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CHAPTER 09 - Stocks and Their Valuation

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CHAPTER 09 - Stocks and Their Valuation Powered By Docstoc
					CHAPTER 9
Stocks and Their Valuation

    Features of common stock
    Determining common stock values
    Preferred stock


                                       9-1
     Facts about common stock
   Represents ownership
   Ownership implies control
   Stockholders elect directors
   Directors elect management
   Management’s goal: Maximize the stock
    price


                                            9-2
         Intrinsic Value and Stock Price
   Outside investors, corporate insiders, and analysts
    use a variety of approaches to estimate a stock’s
    intrinsic value (P0).
   In equilibrium we assume that a stock’s price equals
    its intrinsic value.
      Outsiders estimate intrinsic value to determine
            stocks are attractive to buy
            Stocks to be sold
       Stocks with a price below (above) its intrinsic
        value are undervalued (overvalued).

                                                          9-3
Different approaches for estimating the
intrinsic value of a common stock

   i Dividend growth model

   ii Corporate value model

   iii Compare multiples of similar firms



                                          9-5
    i Dividend growth model
     Value of a stock is the present value of the
      future dividends expected to be generated by
      the stock.
    (Present Value)

^       D1           D2            D3                  D
P0                                        ... 
     (1  rs )1
                  (1  rs ) 2
                                (1  rs ) 3
                                                    (1  rs ) 



                                                              9-6
Constant growth stock
   A stock whose dividends are expected to
    grow forever at a constant rate, g.

       D1 = D0 (1+g)1
       D2 = D0 (1+g)2
       Dt = D0 (1+g)t

   If g is constant, the dividend growth formula
    converges to:
           ^    D 0 (1  g)     D1
           P0              
                   rs - g     rs - g
                                               9-7
 Future dividends and their
 present values
                                       t
   $              D t  D0 ( 1  g )



                           Dt
0.25           PVD t 
                       ( 1  r )t


                        P0   PVD t

       0                                   Years (t)
                                                  9-8
What happens if g > Rs [ReqRet]?

      If g > rs, the constant growth formula
       leads to a negative stock price, which
       does not make sense.
      The constant growth model can only be
       used if:
          rs > g
          g is expected to be constant forever

                                                  9-9
If rRiskFree = 7%, rM = 12%, and ß = 1.2,
what is the required rate of return on the
firm’s stock?
      Use the SML to calculate the required
       rate of return (rs):

       rs = rRF + (rMkt – rRF) ß
          = 7% + (12% - 7%)1.2
          = 13%
   SML: Security Market Line
                                             9-10
  If D0 = $2 and g is a constant 6%,
  find the expected dividend stream for
  the next 3 years, and their PVs.


     0             1           2      3
         g = 6%


D0 = 2.00         2.12        2.247   2.382
   1.8761
                   rs = 13%
  1.7599
  1.6509


                                              9-11
What is the stock’s intrinsic value?
   Using the constant growth model:

       ˆ  D1  $2.12
       P0
          rs - g 0.13 - 0.06
           $2.12
         
            0.07
          $30.29



                                       9-12
What is the expected market price
of the stock, one year from now?
   D1 will have been paid out already. So,
    P1 is the present value (as of year 1) of
    D2, D3, D4, etc.
             ^     D2     $2.247
            P1        
                 rs - g 0.13 - 0.06
                $32.10

   Could also find expected P1 as:
           ^
           P1  P0 (1.06)  $32.10
                                                9-13
What are the expected dividend yield,
capital gains yield, and total return
during the first year?
   Dividend yield
      = D1 / P0 = $2.12 / $30.29 = 7.0%
   Capital gains yield
      = (P1 – P0) / P0
      = ($32.10 - $30.29) / $30.29 = 6.0%
   Total return (rs)
      = Dividend Yield + Capital Gains Yield
      = 7.0% + 6.0% = 13.0%

                                               9-14
What would the expected price
today be, if g = 0?
   The dividend stream would be a
    perpetuity.

0               1         2           3
    rs = 13%
                                          ...
               2.00     2.00         2.00
     ^   PMT $2.00
    P0            $15.38
          r   0.13

                                                9-15
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
   Can no longer use just the constant growth
    model to find stock value.
   However, the growth does become
    constant after 3 years.




