MARKETS FOR EQUITY
SECURITIES and EQUITY
VALUATION
1
Types of Equity
Common Stock-- represents ownership
One vote per share
Limited liability
Stockholder compensated by:
Dividends
Price appreciation
Preferred Stock
Dividends are relatively high and fixed
Dividends paid ahead of common if declared
In the event of liquidation claims are honored as
follows:
Bondholders
Preferred Stockholders
Common Stockholders
2
How could ownership and stock market be
manipulated?
Shareholders
1. Communication with the firm
2. Proxy Contest
3. Shareholder Lawsuit
Corporation
Stock Repurchases: When the company believes the stock
is undervalued. Increases the price.
Leveraged Buyouts: Form a group and use a loan to buy
the stocks. Increase the leverage. Later Reverse Leverage
Buyout is possible.
Stock Offering: When the stock is overvalued.
3
Acquisition
Acquisition:
Merger can be capitalized on tax shield
Less inefficiently and more synergy
Diversification of new firm
Cash or by offering stocks
4
Takeover
Takeover: If company performs poorly.
Target stock price up acquirer stays mostly same
How target protects
Antitakeover Amendments:
2/3 of shareholders vote required. Sometimes for favor of
shareholders, sometimes opposite.
Poisonpill: Sudden decision by the board.
Like an allocation of additional 30% of shares. To make it more costly.
Existing bondholders can demand repayment if there is change of
control
Golden Parachutes: To protect manager
But sometimes manager may act for his self interest, since he is
protected.
Shark-repellent: Staggered board, supermajority, waiting period
etc.
White knight
5
Institutional details (continued)
Primary Markets
There are two kinds of stock offers in the primary markets:
1. IPOs, and
2. Seasoned offers.
Almost all primary market stock offers go through an
investment banker.
The investment banker has one of two roles in the
transaction:
1. marketer: “best effort” to sell the stock for the issuer
2. underwriter: buys the stock from the issuer and re-sells
The investment banker can use three different methods
1. Bookbuilding
2. Auction
3. Fixed price 6
Issue Date Company ticker Offer Price Price 1-day after Price 1-year after
offer offer
6/9/98 Inktomi INKT $18.00 $36.00 $98.25
6/10/98 MicroStrategy MSTR 12.00 21.13 23.25
9/24/98 eBay EBAY 18.00 44.88 146.06
11/10/98 Fox Entertainment FOX 22.50 24.50 20.88
11/10/98 MONY Group MNY 23.50 28.13 30.75
12/2/98 Ticketmaster TMCS 14.00 40.25 32.81
12/4/98 PF Chang’s PFCB 12.00 17.75 24.50
1/15/99 MarketWatch.com MKTW 17.00 97.50 40.13
2/1/99 Perot Systems PER 16.00 43.50 21.44
2/4/99 Del Monte Foods DLM 15.00 15.63 10.25
2/4/99 Delphi Automotive DPH 17.00 18.63 17.50
2/10/99 Prodigy Comm. PRGY 15.00 28.13 25.56
2/19/99 Pinnacle Holdings BIGT 14.00 14.06 51.50
3/11/99 Infosys Tech. INFY 34.00 46.63 660.00
3/24/99 Ducati Motor DMH 31.67 31.06 28.50
3/29/99 Priceline.com PCLN 16.00 69.00 81.81
5/3/99 Goldman Sachs GS 53.00 70.38 91.13
5/10/99 TheStreet.com TSCM 19.00 60.00 6.75
5/19/99 eToys ETYS 20.00 76.56 6.25
5/25/99 barnesandnoble.com BNBN 18.00 25.63 9.81
7
5/26/99 Edgar Online EDGR 9.50 9.31 5.81
Institutional details (continued)
Secondary stock offering
If more than demand, price down
Usually done when price is high
Sometimes preemptive right before the offer (1
month)
This right can be sold.
Shelf Registration
First meet the requirements of SEC and delay the
offer.
Company structure may change in the meantime.
Circuit Breakers
8
Institutional details (continued)
Secondary Markets
The secondary markets are re-sale
markets. Trades on the NYSE and
NASDAQ and similar exchanges are
secondary market transactions.
