shares, with voting rights but dividend
  restrictions.
• New shares might be called Class A shares, with
  voting restrictions but full dividend rights.

5
When is a stock sale an initial public offering
(IPO)?

• A firm goes public through an IPO when the
  stock is first offered to the public.

6
Average Initial Returns on IPOs in Various
Countries
100 75 50 25
Japan
United States
Brazil
Portugal
Sweden
Malaysia
Canada
7
Different Approaches for Valuing Common Stock

• Dividend growth model
• Free cash flow method
• Using the multiples of comparable firms

8
Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
9
For a Constant Growth Stock
D1 D0(1 g)1 D2 D0(1 g)2 Dt Dt(1 g)t
If g is constant, then
P0 .
D0(1 g) ks - g
D1 ks - g

10

0.25
0
Years (t)
11
What happens if g gt ks?

• If kslt g, get negative stock price, which is
  nonsense.
• We cant use model unless (1) ksgt g and (2) g is
  expected to be constant forever.

12
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.
13
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
g 6
2.247
2.382
D0 2.00
2.12
13
1.8761
1.7599
1.6509
14
Whats the stocks market value? D0 2.00, ks
13, g 6.
Constant growth model
D1
2.12
P0
ks g 0.13 0.06
2.12

30.29.
0.07
15
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,
• Could also find P1 as follows

D2
2.247

P1
ks g 0.13 0.06
32.10.


P1 P0(1.06) 32.10.
16
Find the expected dividend yield, capital gains
yield, and total return during the first year.
D1
2.12
Dividend yld
7.0.
P0
30.29

P1 P0
32.10 30.29
Cap gains yld

30.29
P0
6.0.
Total return 7.0 6.0 13.0.
17
Rearrange model to rate of return form

Then, ks 2.12/30.29 0.06 0.07 0.06
13.
18
What would P0 be if g 0?

The dividend stream would be a perpetuity.
0
1
2
3
13
...
2.00
2.00
2.00

PMT k
2.00 0.13
P0 15.38.
19
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.

20
Nonconstant growth followed by constant growth
0
1
2
3
4
...
ks 13
g 30
g 30
g 30
g 6
D0 2.00 2.600 3.380 4.394
4.658
2.301
2.647
3.045
.
4.658

66.54
P


46.116
3
.
.
13
0
06
-
0

54.109 P0
21
What is the expected dividend yield and capital
gains yield at t 0? At t 4?
2.60 54.11
Div. yield0 4.81.
Cap. gain0 13.00 4.81 8.19.
22

• During nonconstant growth, D/P and capital gains
  yield are not constant, and capital gains yield
  is less than g.
• After t 3, g constant 6 capital gains
  yield k 13 so D/P 13 6 7.

23
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 2.00 2.12
1.77
1.57
2.12
1.39



P
30.29.
20.99
3
.
0
07
25.72
24
What is D/P and capital gains yield at t 0 and
at t 3?
D1
2.00 25.72
7.78.
t 0
P0
CGY 13 7.78 5.22.
t 3 Now have constant growth with g capital
gains yield 6 and D/P 7.
25
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
(
)

D
g
1
D

1
0


P
0
-
-
k
g
k
g
s
s
2.00(0.94) 1.88 0.13 (-0.06) 0.19
9.89.
26
What is the annual D/P and capital gains yield?
Capital gains yield g -6.0, Dividend yield
13.0 (-6.0) 19. D/P and cap. gains yield
are constant, with high dividend yield (19)
offsetting negative capital gains yield.
27
Free Cash Flow Method

• The free cash flow method suggests that the value
  of the entire firm equals the present value of
  the firms free cash flows (calculated on an
  after-tax basis).
• Recall that the free cash flow in any given year
  can be calculated as
• NOPAT Net capital investment.

28
Using the Free Cash Flow Method

• Once the value of the firm is estimated, an
  estimate of the stock price can be found as
  follows
• MV of common stock (market capitalization) MV
  of firm MV of debt and preferred stock.
• P MV of common stock/ of shares.

29
Issues Regarding the Free Cash Flow Method

• Free cash flow method is often preferred to the
  dividend growth model--particularly for the large
  number of companies that dont pay a dividend, or
  for whom it is hard to forecast dividends.

(More...)
30
FCF Method Issues Continued

• Similar to the dividend growth model, the free
  cash flow method generally assumes that at some
  point in time, the growth rate in free cash flow
  will become constant.
• Terminal value represents the value of the firm
  at the point in which growth becomes constant.

31
FCF estimates for the next 3 years are -5, 10,
and 20 million, after which the FCF is expected
to grow at 6. The overall firm cost of capital
is 10.
0
1
2
3
4
...
k 10
g 6
-5 10 20 21.20
-4.545
8.264
15.026
21.20 0.04
530 TV3
398.197
416.942
TV3 represents the terminal value of the firm,
at t 3.
32
If the firm has 40 million in debt and has 10
million shares of stock, what is the price per
share?
Value of equity Total value Value of debt
416.94 40
376.94 million.
Price per share Value of equity/ of shares
376.94/10
37.69.
33
Using the Multiples of Comparable Firms to
Estimate Stock Price

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

34
What is market equilibrium?
In equilibrium, stock prices are stable. There is
no general tendency for people to buy versus to
sell. In equilibrium, expected returns
must equal required returns

ks D1/P0 g ks kRF (kM kRF)b.
35
Expected returns are obtained by estimating
dividends and expected capital gains (which can
be found using any of the three common stock
valuation approaches). Required returns are
obtained from the CAPM.

ks D1/P0 g ks kRF (kM kRF)b.
36
How is equilibrium established?
D1 P0

If ks g gt ks, then P0 is too low (a
bargain). Buy orders gt sell orders P0 bid up
D1/P0 falls until D1/P0 g ks ks.

37
Why do stock prices change?
D1 ki g

P0
1. ki could change ki kRF (kM kRF
)bi. kRF k IP. 2. g could change due
to economic or firm situation.
38
Whats the Efficient Market Hypothesis?
EMH Securities are normally in equilibrium and
are fairly priced. One cannot beat the
market except through good luck or better
information.
39
1. Weak-form EMH 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.
40
2. Semistrong-form EMH All publicly available
information is reflected in stock prices, so
doesnt pay to pore over annual reports looking
for undervalued stocks. Largely true, but
superior analysts can still profit by finding and
using new information.
41
3. Strong-form EMH 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.
42
Markets are generally efficient because
1. 15,000 or so trained analysts MBAs, CFAs,
Technical PhDs. 2. Work for firms like Merrill,
Morgan, Prudential, which have a lot of
money. 3. Have similar access to data. 4. Thus,
news is reflected in P0 almost instantaneously.
43
Preferred Stock

• Hybrid security.
• Similar to bonds in that preferred stockholders
  receive a fixed dividend that must be paid before
  dividends can be paid on common stock.
• However, unlike interest payments on bonds,
  companies can omit dividend payments on preferred
  stock without fear of pushing the firm into
  bankruptcy.

44
Whats the expected return of preferred stock
with Vp 50 and annual dividend 5?