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The Valuation OF STOCKS PPT _ BEC DOMS

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The Valuation OF STOCKS PPT _ BEC DOMS Powered By Docstoc
					  The Valuation and
Characteristics of Stock
                 Common Stock

 Corporations are owned by           common
  stockholders
   Stockholders choose directors

 Most large companies are “widely held’
   Ownership spread among many investors.

 Investors don’t think of a role as owner
   Interested mostly in future cash flows.

                                               2
              The Return on an
        Investment in Common Stock
   Income in a stock investment comes from:
         dividends
         gain or loss on the difference between the purchase and sale price
   If you buy a stock for price P0, hold it for one year, receive a dividend
    of D1, then sell it for price P1, you return, k, would be:

                          D 1 +  P1 - P 0 
               k =
                                      P0
                                or                                       A capital gain (loss) occurs

        k =
                     D1
                                      +
                                                P1 - P 0                if you sell the stock for a
                     P0                              P0
                                                                          price greater (lower) than
              d iv id e n d y ie ld       c a p ita l g a in s y ie ld
                                                                                you paid for it.

                                                                                                        3
           The Return on an
     Investment in Common Stock
   Solve the previous equation for P0, the stock’s price
    today:
          k P 0  D 1   P1  P 0 
     P 0  k P 0  D 1  P1
    1  k  P0    D 1  P1
                    D 1  P1
            P0 
                    1  k 
    The return on a stock investment is the interest rate
    that equates the present value of the investment’s
    expected future cash flows to the amount invested
    today, the price, P0
                                                            4
                   The Nature of Cash Flows
                    from Stock Ownership
          Comparison of Cash Flows from Stocks and Bonds


For stockholders:                        For bondholders:
Expected dividends and future selling    Interest payments are guaranteed,
price are not known with any precision   constant
Similarity to bond cash flows is         Maturity value is fixed
superficial – both involve a stream of   At maturity, the investor receives face
small payments followed by a larger      value from the issuing company.
payment
When selling, investor receives money
from another investor




                                                                                   5
                The Basis of Value

The basis for stock value is the present value of
  expected cash inflows even though dividends
  and stock prices are difficult to forecast
    Make assumptions about future dividends and selling
     price
    Discount these assumptions at an appropriate interest
     rate


      0  2 D nk
         F , V ,
               
      P , D n 
        PP  V
         1 
      =  V nkP
       D 2k
        V F  F
              PP
              F n
        
       1k  , 


                                                             6
                               The Basis of Value
                                                                        Example 8.1



          Q: Joe Simmons is interested in the stock of Teltex Corp. He feels it is
             going to have two very good years because of a government contract,
             but may not do well after that. Joe thinks the stock will pay a dividend
             of $2 next year and $3.50 the year after. By then he believes it will be
             selling for $75 a share, at which price he'll sell anything he buys now.
             People who have invested in stocks like Teltex are currently earning
             returns of 12%. What is the most Joe should be willing to pay for a
Example




             share of Teltex?




                                                                                        7
  The Intrinsic (Calculated) Value
         and Market Price

 A stock’s intrinsic value is based on
  assumptions about future cash flows made
  from fundamental analysis of the firm and
  its industry
 Different investors with different cash flow
  estimates will have different intrinsic
  values


                                                 8
Growth Models of Common Stock
          Valuation

 Based on predicted growth rates since
  forecasting exact future prices and
  dividends is difficult

 More likely to forecast a          growth
  rate of earnings            rather than
  cash flows

                                              9
Developing Growth-Based Models

   A stock’s value today is the sum of the present values of
    the dividends received while the investor holds it and the
    price for which it is eventually sold
             D D     D   P
          P= 1  22 nn nn
          0
            1 1
             
             k   k   
                     1 1
                      k   k

    An Infinite Stream of Dividends
    ○ Many investors buy a stock, hold for awhile, then sell, as
      represented in the above equation
        • Not convenient for valuation purposes



                                                                   10
Developing Growth-Based Models
 A person who buys stock at time n will hold it
  until period m and then sell it
    Their valuation will look like this:
          D     D    P
         = + … m- + m-
        P n1+ +
        n
          +
          1k  +m  +m
               1k 1k
                  n
                      
                        n




  Repeating this process until infinity results in:
                        
                                Di
                    P 
                              1 + k
                     0               i
                        i=1




   Conceptually it’s possible to replace the final
   selling price with an infinite series of dividends
                                                        11
           The Constant Growth Model
   If dividends are assumed to be growing at a constant rate forever and the last
    dividend paid is, D0, then the model is:

                           D (1g i
                            
                                   )
                    P      0

                            (1k)i
                     0
                       i1

    This represents a series of fractions as follows
                1    g  g
                 g 01 01 
                                            2              3
               D D D
             P=0
                   