While the company that issued the stock
does not participant in a secondary
market trade, these trades are still very
important to the company because
these trades determine the market
value of the company‟s stock. 9
Institutional details (continued)
Secondary Markets (continued)
The NYSE is an exchange,
10
Institutional details (continued)
Secondary Markets (continued)
The NYSE is an exchange,
An exchange is an auction with a physical
location that brings all traders in a stock
to one location.
The physical location for an exchange
creates overhead costs for the exchange.
Specialist and Floor broker
http://www.nyse.com/about/members/1022221394057.html
11
Institutional details (continued)
Secondary Markets (continued)
The market for stocks traded through dealers used to be
called the over-the-counter market. Recently NASDAQ
has become differentiated from the over-the-counter
market. The over-the-counter market has become dealer
traded stocks not available in the NASDAQ system.
Dealers provide bid and ask quotes for the stock they trade.
The NASDAQ system is designed to find the „best‟ dealer
price available (highest bid and lowest ask).
12
No not a club! NASDAQ in New York
Institutional details (continued)
Secondary Markets (continued)
There are also;
OTC Bulletin Board
Stocks value less than 1$
Less liquid so mostly individual
investor
Pink Sheet
Small,family control.
Almost not enough information
13
Ways of trading securities other than regular trade
Short sale
Limit order
Market order
14
And trading with margin…
Margin rate is set by FED Reserve
About 50 % of the portfolio is initial investment–Rest is
borrowed from the broker.
Return= (Selling price – initial investment – principal loan –
interest + dividend) / initial investment
MM = Total Val. of the Stc.– Borrowed Amount from Broker
Total Value of the Stock
MP = (1-Initial margin rate) * Initial Stock Price
(1-Maintenance margin)
You may gain or lose more with loan !
Buying on margin is a classic example of leverage and we
know that leverage increases risk.
15
Margin Requirement
Let’s assume that we borrow £15,000 at a rate of 7% to
increase the positions in each of the three stock
in our portfolio by £5,000.
Security Original Margin Position Market Falls Market Rises
position 20% 20%
FLYBY £5,000 £10,000 £8,000 £12,000
UO £6,000 £11,000 £8,800 £13,200
GDAY £4,000 £9,000 £7,200 £10,800
Margin Loan £0 £15,000 £15,000 £15,000
Total Equity £15,000 £30,000 £24,000 £36,000
Value
Net Equity £15,000 £15,000 £9,000 £21,000
Value
16
Margin Requirement
The impact of margin on portfolio return is the following
Ending Repayment of Net Gain Investor Return
Portfolio Principal and (Loss)
Value Interest
Market Rises £36,000 £16,050 £19,950 (19,950-15,000)/15,000 =
by 20% 33%
Market £30,000 £16,050 £13,950 (13,950-15,000)/15,000 =
Unchanged -7%
Market falls £24,000 £16,050 £7,950 (7,950-15,000)/15,000 =
by 20% -47%
17
Margin Requirement
Points about investor returns with margin.
1. When there is no change in the market
the investor looses because of the
interest owed on the borrowing.
2. Leverage magnifies the both good and
bad news.
18
Stock Indexes
Dow Jones Industrial Average
Price-weighted average
Day t = Sum of the price of the stocks
TYPES of stocks
Change = ( Day (t+1) – Day t ) / Day t
30 large U.S. firms
Standard and Poor’s (S&P) 500
Value-weighted
Day t = Sum (# of outstanding stock Q * price
of stock Q)
Change = (Day (t+1) / Day t )*Index value at
Day t (base=100)
500 large U.S. firms
19
Valuing Stocks (continued)
Pricing Dividend Paying Stocks
A dividend paying stock provides two types
of cash flows:
1. a infinite stream of future dividends,
and
2. a sales price when the investor sell the
stock.
To value a stock we must identify the
amount and timing of these cash flows.
20
Valuing Stocks (continued)
Pricing Dividend Paying Stocks (continued)
Since we are trying to value an infinite
stream of dividends, we need to make
some assumptions about the future
dividends to make this work.
Three types of future dividend streams:
1. constant future dividends (no growth),
2. constant growth in future dividends, or
3. non-constant growth in future
dividends.
21
Valuing Stocks (continued)
Constant Future Dividends
When we assume constant future dividends,
we are assuming a fixed cash flow, at a regular
interval, that continues forever.