                                            9-16
     Valuing common stock with
     nonconstant growth

     0 r = 13% 1               2              3              4
        s
                                                              ...
       g = 30%       g = 30%       g = 30%        g = 6%
D0 = 2.00        2.600         3.380         4.394         4.658
    2.301
    2.647
    3.045
                                             4.658
   46.114                          $
                                   P3                      $66.54
                 ^                        0.13 - 0.06
  54.107    = P0
                                                                   9-17
Find expected dividend and capital gains
yields during the first and fourth years.
   Dividend yield (first year)
      = $2.60 / $54.11 = 4.81%
   Capital gains yield (first year)
      = 13.00% - 4.81% = 8.19%
   During nonconstant growth, dividend yield
    and capital gains yield are not constant,
    and capital gains yield ≠ g.
   After t = 3, the stock has constant growth
    and dividend yield = 7%, while capital
    gains yield = 6%.
                                             9-18
     Nonconstant growth:
     What if g = 0% for 3 years before long-
     run growth of 6%?

     0 r = 13% 1                2              3               4
        s
                                                                ...
       g = 0%          g = 0%       g = 0%          g = 6%
D0 = 2.00           2.00        2.00          2.00            2.12
    1.77
    1.57
    1.39
                                             2.12
   20.99                            $
                                    P3                       $30.29
                ^                          0.13 - 0.06
  25.72     = P0
                                                                     9-19
    ii Corporate value model
   Also called the free cash flow method.
    Suggests the value of the entire firm
    equals the present value of the firm’s
    free cash flows.
   Remember, free cash flow is the firm’s
    after-tax operating income less the net
    capital investment
       FCF = NOPAT – Net capital investment
                                               9-23
    Applying the corporate value model

   Find the market value (MV) of the firm,
    by finding the PV of the firm’s future
    FCFs.
   Subtract MV of firm’s debt and preferred
    stock to get MV of common stock.
   Divide MV of common stock by the
    number of shares outstanding to get
    intrinsic stock price (value).
                                         9-24
        Issues regarding the
        corporate value model
   Preferred to the dividend growth model,
       Firms that don’t pay dividends
       When dividends are hard to forecast.
   Similar to dividend growth model, assumes at
    some point free cash flow will grow at a constant
    rate.
   Terminal value (TVN) represents value of firm at
    the point that growth becomes constant.

                                                  9-25
   Given the long-run gFCF = 6%, and
   WACC of 10%, use the corporate value
   model to find the firm’s intrinsic value.


   0 r = 10%   1    2         3                4
                                                   ...
                                   g = 6%
               -5   10        20              21.20
 -4.545
  8.264
 15.026                               21.20
398.197                    530 =                    = TV3
                                   0.10 - 0.06
416.942

                                                     9-26
If the firm has $40 million in debt and
has 10 million shares of stock, what is
the firm’s intrinsic value per share?
   MV of equity = MV of firm – MV of debt
                 = $416.94 - $40
                 = $376.94 million
   Value per share = MV of equity / # of shares
                    = $376.94 / 10
                    = $37.69



                                             9-27
         iii Firm multiples method
   Analysts often use the following multiples to
    value stocks.
       P / E -- Price Earnings Ratio
       P / CF -- Price Cash Flow Ratio
       P / Sales -- Price Sales Ratio

EXAMPLE: Based on comparable firms, estimate
  the appropriate P/E. Multiply this by expected
  earnings to back out an estimate of the stock
  price.

                                                    9-28
What is market equilibrium?
   In equilibrium, stock prices are stable and
    there is no general tendency for people to
    buy versus to sell.
   In equilibrium, two conditions hold:
       The current market stock price equals its
                              ^
        intrinsic value (P0 = P0).
       Expected returns must equal required returns.
        ^    D1
        rs     g         rs  rRF  (rM - rRF )b
             P0
                                                      9-29
Market equilibrium
   Expected returns determined by:
       estimating dividends
        and expected capital gains.
   Required returns are determined by
    estimating risk and applying the CAPM

           (Capital Asset Pricing Model)

                                           9-30
How is market equilibrium
established?
   If price is below intrinsic value …
       The current price (P0) is “too low” and
        offers a bargain.
       Buy orders will be greater than sell orders.
       P0 will be bid up until expected return
        equals required return.


                                                  9-31
        How are the equilibrium
        values determined?
Are equilibrium intrinsic value and expected return
estimated
       Managers
       Something else?


Equilibrium levels are based on the market’s
estimate of intrinsic value and the market’s required
rate of return -- dependent upon the attitudes of
the marginal investor.
                                                  9-32
Preferred stock
   Hybrid security.
   Like bonds, preferred stockholders
    receive a fixed dividend that must be
    paid before dividends are paid to
    common stockholders.
   However, companies can omit
    preferred dividend payments without
    fear of pushing the firm into
    bankruptcy.
                                        9-33
If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?

 Vp = D / r p
 $50 = $5 / rp

  ^ = $5 / $50
  rp
     = 0.10 = 10%



                                        9-34

				
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