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Chapter 6

Chapter 6. Equities. Common Stock . Represents ownership of a business entity with claims on earnings and dividends Can have different classes of stock where one class can be given disproportionate powers Right to vote Proxy. Intrinsic Value .

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Chapter 6

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  1. Chapter 6 Equities

  2. Common Stock • Represents ownership of a business entity with claims on earnings and dividends • Can have different classes of stock where one class can be given disproportionate powers • Right to vote • Proxy

  3. Intrinsic Value • Present value of expected net cash flows that accrues to the owner of security

  4. Dividend Discount Model • Process of evaluating stocks on basis of present value of their expected stream of dividends • Also known as the dividend valuation model

  5. Intrinsic Value of Common Stock P0 = price of stock today dt = dividend during period t r = required rate of return H = holding period PH = price of the stock at the end of the holding period

  6. Holding Period Model Is Misleading • Problem with defining price of stock in terms of dividends and selling price is that this is circular argument, as it begs the question of what determines selling price. • Selling price is present value of dividends to be paid forever thereafter.

  7. Dividend Discount Model • Because model runs to infinity, it can’t be implemented without making additional assumptions about pattern of future dividends.

  8. Required Rate of Return • Rate of return on an investment required by market to justify degree of risk incurred • Risk-free rate plus the risk premium • In equilibrium (quantity supplied equals quantity demanded), required rate of return equal to expected rate of return.

  9. Value Cannot Be Based on Earnings • Double counting • Earnings retained (i.e., reinvested) in firm should lead to higher earnings in future • Higher earnings are NOT additional value to investor, but simply a return on value of earnings previously invested

  10. Valuation of Stocks That Don’t Pay Dividends • If they will never, ever pay a dividend: • Truly worthless • If they will start paying a dividend in the future: • Value today based on when they are expected to start paying dividends, and amount of payment at that time

  11. Gordon (Constant) Growth Model • Form of dividend discount model • Used to evaluate the intrinsic value of an asset based on assumptions of constant growth rate g of cash flow or dividends and a known discount rate r, where r>g. (continued)

  12. Gordon (Constant) Growth Model (continued) Vo = d1/(r – g) = d0 x (1 + g)/(r – g) where V0 = intrinsic value, d1 = next year’s dividend, g = growth rate of dividends, and r = required rate of return. dn = dn – 1(1+g) or dn = d0(1 + g)n

  13. Implications of Growth Model • Decrease in required rate of return (that is, discount rate), will cause value of stock to be higher • Increase in expected growth rate of dividends (g), will cause value of stock to be higher • Increase in next year’s expected dividend (d1) will cause value of stock to be higher

  14. Alternative Meaning of “g” • Can solve constant growth rate model for r: r = d1/Vo + g = dividend yield plus growth rate • Return to investor equals dividend yield plus expected percentage price change • If discount rate = expected return, then dividend growth rate = expected percentage price change

  15. Zero Growth Model • Assume dividends will never change (i.e., no growth) P = d / r where P = intrinsic value of a stock whose dividends are expected to form a perpetuity d = the constant, annual dividend r = discount rate

  16. Selection of Discount Rate • Sufficient to compensate investor for the riskiness of dividend stream • Frequently use CAPM: ri = r f +  (r m – r f)

  17. Application of CAPM Risk-free rate • interest rate on riskless investment, such as Treasury bill Market portfolio • portfolio of all assets, but good surrogate is S&P 500

  18. Market-Price Based Ratios • Used to judge relative appropriateness of current stock price • Price-earnings ratio • Price-cash flow ratio • Price-free cash flow ratio • Price-sales ratio • Price-earnings/growth rate ratio

  19. Earnings Per Share (EPS) • Net income of company, minus any preferred dividend requirements, divided by the number of outstanding common shares • Provides investor or potential investor with information on stability of dividends and capital gains potential • Considered one of most important indications of value of common stock

  20. Price-Earnings (P/E) Ratio • Share price of stock divided by its actual or anticipated earnings per share • For trailing earnings, stock price relative to most recent 12-month earnings per share • Factual • For ex ante earnings, stock price relative to expected next 12-month earnings. • Fantasy

  21. Dividend Payout Ratio • Dividends on common stock paid out as percentage of net income (after preferred dividends)

  22. Growth Model & P/E Ratio Where E0 = last year’s earnings m = the payout ratio (continued) P0 = E0 x m x (1 + g)/(r – g)

  23. Growth Model & P/E Ratio (continued) Dividing through by last year’s earnings produces the price-to-past earnings ratio:  P0 / E0 = m x (1 + g) / (r – g)or P0 / [E0 x (1+g)] = m / (r – g) P0 / E1 = m / (r – g)

  24. Characteristics of Companies with High P/E Ratios • High expected growth rate of earnings • Low discount rate (less risky) • Small spread between the discount rate and growth rate

  25. Growth Stocks vs. Value Stocks • Growth stocks synonymous with above average PE ratios • Value stocks synonymous with below average PE ratios • Recent evidence suggests value stocks perform better than growth stocks the majority of the time

  26. Forecasting with P/E Ratio • Individual stock: • Forecast earnings per share • Forecast P/E ratio • Multiply the two together • Market: • Forecast earnings for index • Forecast P/E for that index • Multiply the two together

  27. Other Equity Instruments • Straight Preferred stock and Participating Preferred stock • Rights Offering • Warrants

  28. Rights • Issued to raise new capital • Exercise Price < Market Price • Sometimes by a large margin • Hence, Intrinsic Value > 0 • Short lifespan • Transferable • Trade on exchanges or OTC for larger companies

  29. Mechanics of Dividends • Declaration date • Ex-dividend date • Record date • Payment date

  30. Dividend Patterns • Many companies boast of number of years of consecutive dividend payments • Dividends paid on same date of each quarter • Dividend increases usually same quarter of each year

  31. Non-Traditional Investments • Collectables –requires a market for the asset • Noncollectables –items that are unique and expensive • Natural Resources –depletion allowance on some mineral rights • Precious Metals –rare metallic chemical element of high, durable economic value

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