This is a perpetuity and putting the perpetuity
formula in stock terminology we get the
. following formula :
D
P0
r
where: P0 = today’s price, D = the dividend and
r = the risk-adjusted discount rate. 22
Valuing Stocks (continued)
Constant Growth in Dividends
When we assume a constant growth rate in
dividends, we assume a regular dividend
stream with an infinite number of future
dividends that increase at a constant rate
(g).
Under this assumption we can determine
the amount of any future dividend with
the following formula:
23
Valuing Stocks (continued)
Constant Growth in Dividends (continued)
Dt D0 1 g
t
With this formula for future dividends we can value the stock
with the following formula
D0 1 g D0 1 g D0 1 g D0 1 g
2 3 4
P0
1 r 1 r
2
1 r
3
1 r
4
However, we still have the problem of finding the sum of
an infinite stream of dividends 24
Valuing Stocks (continued)
Constant Growth in Dividends (continued)
We need one more assumption to make this
work. The assumption is the (r > g).
With this assumption we get the following
formula.
D1
P0
r g
25
Valuing Stocks (continued)
Pricing Example for Constant Growth in Dividends
Let‟s assume that a stock pays annual dividend
and the next dividend is $2.00, the dividend
grows at a rate 1% per quarter, and the
annualized discount rate is 10%.
$2.00
P0 $28 .89
0.1 0.01
26
Valuing Stocks (continued)
Non-Constant Growth in Dividends
When (g > r), dividends are said to grow at
a non-constant rate. The reason for this
statement is that (g > r) cannot be
sustained in the long-run.
Under non-constant growth, dividends are
assume to grow at the high rate for a few
period and then settle into a constant
growth rate with ( r > g ) thereafter.
27
Valuing Stocks (continued)
Non-Constant Growth in Dividends (continued)
The formula under non-constant growth in dividends is:
Dn 1
n
Dt (r g )
P0 t
t 1 1 r 1 r n
28
Valuing Stocks (continued)
Example for Non-Constant Growth in Dividends
Let‟s assume a company‟s next dividend is
$0.50 and it is expected to grow at 2.5%
for each of the next three periods. After
this early period dividends will grow at 1%
annually for the forseeable future. At an
annual discount rate of 10% what is the
current price of this stock.
29
Valuing Stocks (continued)
Example for Non-Constant Growth in Dividends
P0
$0.50 $0.50 *1.025 $0.50 *1.0252
$0.50 *1.0253
2 3
1.1 1.1 1.1 1.14
$0.50 *1.0253 *1.01 1
* 4
0.1 0.01 1.1 High growth
period
Functions like Do (last Normal growth
dividend) of normal period
period
P0 $0.4545 $0.4031 $0.3947 $0.3678 $4.13
P0 $5.7501
30
Another Method for
Common Stock Valuation
Adjusted Dividend Discount Model
Et E0 * (1 g ) t
P
Pt * Et
E
Then we discount any dividend payment and the
price at time t.
31
Another Method for
Common Stock Valuation
Suppose current earnings is $15 per share.
Expected to grow at 10%. We will keep the
security for 5 years and sell it. Industry‟s P/E ratio
is 7 and will remain the same. Dividends are
constant and $2. Required rate of return is 12%
$24.16 $15 * (1 0.1) 5
$169.12 7 * $24.16
$2 $2 $2 $2 $2 $169.12
P0 2
3
4
(1.12) (1.12) (1.12) (1.12) (1.12)5
P0 1.79 1.59 1.42 1.27 97.1
P0 $103.17 32
Diversification
Standard deviation provides a measure of
the total risk of a stock, but is not an
appropriate measure of risk for
determining the risk-adjusted discount
because standard deviation examines
the risk of a stock in isolation.
Investor‟s seldom own only one assets, so
we must considered the interaction of
the different assets.
They gave me a
Nobel in 1990 for
this! 33
Risk-Adjusted Discount Rates (continued)
Diversification (continued)
The process of adding stocks to a portfolio
that reduces the standard deviation (risk)
of the portfolio is referred to as
diversification.
Diversification reduces, but does not
eliminate, risk. From the risk reduction
process we can define total risk (standard
deviation) as having two component parts.
