FM11 Ch 07 Stocks and Their Valuation

7 - 1
CHAPTER 7
Stocks and Their Valuation

Features of common stock

Determining common stock
values

Efficient markets

Preferred stock
7 - 2

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
7 - 3

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?
7 - 4

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 - 5
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.
7 - 6
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.
7 - 7

Dividend growth model

Using the multiples of comparable
firms

Free cash flow method (covered in
Chapter 15)
Different Approaches for Valuing
Common Stock

7 - 8
( ) ( ) ( ) ( )
∞
∞
+
++
+
+
+
+
+
=
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?
7 - 9
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:
7 - 10
( )
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
7 - 11
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
>
−
=
7 - 12
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
:
7 - 13
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
7 - 14

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
7 - 15
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
7 - 16
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%.
7 - 17
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.
7 - 18
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%.
^
7 - 19
What would P

0
be if g = 0?
The dividend stream would be a
perpetuity.
2.00 2.002.00
0 1 2 3
r
s
=13%
P
0
= = = $15.38.
PMT
r
$2.00
0.13
^
7 - 20
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.

^
7 - 21
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
=
−
=
7 - 22

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…)
7 - 23

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%.
7 - 24


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
7 - 25
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.