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 • Management’s 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 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t • If g is constant, the dividend growth formula converges to:

8. $ 0.25 0 Years (t) Future dividends and their present values

9. What happens if g > ks? • If g > 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 > g • g is expected to be constant forever

10. If kRF = 7%, kM = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? • Use the SML to calculate the required rate of return (ks): ks = kRF + (kM – kRF)β = 7% + (12% - 7%)1.2 = 13%

11. 0 1 2 3 g = 6% 2.12 2.247 2.382 D0 = 2.00 1.8761 ks = 13% 1.7599 1.6509 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 stock’s 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. 0 1 2 3 ks = 13% ... 2.00 2.00 2.00 What would the expected price today be, if g = 0? • The dividend stream would be a perpetuity.

16. Supernormal growth:What 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. 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 46.114 3 - 0.13 0.06 54.107 = P0 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. 0 1 2 3 4 ks = 13% ... g = 0% g = 0% g = 0% g = 6% D0 = 2.00 2.00 2.00 2.00 2.12 1.77 1.57 1.39 2.12 $ P = = $30.29 20.99 3 - 0.13 0.06 ^ 25.72 = P0 Nonconstant growth:What 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.

23. Corporate value model • Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. • Remember, free cash flow is the firm’s after-tax operating income less the net capital investment • FCF = NOPAT – Net capital investment

24. Applying the corporate value model • Find the market value (MV) of the firm. • Find PV of firm’s future FCFs • Subtract MV of firm’s debt and preferred stock to get MV of common stock. • MV of = MV of – MV of debt andcommon stock firm preferred • Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value). • P0 = MV of common stock / # of shares

25. Issues regarding the corporate value model • Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast. • Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. • Terminal value (TVn) represents value of firm at the point that growth becomes constant.

26. 0 1 2 3 4 k = 10% ... g = 6% -5 10 20 21.20 -4.545 8.264 15.026 21.20 398.197 530 = = TV3 0.10 - 0.06 416.942 Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value.

27. If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share? • MV of equity = MV of firm – MV of debt = $416.94m - $40m = $376.94 million • Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69

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

29. 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.

30. Market equilibrium • Expected returns are obtained by estimating dividends and expected capital gains. • Required returns are obtained by estimating risk and applying the CAPM.

31. 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

32. 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 (β) could change • Growth rate (g) could change • Due to economic (market) conditions • Due to firm conditions

33. 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

34. Weak-form efficiency • Can’t 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.

35. Semistrong-form efficiency • All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks. • Largely true, but superior analysts can still profit by finding and using new information

36. 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 that’s illegal.

37. 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.

38. 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.

39. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? Vp = D / kp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%