# CHAPTER 8 Stocks and Their Valuation

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```					Stocks and Their Valuation

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

8-1
   Represents ownership
   Ownership implies control
   Stockholders elect directors
   Directors elect management
   Management’s goal: Maximize the
stock price

8-2
Social/Ethical Question
   Should management be equally concerned
and “the public,” or just the stockholders?
   In an enterprise economy, management
should work for stockholders subject to
constraints (environmental, fair hiring,
etc.) and competition.

8-3
Types of stock market
transactions
   Secondary market
   Primary market
   Initial public offering market
(“going public”)

8-4
Different approaches for
valuing common stock
   Dividend growth model
   Corporate value model
   Using the multiples of comparable
firms

8-5
Dividend growth model
   Value of a stock is the present value of the
future dividends expected to be generated by
the stock.

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

8-6
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              
ks - g      ks - g
8-7
Future dividends and their
present values
t
\$             D t  D0 ( 1  g )

Dt
0.25          PVD t 
( 1  k )t

P0   PVD t

0                                  Years (t)
8-8
What happens if g > ks?
   If g > ks, the constant growth formula
leads to a negative stock price, which
does not make sense.
   The constant growth model can only be
used if:
   ks > g
   g is expected to be constant forever

8-9
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
ks = 13%
1.7599
1.6509

8-10
What is the stock’s market value?
   Using the constant growth model:

D1      \$2.12
P0         
k s - g 0.13 - 0.06
\$2.12

0.07
 \$30.29

8-11
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         
k s - g 0.13 - 0.06
 \$32.10

   Could also find expected P1 as:
^
P1  P0 (1.06)  \$32.10
8-12
What is 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 (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%

8-13
What would the expected price
today be, if g = 0?
   The dividend stream would be a
perpetuity.

0               1         2           3
ks = 13%
...
2.00     2.00         2.00
^   PMT \$2.00
P0            \$15.38
k   0.13

8-14
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.

8-15
Valuing common stock with
nonconstant growth

0 k = 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
8-16
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%.
8-17
Nonconstant growth:
What if g = 0% for 3 years before long-
run growth of 6%?

0 k = 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
8-18
Find expected dividend and capital gains
yields during the first and fourth years.

   Dividend yield (first year)
= \$2.00 / \$25.72 = 7.78%
   Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
   After t = 3, the stock has constant
growth and dividend yield = 7%,
while capital gains yield = 6%.

8-19
If the stock was expected to have
negative growth (g = -6%), would anyone
buy the stock, and what is its value?

   The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.

^     D1      D0 ( 1  g )
P0         
ks - g     ks - g
\$2.00 (0.94) \$1.88
                     \$9.89
0.13 - (-0.06) 0.19

8-20
Find expected annual dividend and
capital gains yields.
   Capital gains yield
= g = -6.00%
   Dividend yield
= 13.00% - (-6.00%) = 19.00%

   Since the stock is experiencing constant
growth, dividend yield and capital gains
yield are constant. Dividend yield is
sufficiently large (19%) to offset a negative
capital gains.
8-21
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
8-22
Issues regarding the
corporate value model
   Often preferred to the dividend growth
model, especially when considering number
of firms that don’t pay dividends or 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.
8-23
Given the long-run gFCF = 6%, and
WACC of 10%, use the corporate value
model to find the firm’s intrinsic value.

0 k = 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

8-24
Firm multiples method
   Analysts often use the following multiples
to value stocks.
   P/E
   P / CF
   P / Sales
   EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.
8-25
Factors that affect stock price
   Required return (ks) could change
   Changing inflation could cause kRF to
change
   Market risk premium or exposure to
market risk (β) could change
   Growth rate (g) could change
   Due to economic (market) conditions
   Due to firm conditions
8-26
What is the Efficient Market
Hypothesis (EMH)?
   Securities are normally in equilibrium
and are “fairly priced.”
   Investors cannot “beat the market”
except through good luck or better
information.
   Levels of market efficiency
   Weak-form efficiency
   Semistrong-form efficiency
   Strong-form efficiency
8-27
Weak-form efficiency
   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.

8-28
Semistrong-form efficiency
   All publicly available information is
reflected in stock prices, so it doesn’t
pay to over analyze annual reports
looking for undervalued stocks.
   Largely true, but superior analysts
can still profit by finding and using
new information

8-29
Strong-form efficiency
   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.

8-30
Is the stock market efficient?
   Empirical studies have been conducted to
test the three forms of efficiency. Most of
which suggest the stock market was:
   Highly efficient in the weak form.
   Reasonably efficient in the semistrong form.
   Not efficient in the strong form. Insiders could
and did make abnormal (and sometimes
illegal) profits.
   Behavioral finance – incorporates elements
of cognitive psychology to better
understand how individuals and markets
respond to different situations.
8-31
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.
8-32
If preferred stock with an annual
dividend of \$5 sells for \$50, what is the
preferred stock’s expected return?

Vp = D / kp
\$50 = \$5 / kp

kp = \$5 / \$50
= 0.10 = 10%

8-33

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