CHAPTER 8

1. CHAPTER 8 Stocks, Stock Valuation, and Stock Market Equilibrium

2. Topics in Chapter • Features of common stock • Determining common stock values • Efficient markets • Preferred stock

3. Common Stock: Owners, Directors, and Managers • Represents ownership. • Ownership implies control. • Stockholders elect directors. • Directors hire management. • Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

4. Classified Stock • 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. Initial Public Offering (IPO) • A firm “goes public” through an IPO when the stock is first offered to the public. • Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.

6. Seasoned Equity Offering (SEO) • A seasoned equity offering occurs when a company with public stock issues additional shares. • After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.

7. Different Approaches for Valuing Common Stock • Dividend growth model • Using the multiples of comparable firms • Free cash flow method (covered in Chapter 15)

8. ^ D1 D2 D3 D∞ P0 = + +…+ + (1+rs)1 (1+rs)2 (1+rs)3 (1+rs)∞ 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. ^ D0(1+g) D1 P0 = = rs - g rs - g For a constant growth stock: D1 = D0(1+g)1 D2 = D0(1+g)2 Dt = D0(1+g)t If g is constant and less than rs, then:

10. 0 1 2 3 4 g=6% 2.12 2.2472 2.3820 1.8761 13% 1.7599 1.6508 Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)

11. ^ D0(1+g) D1 $2.12 $2.12 P0 = = = = $30.29. rs - g rs - g 0.13 - 0.06 0.07 Intrinsic Stock Value: D0 = 2.00, rs = 13%, g = 6%. Constant growth model:

12. D2 ^ $2.2427 P1 = = = $32.10 rs - g 0.07 Expected value one year from now: • D1 will have been paid, so expected dividends are D2, D3, D4 and so on.

13. D1 $2.12 Dividend yield = = = 7.0%. P0 $30.29 ^ P1 - P0 $32.10 - $30.29 CG Yield = = P0 $30.29 = 6.0%. Expected Dividend Yield and Capital Gains Yield (Year 1)

14. Total Year-1 Return • Total return = Dividend yield + Capital gains yield. • Total return = 7% + 6% = 13%. • Total return = 13% = rs. • For constant growth stock: • Capital gains yield = 6% = g.

15. D1 ^ ^ D1 P0 = to rs + g. = rs - g P0 ^ Then, rs = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. Rearrange model to rate of return form:

16. 0 1 2 3 rs=13% 2.00 2.00 2.00 PMT $2.00 ^ P0 = = = $15.38. r 0.13 If g = 0, the dividend stream is a perpetuity.

17. Supernormal Growth Stock • Supernormal growth of 30% for 3 years, and then long-run constant g = 6%. • Can no longer use constant growth model. • However, growth becomes constant after 3 years.

18. Nonconstant growth followed by constant growth (D0 = $2): rs=13% 0 1 2 3 4 g = 30% g = 30% g = 30% g = 6% 2.60 3.38 4.394 4.6576 2.3009 2.6470 3.0453 ^ $4.6576 46.1135 P3 = = $66.5371 0.13 – 0.06 ^ 54.1067 = P0

19. Intrinsic Stock Value vs. Quarterly Earnings • Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. • Sometimes managers have bonuses tied to quarterly earnings.

20. 0 1 2 3 4 rs=13% g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 1.7699 1.5663 2.12 1.3861    P 30.2857 20.9895 3 0.07 25.7118 Suppose g = 0 for t = 1 to 3, and then g is a constant 6%.

21. Preferred Stock • Hybrid security. • Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. • However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.

22. D1 ^ P0 = rs - g Why are stock prices volatile? • rs = rRF + (RPM)bi could change. • Inflation expectations • Risk aversion • Company risk • g could change.

23. Consider the following situation. D1 = $2, rs = 10%, and g = 5%: P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40. What happens if rs or g change?

24. Stock Prices vs. Changes in rs and g

25. Are volatile stock prices consistent with rational pricing? • Small changes in expected g and rs cause large changes in stock prices. • As new information arrives, investors continually update their estimates of g and rs. • If stock prices aren’t volatile, then this means there isn’t a good flow of information.

26. What is market equilibrium? • In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. • The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. (More…)

27. ^ rs = D1/P0 + g = rRF + (rM - rRF)b. In equilibrium, expected returns must equal required returns:

28. ^ D1 P0 ^ If rs = + g > rs, then P0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the price will be bid up until: D1/P0 + g = rs = rs. ^ How is equilibrium established?

29. What’s the Efficient MarketHypothesis (EMH)? • Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information. (More…)

30. Weak-form EMH • 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.

31. Semistrong-form EMH • All publicly available information is reflected in stock prices, so it doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true.

32. 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 that’s illegal.