stocks and their valuation

1
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
CHAPTER 6
Stocks and Their Valuation
 6.1 Key Characteristics of
Stocks
 6.2 Types of Common Stock
 6.3 The Market for Common
Stock
 6.4 Common Stock Valuation

2
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
6.1 Key Characteristics of Stocks


3
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.

Common Stock: Owners,
Directors, and Managers
4
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
6.2 Types of Common Stock


5
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 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.
What’s classified stock? How
might classified stock be used?
6
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012

 The dividends of tracking stock are tied
to a particular division, rather than the
company as a whole.

Investors can separately value the
divisions.
Its easier to compensate division
managers with the tracking stock.
 But tracking stock usually has no
voting rights, and the financial
disclosure for the division is not as
regulated as for the company.
What is tracking stock?
7
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
6.3 The Market for Common
Stock

8
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
When is a stock sale an
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.
9

B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What is a 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.
10
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
6.4 Common Stock Valuation


11
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 Dividend growth model
 Using the multiples of comparable
firms
 Free cash flow method
Different Approaches for
Valuing Common Stock
12
B02022 – Chapter 6 - Stocks and

Their Valuation
23/8/2012
       










ssss
r
D
r
D
r
D
r
D
P
1
. . .
111
ˆ
3
3
2

2
1
1
0
One whose dividends are expected to
grow forever at a constant rate, g.
Stock Value = PV of Dividends
What is a constant growth stock?
13
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
For a constant growth stock,
 
 
 
D D g
D D g
D D g
t t
t
1 0
1
2 0
2
1
1
1
 
 

 
 
gr
D
gr
gD
P
ss





1
0
0
1
ˆ
If g is constant, then:
14
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 
D D g
t
t
 
0
1

 
t
t
t
r
D
PVD


1
!P r,>g
0
If
P PVD
t0
 
$
0.25
Years (t)
0
15
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What happens if g > r
s
?
 If r
s
< g, get negative stock price,

which is nonsense.
 We can’t use model unless (1) g  r
s

and (2) g is expected to be constant
forever. Because g must be a long-
term growth rate, it cannot be  r
s
.
.r requires
ˆ
s
1
0
g
gr
D
P
s



16
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Assume beta = 1.2, r
RF
= 7%, and
RP

M
= 5%. What is the required
rate of return on the firm’s stock?
r
s
= r
RF
+ (RP
M
)b
Firm

= 7% + (5%) (1.2)
= 13%.
Use the SML to calculate r
s
:
17
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
D
0
was $2.00 and g is a
constant 6%. Find the
expected dividends for the
next 3 years, and their PVs. r
s

= 13%.

0 1
2.2472
2
2.3820
3
g=6%
4
1.8761
1.7599
1.6508
D
0
=2.00
13%
2.12
18
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What’s the stock’s market
value?
D
0
= 2.00, r
s
= 13%, g = 6%.
Constant growth model:
 
gr
D

gr
gD
P
ss





1
0
0
1
ˆ
= = $30.29.
0.13 - 0.06
$2.12 $2.12
0.07
19
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What is the stock’s market
value one year from now, P
1
?
 D
1
will have been paid, so expected
dividends are D

2
,

D
3
, D
4
and so on.
Thus,



^
D
2
P
1
= r
s
- g
= $2.2427 = $32.10
0.07
20
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Find the expected dividend
yield and capital gains yield
during the first year.
Dividend yield = = = 7.0%.

$2.12
$30.29
D
1

P
0

CG Yield = =
P
1
- P
0

^
P
0

$32.10 - $30.29
$30.29
= 6.0%.
21
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Find the total return during
the
first year.
 Total return = Dividend yield +
Capital gains yield.

 Total return = 7% + 6% = 13%.
 Total return = 13% = r
s
.
 For constant growth stock:
Capital gains yield = 6% = g.
22
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Rearrange model to rate of return form:
.r to
ˆ
0
1
s
1
0
g
P
D
gr
D
P
s




Then, r

s
= $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.
^
23
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What would P
0
be if g = 0?
The dividend stream would be a
perpetuity.
2.00 2.00 2.00
0 1 2 3
r
s
=13%
P
0
= = = $15.38.
PMT
r
$2.00
0.13
^
24
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012

If we have supernormal growth of
30% for 3 years, then a long-run
constant g = 6%, what is P
0
? r is
still 13%.
 Can no longer use constant growth
model.
 However, growth becomes constant
after 3 years.
^
25
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Nonconstant growth followed by constant
growth:
0
2.3009
2.6470
3.0453
46.1135
1 2 3 4
r
s
=13%
54.1067 = P
0
g = 30% g = 30% g = 30% g = 6%
D

0
= 2.00 2.60 3.38 4.394 4.6576
^
5371.66$
06.013.0
6576.4$
P
ˆ
3



26
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What is the expected
dividend yield and capital
gains yield at t = 0? At t = 4?
Dividend yield = = = 4.8%.
$2.60
$54.11
D
1

P
0

CG Yield = 13.0% - 4.8% = 8.2%.
At t = 0:

(More…)
27
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 During nonconstant growth, dividend
yield and capital gains yield are not
constant.
 If current growth is greater than g,
current capital gains yield is greater
than g.
 After t = 3, g = constant = 6%, so the t
t = 4 capital gains gains yield = 6%.
 Because r
s
= 13%, the t = 4 dividend
yield = 13% - 6% = 7%.
28
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 The current stock price is $54.11.
 The PV of dividends beyond year 3 is
$46.11 (P
3
discounted back to t = 0).
 The percentage of stock price due to
“long-term” dividends is:

Is the stock price based on

short-term growth?
^
= 85.2%.
$46.11
$54.11
29
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
If most of a stock’s value is
due to long-term cash flows,
why do so many managers
focus on 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.
30
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Suppose g = 0 for t = 1 to 3,
and then g is a constant 6%.
What is P
0
?
0

1.7699
1.5663
1.3861
20.9895
1 2 3 4
r
s
=13%
25.7118
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
2.12
.

