Chapter 8 - The Valuation and Characteristics of Stock

1. Chapter 8 - The Valuation and Characteristics of Stock

2. Common Stock • Corporations are owned by common stockholders • Most large companies are “widely held’ • Ownership spread among many investors. • Investors don’t think of their role as owners

3. The Return on an Investment in Common Stock • Income in a stock investment comes from: • dividends • gain or loss on the difference between the purchase and sale price • If you buy a stock for price P0, hold it for one year, receive a dividend of D1, then sell it for price P1, you return, k, would be: A capital gain (loss) occurs if you sell the stock for a price greater (lower) than you paid for it.

4. The Return on an Investment in Common Stock • Solve the previous equation for P0, the stock’s price today:

5. The Return on an Investment in Common Stock • The return on a stock investment is the interest rate that equates the present value of the investment’s expected future cash flows to the amount invested today, the price, P0

6. Figure 8-1 Cash Flow Time Line for Stock Valuation

7. The Nature of Cash Flows from Stock Ownership • For stockholders: • Expected dividends and future selling price are not known with any precision • Similarity to bond cash flows is superficial – both involve a stream of small payments followed by a larger payment • When selling, investor receives money from another investor • For bondholders: • Interest payments are guaranteed, constant • Maturity value is fixed • At maturity, the investor receives face value from the issuing company. Comparison of Cash Flows from Stocks and Bonds

8. The Basis of Value • The basis for stock value is the present value of expected cash inflows even though dividends and stock prices are difficult to forecast

9. Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows • Joe Simmons is interested in the stock of Teltex Corp. He feels it is going to have two very good years because of a government contract, but may not do well after that. • Joe thinks the stock will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now. • People who have invested in stocks like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex?

10. Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and $3.50 plus $75 at the end of two years.

11. The Intrinsic (Calculated) Value and Market Price • A stock’s intrinsic value is based on assumptions about future cash flows made from fundamental analysis of the firm and its industry • Different investors with different cash flow estimates will have different intrinsic values

12. Growth Models of Common Stock Valuation • Based on predicted growth rates since forecasting exact future prices and dividends is difficult • More likely to forecast a growth rate of earnings rather than cash flows

13. Developing Growth-Based Models • A stock’s value today is the sum of the present values of the dividends received while the investor holds it and the price for which it is eventually sold An Infinite Stream of Dividends Many investors buy a stock, hold for awhile, then sell, as represented in the above equation

14. Developing Growth-Based Models • A person who buys stock at time n will hold it until period m and then sell it • Their valuation will look like this: Repeating this process until infinity results in:

15. The Constant Growth Model • If dividends are assumed to be growing at a constant rate forever and the last dividend paid is, D0, then the model is: This represents a series of fractions as follows If k>g, the fractions get smaller (approach zero) as exponents get larger

16. Constant Normal Growth The Gordon Model • Constant growth model can be simplified to k must be greater than g. The Gordon Model is a simple expression for forecasting the price of a stock that’s expected to grow at a constant, normal rate

17. Concept Connection Example 8-3 Constant Normal Growth - The Gordon Model Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on stocks similar to Atlas is about 11%. What should a share of Atlas Motors sell for today?

18. The Zero Growth Rate Case —A Constant Dividend • If a stock is expected to pay a constant, non-growing dividend, each dollar dividend is the same • Gordon model simplifies to: A zero growth stock is a perpetuity to the investor

19. The Expected Return • Recast Gordon model to focus on the return (k) implied by the constant growth assumption • The expected return reflects investors’ knowledge of a company • If we know D0 (most recent dividend paid) and P0 (current actual stock price), investors’ expectations are input via the growth rate assumption

20. Two Stage Growth • At times, a firm’s future growth may not be expected to be constant • A new product may lead to temporary high growth • The two-stage growth model values a stock that is expected to grow at an unusual rate for a limited time • Use the Gordon model to value the constant portion • Find the present value of the non-constant growth periods

21. Figure 8-2 Two Stage Growth Model

22. Concept Connection Example 8-5 Valuation Based on Two Stage Growth ZylonCorporation’s stock is selling for $48 a share. We’ve heard a rumor that the firm will make an exciting new product announcement next week. We’ve concluded that this new product will support an overall company growth rate of 20% for about two years.

23. Concept Connection Example 8-5 Valuation Based on Two Stage Growth We feel growth will slow rapidly and level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company. The rate of return on stocks like Zylon is approximately 10%. Is Zylon a good buy at $48?

24. Concept Connection Example 8-5 Valuation Based on Two Stage Growth • D1 = D0 (1+g1) = $2.00(1.20) = $2.40 • D2 = D1 (1+g1) = $2.40(1.20) = $2.88 • D3 = D2(1+g2) = $2.88(1.06) = $3.05

25. Concept Connection Example 8-5 Valuation Based on Two Stage Growth We’ll develop a schedule of expected dividend payments: Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2, so: Year Expected Dividend Growth 1 $2.40 20% 2 $2.88 20% 3 $3.05 6%

26. Concept Connection Example 8-5 Valuation Based on Two Stage Growth Then we take the present value of D1, D2 and P2: Compare $67.57 to the listed price of $48.00. If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy Zylon’s stock.

