Chapter 7 Fin 325, Section 04 – Spring 2010 Washington State University

1. Valuing Stocks Chapter 7 Fin 325, Section 04 – Spring 2010 Washington State University

2. Common Stock • Equity securities (stocks) represent ownership in a corporation • Common stockholders are residual claimants • The market value of a firm’s common stock depends on many factors including: • The company’s profitability (cash flows) • The company’s growth potential • Current market interest rates • Conditions in the overall stock market

3. Stock Markets Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time This liquidity, allowing buyers and sellers the means to transact with each other, gives people the confidence to buy shares in the first place

4. NYSE Trading Floor Overview: http://www.youtube.com/watch?v=Q7FdaiPQuDg NYSE Trading Floor Tour: http://www.youtube.com/watch?v=TPUDPhpCecA • New York Stock Exchange • Largest U.S. stock exchange in terms of dollar volume of trading • Located in New York City at the corner of Wall and Broad streets • Home to nearly 2,700 listed firms • Trading Posts • Specialists • Brokers

5. http://finance.yahoo.com/q?s=MCD

6. To list its stock on the NYSE a company must meet minimum requirements and pay listing fees and annual fee to NYSE • Total number of stockholders • Level of trading volume • Corporate earnings • Firm size • What if a firm doesn’t meet these criteria, or doesn’t want to pay the high NYSE fees? • If they want to list on an organized exchange, they could list on the exchange down the street: the American Stock Exchange

7. The American Stock Exchange (AMEX) • The nation’s second largest floor-based stock exchange • Also called the ‘curb’ exchange • Uses a specialist system like the NYSE • Also active in trading derivative securities and a very popular security called an Exchange Traded Fund (ETF) • What if a firm doesn’t need or want to be traded on an organized, floor-based exchange? • They can trade over-the-counter on NASDAQ

8. The Nasdaq Stock Market • An electronic stock market without a physical trading floor • Home of thousands of the smallest publicly-traded firms, as well as many high-tech giants • Microsoft, Apple, Intel, Google • Nasdaq lists around 3,000 domestic and foreign companies • Second largest equity market in the world behind the NYSE • Uses a market maker system rather than a specialist system

9. Tracking the Stock Market Check Yahoo Finance: http://finance.yahoo.com/ • How do we determine the overall direction of the market? • We use stock indices • The three most-recognized indices are: • The Dow Jones Industrial Average (DJIA) • The Standard & Poor’s 500 Index (S&P500) • The Nasdaq Composite Index

10. Dow 30 Components: http://money.cnn.com/data/dow30/ • The Dow Jones Industrial Average (DJIA) • Invented in 1896, consisting of 12 companies • The only surviving company from the original twelve is General Electric • Price-weighted index - computed by adding up the stock prices and dividing by the number 12 • The DJIA now consists of 30 large firms, representing 30 percent of the total U.S. stock value • Firms are occasionally added or deleted from the index • E.g. Altria Group and Honeywell were replaced by Chevron and Bank of America on February 19, 2008

11. The S&P 500 • Was created in 1957 • Intended to represent 10 sectors of the economy • Value-weighted index - uses market capitalization to compute the index rather than stock prices • Represents roughly 80 percent of the overall stock market value • Considered to be superior to the DJIA because of the much wider coverage and the more useful way it is calculated

12. The Nasdaq Composite Index • Launched in 1971 • Like the S&P 500 index, it uses a market capitalization weighted average • Measures the market capitalization of all stocks listed on the Nasdaq stock exchange • Because of the dominance of the large high-tech firms on Nasdaq, this index is considered a measure of the performance of the technology sector

13. Trading Stocks • Brokerage Accounts • Full-service Stockbrokers (Merrill Lynch) • Discount Brokerage (E-trade, Scottrade) • Buy and sell orders go through the brokerage firm to a market maker or specialist • Bid/Ask spreads • Bid price = price at which the dealer will buy • Ask price = price at which the dealer will sell • The bid/ask spread is the profit for the market maker

14. Types of Orders • Market order • Broker buys or sells at best price available at the moment • Limit order • Order to buy or sell at a specific price • Example: Suppose a share is currently selling for $75 • Buy limit is at a price less than the current market price. Place a limit order to buy at $72 • Sell limit is at a price greater than the current market price. Place a limit order to sell shares you own at $79