             0
                1
               k  
                     1
                      k
                       2
                         1
                         
                          k
                           3




    If k>g, the fractions get smaller (approach zero) as exponents get
    larger
     ○ If k>g growth is normal
     ○ If k<g growth is supernormal
          • Can occur but lasts for limited time period
                                                                                     12
             Working with Growth Rates
                                                              Example 8.2




          Q. Apex Corp. paid a dividend of $3.50 this year. What are its
             next three dividends if it is expected to grow at 7%?
Example




          A. SOLUTION: In this case D0 = $3.50 and g = .07, so
             (1+g) = 1.07. Then
             D1 = D0(1+g) = $3.50(1.07) = $3.75,
             D2 = D1(1+g) = $3.75(1.07) = $4.01, and
             D3 = D2(1+g) = $4.01(1.07) = $4.29.




                                                                            13
    Constant Normal Growth —
       The Gordon Model

 Constant growth model can be simplified
  to                  k must be
        D1              greater
  P0                   than g.
       k g

  The Gordon Model is a simple expression
  for forecasting the price of a stock that’s
  expected to grow at a constant, normal
  rate
                                                14
                    Constant Normal Growth—
                       The Gordon Model
                                                                    Example 8.3

          Q: Atlas Motors is expected to grow at a constant rate of 6% a year
             into the indefinite future. It recently paid a dividends of $2.25 a
             share. The rate of return on stocks similar to Atlas is about 11%.
             What should a share of Atlas Motors sell for today?

                      D1
Example




          A:
               P0 
                    k -g
                      $ 2 .2 5 ( 1 .0 6 )
                  
                         .1 1 - .0 6
                   $ 4 7 .7 0



                                                                                   15
   The Zero Growth Rate Case —
       A Constant Dividend

 If a stock is expected to pay a constant,
  non-growing dividend, each dollar
  dividend is the same
 Gordon model simplifies to:
                  D
             P0 
                  k
  A zero growth stock is a perpetuity to the
  investor

                                               16
              The Expected Return
 Recast Gordon model to focus on the return (k)
  implied by the constant growth assumption
                      D1
                   k    g
                      P0
   The expected return reflects investors’
   knowledge of a company
    ○If we know D0 (most recent dividend paid) and P0
     (current actual stock price), investors’ expectations
     are input via the growth rate assumption


                                                             17
                Two Stage Growth

 At times, a firm’s future growth may not be
  expected to be constant
    A new product may lead to temporary high growth


 The two-stage growth model values a stock that is
  expected to grow at an unusual rate for a limited
  time
    Use the Gordon model to value the constant portion
    Find the present value of the non-constant growth
     periods

                                                          18
                              Two Stage Growth
                                                                    Example 8.5



          Q: Zylon Corporation’s stock is selling for $48 a share according to
             The Wall Street Journal. We’ve heard a rumor that the firm will
             make an exciting new product announcement next week. By
             studying the industry, we’ve concluded that this new product will
             support an overall company growth rate of 20% for about two
             years. After that, we feel growth will slow rapidly and level off at
Example




             about 6%. The firm currently pays an annual dividend of $2.00,
             which can be expected to grow with the company. The rate of
             return on stocks like Zylon is approximately 10%. Is Zylon a
             good buy at $48?

          A: We’ll estimate what we think Zylon should be worth given our
             expectations about growth.




                                                                                    19
                         Two Stage Growth
                                                            Example 8.5



          We’ll develop a schedule of expected dividend payments:
                  Expected
           Year   Dividend     Growth
             1      $2.40        20%
Example




             2      $2.88        20%
             3      $3.05        6%
          Next, we’ll use the Gordon model at the point in time where the
          growth rate changes and constant growth begins. That’s year 2,
          so:
                   D      35
                          .
                         $0
                 P
                 2 3
                            65
                             72
                             $.
                    -2   1-0
                   kg . 0. 6


                                                                            20
                            Two Stage Growth
                                                               Example 8.5



          Then we take the present value of D1, D2 and P2:
          P 1 V ,1 + 2 V ,2 + 2 V ,2
               k  D PF  PPF 
          0 DPF         k       k 
             $. 0PF,1 + 2 8PF,2 + 7. 5PF,2
               2  V 0  $.  V 0  $6  V 0 
                4 1     8 1       2 1 
               2  99 $.  86 $6  86
             $. 0 . 01+ 2 8 . 24 + 7. 5 . 24
                40        80         20
Example




             $7 7
                5
               6.


               Compare $67.57 to the listed price of $48.00.
                If we are correct in our assumptions, Zylon
                 should be worth about $20 more than it is
                selling for in the market, so we should buy
                                 Zylon’s stock.