34
Risk-Adjusted Discount Rates (continued)
Diversification (continued)
Total risk = Systematic risk
+ Unsystematic Risk
Another way of saying this is:
Total risk = Market risk
+ company-specific risk
35
Risk-Adjusted Discount Rates (continued)
Diversification (continued)
36
Risk-Adjusted Discount Rates (continued)
Diversification (continued)
Risk reduction from diversification operates
through correlation.
Correlation measures how two assets move
relative to each other.
Correlation is a standardized measure with
the following range of values:
-1 1 means stock moves more than the
market
44
Risk-Adjusted Discount Rates (continued)
Beta (β) (continued)
Figure 6-7
Company Beta (from 5/01)
Microsoft 1.80
Best Buy 1.74
Citigroup 1.28
Neiman Marcus 1.04
Ford Motor 0.85
Sears 0.63
Campbell Soup 0.48
Eli Lilly 0.37
45
Risk-Adjusted Discount Rates (continued)
CAPM
β provides a measure of the relevant risk of
an individual stock in a world with well-
diversified investors, but we need a risk-
adjusted discount rate, so we need to use
β to create a expected return.
The Capital Asset Pricing Model (CAPM) uses
β to calculate an expected return for a
stock .
46
Risk-Adjusted Discount Rates (continued)
CAPM (continued)
4. Replace βm with 1 in the equality and solve for
E(rj). The results is the CAPM
E r j r f E rm r f j
47
Risk-Adjusted Discount Rates (continued)
CAPM (continued)
E(rj) = rf + [E(rm) – rf]βj
Security Market Line (SML)
Slope = E(rm) - rf
E(rj)
Risk Premium
r
f Risk-free rate
βj Beta
48
Risk-Adjusted Discount Rates (continued)
CAPM (continued)
Important concepts from the CAPM:
1. The expected return from a risky asset
equals the riskfree rate plus a risk
premium,
2. The risk premium equals the market
risk premium [E(rm) – rf] times the
security‟s market risk measure (β),
and
3. β measures the security‟s correlation
with the market.
49
Arbitrage Pricing Theory
E(r) = Bo + Σ BiFi
The equilibrium, expected return linearly
depend on the covariance between asset‟s
returns and factors in market.
Economic
Market-Related
Firm-Specific
Wait a sec! Only market?
No way!
50
Measuring Performance
Two common methods for measuring a
stock‟s risk-adjusted return are:
1. Sharpe Index
[R-Rf]/
where:
R = the average return on the stock
Rf = the average risk free rate
= the standard deviation of stock‟s returns
51
Measuring Performance
2. Treynor Index
[R-Rf]/
where:
R = the average return on the stock
Rf = the average risk free rate
= the stock‟s beta
52
An Advanced Example of Pricing Stocks
Label Goodyear Cisco
Current price $27 5/8 $69
Earnings growth, -10.0% 42.9%
Last 5 years
Earnings growth, 29.2% 34.1%
current year
Estimated growth, 10.3% 30.6%
next 5 years
EPS $1.76 $0.36
Beta (β) 0.89 1.33
53
An Advanced Example of Pricing Stocks
Current annual $1.20 None current or past
dividend
Dividend yield 4.34% na
Annual dividend history
2000 $1.20 na
1999 $1.20 na
1998 $1.20 na
1997 $1.12 na
1996 $1.00 na
1995 $0.80 na
1994 $0.60 na
54
An Advanced Example of Pricing Stocks
Pricing Goodyear
Goodyear pays dividends. The dividends
were increasing slowly, but have been
constant for the last three years. So,
use either the no growth or constant
growth formulas.
The current T-bill yield (riskfree rate) is
5.75% and returns on the market
portfolio (S&P 500) have been 26.76%
over the last 5 years.
55
An Advanced Example of Pricing Stocks
Pricing Goodyear
Er 575% 26.76% 575% * 089 24.4%
. . .
Then under the no growth assumption, the price of
Goodyear is
$1.20
P $4.92
.244
56
An Advanced Example of Pricing Stocks
(continued)
Pricing Goodyear
The growth rate in dividends from 1994 to 2000 has been
12.25% on average, so under the assumption of constant
growth the price of Goodyear is:
D1 $1.201 .1225
P0 $11.09
r g .244 .1225
Since the market price is $27.625 and Goodyear’s dividend yield is
4.34% during the time when the market return is 26.76%,
the dividend models are failing to capture some of the
firm’s future cash flows available to stockholders. 57