27. Practical Limitations of Pricing Models • Stock valuation models give estimated results since the inputs are approximations of reality • Actual growth rate can be VERY different from predicted growth rates

28. Practical Limitations of Pricing Models • Comparison to Bond Valuation • Bond valuation is precise because the inputs are precise. • Future cash flows are guaranteed in amount and time, unless firm defaults. • Stocks That Don’t Pay Dividends • Have value because of expectation that they will someday pay them. • Some firms don’t pay dividends even if they are profitable • Firms are growing and using profits to finance the growth

29. Valuing New Stocks Investment Banking and The Initial Public Offering (IPO) • IPOs are the first public sales of a new company stocks

30. IPO Process • Investment Banking • Syndication • Registration • Underwriting • Best Efforts

31. Promoting and Pricing the IPO • Quiet Period • Book Building and the Road Show • Ends before the IPO date

32. Prices After the IPO • The Investment Bank in the Middle • Underpricing and IPO Pops • A little Big Pop History • POP Strategies • Market Stabilization

33. Insights – Practical Finance • Facebook’s IPO • Most anticipated IPO in history • NASDAQ trading issues • Fourth largest IPO in history

34. Some Institutional Characteristics of Common Stock • Corporate Organization and Control • Controlled by Board of Directors • elected by stockholders • Board appoints top management who appoint middle/lower management • Board consists of top managers and outside directors (may include major stockholders) • In widely held corporations, top management in “control”

35. Some Institutional Characteristics of Common Stock • Preemptive Rights • Allows stockholders to maintain a proportionate share of ownership • If firm issues new shares, existing shareholders can purchase pro rata share of new issue

36. Voting Rights and Issues • Each share of common stock has one vote • Vote for directors and other issues at the annual stockholders’ meeting • Vote usually cast by proxy

37. Majority and Cumulative Voting • Majority Voting • gives the larger group control of the company • Cumulative Voting • gives minority interest a chance at some representation on the board • Shares With Different Voting Rights • Different classes of stock can be issued different rights • Some stock may be issued with limited or no voting rights

38. Stockholders’ Claim on Income And Assets • Stockholders have a residual claim on income and assets • What is not paid out as dividends is retained for reinvestment in the business (retained earnings) • Common stockholders are last in line, they bear more risk than other investors

39. Preferred Stock • A hybrid security with characteristics of common stock and bonds • Pays a constant dividend forever • Specifies the initial selling price and the dividend • No provision for the return of capital to the investor

40. Valuation of Preferred Stock • Since securities are worth the present value of their future cash flows, preferred stock is worth the present value of the indefinite stream of dividends.

41. Concept Connection Example 8-6 Pricing Preferred Stock Roman Industries’ $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Roman’s preferred sell for today? Just substitute the new market interest rate into the preferred stock valuation model to determine today’s price:

42. Characteristics of Preferred Stock • Cumulative Feature - can’t pay common dividends unless cumulative preferred dividends are current • Never returns principal • Stockholders cannot force bankruptcy • Receives preferential treatment over common stock in bankruptcy • No voting rights • Dividend payments not tax deductible to the firm

43. Securities Analysis • The art and science of selecting investments • Fundamental analysis looks at a company’s business to forecast value • Technical analysis bases value on the pattern of past prices and volume • The Efficient Market Hypothesis (EMH) - financial markets are efficient since new information is instantly disseminated

44. Options and Warrants Options and warrants make it possible to invest in stocks without holding shares • Options • Gives the holder the temporary right to buy or sell an asset at a fixed price • Speculate on price changes without holding the asset • Warrants • Similar but less common

45. Stock Options • Stock options speculate on stock price movements • Trade in financial markets • Call option — option to buy • Put option — option to sell • Options are Derivative Securities • Derive value from prices of underlying securities • Provide leverage – amplifying returns

46. Call Option • Basic Call Option • Gives owner (the holder) the right to buy stock at a fixed price (the exercise or strike price) for a specified time period • Once expired, it can’t be exercised • Option price < price of the underlying stock

47. Figure 8-3 Basic Call Option Concepts

48. Call Options • The more volatile the stock’s price, the more attractive the option • Stock’s price more likely to exceed the strike price before the option expires • The longer the time until expiration the more attractive the option • The stock’s price is more likely to exceed the strike price before the option expires

49. The Call Option Writer • The option writer originates the contract • The original writer must stand ready to deliver on the contract regardless of how many times the option is sold • Call writer hopes stock price will remain stable or not rise

50. Intrinsic Value • Intrinsic value of a call is the difference between the underlying stock’s current price and the option’s strike price • If out-of-the-money, intrinsic value is zero • Option always sells for intrinsic value or above • Time premium - difference between option’s intrinsic value and price