                                                                             21
        Practical Limitations of
            Pricing Models
 Stock valuation models give estimated
  results since the inputs are approximations
  of reality

 Actual growth rate can be VERY different
  from predicted growth rates
   Even if growth rates differ slightly, it can be a
    big difference in the decision
   Allow for a margin for error in estimations

                                                        22
        Practical Limitations of Pricing
                    Models
Comparison to Bond            Stocks That Don’t Pay Dividends
  Valuation                   Have value because of expectation
 Bond valuation is precise   that they will someday pay them.
  because the inputs are      Some firms don’t pay dividends
  precise.                    even if they are profitable
 Future cash flows are       Firms are growing and using profits to
  guaranteed in amount and    finance the growth
  time, unless firm
  defaults.



                                                                       23
     Some Institutional Characteristics of
               Common Stock

Corporate Organization and Control

   Controlled by Board of Directors
     elected by stockholders
   Board appoints top management             who
    appoint middle/lower management
   Board consists of top managers and outside
    directors (may include major stockholders)
   In widely held corporations, top management in
    “control”
                                                     24
         Stockholders’ Claim on
           Income And Assets
 Stockholders have a residual claim on income
  and assets
 What is not paid out as dividends is retained for
  reinvestment in the business (retained earnings)
 Common stockholders are last in line, they bear
  more risk than other investors




                                                      25
                 Preferred Stock

 A hybrid security with characteristics of
  common stock and bonds
   Pays a constant dividend forever
   Specifies the initial selling price and the
    dividend
   No provision for the return of capital to the
    investor


                                                    26
       Valuation of Preferred Stock

 Since securities are worth the present value of
  their future cash flows, preferred stock is worth
  the present value of the indefinite stream of
  dividends.


                           
                               D   p
                   P   p
                               k


                                                      27
                                Preferred Stock
                                                                  Example 8.6



          Q: Roman Industries’ $6 preferred originally sold for $50. Interest
             rates on similar issues are now 9%. What should Roman’s
             preferred sell for today?
Example




          A: Just substitute the new market interest rate into the preferred
             stock valuation model to determine today’s price:
                     $6
             P
             0          $6 7
                           6
                          6.
                     0
                     .9




                                                                                28
              Characteristics of
               Preferred Stock

 Cumulative Feature - can’t pay common dividends
  unless cumulative preferred dividends are current
 Never returns principal
 Stockholders cannot force bankruptcy
 Receives preferential treatment over common
  stock in bankruptcy
    Lower priority than bondholders
 No voting rights
 Dividend payments not tax deductible to the firm

                                                      29
                Securities Analysis
The art and science of selecting investments
 Fundamental analysis looks at               a
  company’s business to forecast value
 Technical analysis bases value             on
  the pattern of past prices                and
  volume
 The Efficient Market Hypothesis (EMH) -
  financial markets are efficient since new
  information is instantly disseminated
    Impossible to consistently beat the market

                                                  30
                Options and Warrants

Options and warrants make it possible to
invest in stocks without holding shares
          Options                      Warrants
    Gives the holder the      Similar but less common
     temporary right to buy
     or sell an asset at a
     fixed price
    Speculate on price
     changes without holding
     the asset


                                                         31
                  Stock Options

Stock options speculate on stock             price
   movements
 Trade in financial markets
 Call option — option to buy
 Put option — option to sell
 Options are Derivative Securities
   Derive value from prices of underlying securities
   Provide leverage – amplifying returns
                                                        32
                   Writing Options

 People write options for the premium income, hoping
  that the option will never be exercised
 Option writers give up what option buyers make
 Covered option — writer owns underlying stock
 Naked option — writer does not own the underlying
  stock
   Purchase it at the current price if exercised



                                                    33
                            Warrants

Options                    Warrants
Trade between investors,   Issued by underlying company
not between the            When exercised – new stock is
companies that issue the   issued and company receives the
underlying stocks          exercise price
Secondary market           Primary market instruments while
instruments                options are secondary market
                           instruments




                                                              34
                    Warrants

 Similar to calls with a longer expiration
  period (several years vs. months)
 Issued as a “sweetener” (especially for
  risky bonds)
 Can generally be detached from another
  issue and sold separately



                                              35
        Employee Stock Options

 More like warrants than traded options
   Expire after several years
   Strike price set far out of the money
   May receive options in lieu of salary increases
 Wanted if future expectations are good
 Companies offering options may pay lower
  salaries
   Attract employees not otherwise affordable

                                                      36
       Employee Stock Options
  Executive Stock Option Problem
 Senior executives may receive most of the
  stock options
 Provide an incentive for executives to
  misstate financial statements and inflate
  stock prices
   Negatively impacts a firm’s pension plan if heavily
    invested in its own stock
   As a result of overhauling financial reporting,
    companies must recognize employee stock options as
    expenses when they are issued
                                                          37

				
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