15. Basic Stock Valuation D1 D2 + P2 0 1 2 • Consider a two-year horizon: • The present value of the cash flows in years 1 and 2 is today’s stock value

16. In general, for any time horizon:

17. Dividend Discount Models We can extend the equation above for an infinite stream of dividends and no future selling price The stock’s value to the investor is the present value of all future dividends

18. To use this model in practice, analysts make a simplifying assumption to make the model workable: constant perpetual growth • This model is often called the Gordon growth model • There are two important assumptions implicit in this model: constant growth g and i>g • If I is less than g, then the stock price is negative which is nonsense

19. Example: ACME stock recently paid a $4.00 dividend. The dividend is expected to grow at 9% per year indefinitely. What would we be willing to pay if our required return on ACME stock is 14%? D1 4.36 i - g .14 - .09 P0 = = = $87.20

20. Preferred Stock Preferred stock is a hybrid security • Like common stock it has no fixed maturity • It is technically part of equity capital • Like debt , preferred dividends are fixed • Preferred dividends are cumulative • If a company misses preferred stock dividends, they must make them up before they can pay dividends to common stockholders

21. Preferred stock is owned primarily by other companies rather than individuals • Corporations can exempt 70 percent of dividend income from taxes • Preferred stockholders do not have voting rights • Preferred stock pays a constant dividend • It is a special case of the constant perpetual growth model in which g=0 • The formula collapses into the formula for the present value of a perpetuity

22. Coca-Cola’s dividend is $1.36 per share at a time when the market price of its stock is $63.50. What would the value of Coke’s stock be if the dividends were not expected to grow (i.e. g=0)? The company’s cost of capital is 11.5%. P0 = 1.36/.115 = $11.83 • The difference between $63.50 and $11.83 represents the market value of the firm’s expected growth

23. Expected Return • We can rearrange the constant growth formula to solve for i, the expected return on the stock • Expected return comes from two sources • Dividend yield • Expected appreciation of the stock price, or capital gain

24. Additional Valuation Methods • Variable Growth Techniques • For high-growth firms, we can’t use the constant growth formula because we know that the firm can’t sustain the high growth forever • These firms may have two different growth rates • Growth during the supernormal growth period • Steady growth after the firm matures • We can use a multistage growth formula for these firms, but we can also use discounted cash flows in combination with the constant growth model

25. Example: Suppose a firm just paid a dividend of $5 per share. We expect the firm to grow at a rate of 10% for three years, after which it will grow at 4% forever. The required return is 9%.

26. D1 = 5(1+.10) = 5.50 • D2 = 5.50(1.10) = 6.05 • D3 = 6.05(1.10) = 6.655 • D4 = 6.655(1.04) = 6.92 • Now we can calculate the present value of all of the dividends in periods 4 to ∞, where the growth is constant forever P3 = D4/(i-g) = 6.92/(.09-.04) = 138.42 Now we have all the cash flows, and we can find P0 P0 = 5.50/1.091 + 6.05/1.092 + (6.655 + 138.42)/1.093 = $122.17

27. The P/E Model The models we have used so far involve computing a stock’s intrinsic value using discounted cash flows to the investor Another approach is to assess a stock’s relative value The price-earnings (P/E) ratio represents the most common valuation yardstick in the investment industry

28. The P/E ratio is simply the current price of the stock divided by the last four quarters of earnings per share: • The P/E ratio is used as an indication of expected growth of a company • Larger growth rates lead to larger P/E ratios • High P/E stocks are called growth stocks, whereas low P/E stocks are called value stocks

29. Estimating Future Stock Prices • Multiplying the P/E ratio by expected earnings results in an expected stock price

30. Example: The P/E ratio for Caterpillar is 12.98. The company earned $5.05 per share and paid a $1.10 dividend last year. Analysts estimate that the company will grow at an average annual rate of 12.8% over the next 5 years. Calculate the expected price of Caterpillar’s stock price in 5 years. P5 = (P/E) x E0 x (1 + g)5 = 12.98 x $5.05 x (1.128)5 = $119.70