P
3
0 07
30.2857
 
^

31
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What is dividend yield and
capital gains yield at t = 0
and at t = 3?
t = 0:
D

1
P
0
CGY = 13.0% - 7.8% = 5.2%.
 
2.00
$25.72
7.8%.
t = 3: Now have constant growth
with g = capital gains yield = 6% and
dividend yield = 7%.
32
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
If g = -6%, would anyone buy the
stock? If so, at what price?
Firm still has earnings and still pays
dividends, so P
0
> 0:
 
gr
D
gr
gD
P
ss






1
0
0
1
ˆ
^
= = = $9.89.
$2.00(0.94)
0.13 - (-0.06)
$1.88
0.19
33
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What are the annual dividend
and capital gains yield?
Capital gains yield = g = -6.0%.

Dividend yield = 13.0% - (-6.0%)
= 19.0%.

Both yields are constant over time, with
the high dividend yield (19%) offsetting
the negative capital gains yield.
34
B02022 – Chapter 6 - Stocks and

Their Valuation
23/8/2012
 Analysts often use the P/E multiple (the price
per share divided by the earnings per share)
or the P/CF multiple (price per share divided
by cash flow per share, which is the earnings
per share plus the dividends per share) to
value stocks.
 Example:
Estimate the average P/E ratio of
comparable firms. This is the P/E multiple.
Multiply this average P/E ratio by the
expected earnings of the company to
estimate its stock price.
Using the Stock Price Multiples
to Estimate Stock Price
35
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 The entity value (V) is:
the market value of equity (# shares of
stock multiplied by the price per share)
plus the value of debt.
 Pick a measure, such as EBITDA, Sales,
Customers, Eyeballs, etc.
 Calculate the average entity ratio for a
sample of comparable firms. For example,
V/EBITDA
V/Customers

Using Entity Multiples
36
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 Find the entity value of the firm in question.
For example,
Multiply the firm’s sales by the V/Sales
multiple.
Multiply the firm’s # of customers by the
V/Customers ratio
 The result is the total value of the firm.
 Subtract the firm’s debt to get the total
value of equity.
 Divide by the number of shares to get the
price per share.
Using Entity Multiples
(Continued)
37
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
 It is often hard to find comparable firms.
 The average ratio for the sample of
comparable firms often has a wide range.
For example, the average P/E ratio might
be 20, but the range could be from 10 to 50.
How do you know whether your firm
should be compared to the low, average, or
high performers?

Problems with Market
Multiple Methods
38
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Why are stock prices volatile?

gr
D
0
P
s
1


 r
s
= r
RF
+ (RP
M
)b
i
could change.
 Inflation expectations
 Risk aversion
 Company risk

 g could change.

^
39
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Stock value vs. changes
in r
s
and g
D
1
= $2, r
s
= 10%, and g = 5%:
P
0
= D
1
/ (r
s
-g) = $2 / (0.10 - 0.05) = $40.

What if r
s
or g change?
g g g
r
s
4% 5% 6%
9% 40.00 50.00 66.67

10% 33.33 40.00 50.00
11% 28.57 33.33 40.00
40
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Are volatile stock prices
consistent with rational pricing?
 Small changes in expected g and r
s

cause large changes in stock prices.
 As new information arrives, investors
continually update their estimates of
g and r
s
.
 If stock prices aren’t volatile, then
this means there isn’t a good flow of
information.
41
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
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…)
42
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
In equilibrium, expected returns must
equal required returns:
r
s
= D
1
/P
0
+ g = r
s
= r
RF
+ (r
M
- r
RF
)b.
^
43
B02022 – Chapter 6 - Stocks and
Their Valuation

23/8/2012
How is equilibrium
established?
If r
s
= + g > r
s
, then P
0
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, and D
1
/P
0
falls until
D
1
/P
0
+ g = r
s
= r
s
.
^

^
D
1

P
0
^
44
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Why do stock prices change?

1
0
gr
D
P
i


 r
i
= r
RF
+ (r
M
- r
RF
)b

i
could change.
 Inflation expectations
 Risk aversion
 Company risk

 g could change.
^
45
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What’s the Efficient Market
Hypothesis (EMH)?
Securities are normally in
equilibrium and are “fairly priced.”
One cannot “beat the market”
except through good luck or inside
information.
(More…)
46
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
1. 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.
47
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
2. 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.
48
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
3. 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.
49
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
Markets are generally
efficient because:

1. 100,000 or so trained analysts MBAs,
CFAs, and PhDs work for firms like
Fidelity, Merrill, Morgan, and
Prudential.
2. These analysts have similar access to
data and megabucks to invest.
3. Thus, news is reflected in P
0
almost
instantaneously.
50
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
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.
51
B02022 – Chapter 6 - Stocks and
Their Valuation
23/8/2012
What’s the expected return on
preferred stock with V
ps

= $50 and
annual dividend = $5?
%.0.1010.0
50$
5$
5$
50$




ps
ps
ps
r
r
V