Valuation _ Characteristics of Stocks - Chapter 7 by decree

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									                     Chapter 7


                The Valuation and
            Characteristics of Stock


Slides developed by:
 Pamela L. Hall, Western Washington University
Common Stock

   Background
       Stockholders own the corporation, but in
        many instances the corporation is widely held
         • Stock ownership is spread among a large number
           of people
       Because of this, most stockholders are only
        interested in how much money they will
        receive as a stockholder
         • Most equity investors aren’t interested in a role as
           owners

                                                                  2
The Return on an Investment in
Common Stock
   The future cash flows associated with stock ownership consists of
        Dividends
        The eventual selling price of the shares
   If you buy a share of stock for price P0, hold it for one year during
    which time you receive a dividend of D1, then sell it for a price P1,
    you return, k, would be:
                  D1+ P1-P0 
          k=
                           P0                        A capital gain (loss) occurs
                      or                              if you sell the stock for a
                                                      price greater (lower) than
              D1                  P1-P0 
    k=                     +                                you paid for it.
              P0                      P0
          dividend yield       capital gains yield



                                                                                    3
The Return on an Investment in
Common Stock
   We can solve the previous equation for P0, the stock’s
    price today:
          kP0  D1   P1  P0 
     P0  kP0  D1  P1
    1  k  P0  D1  P1
                D1  P1
           P0 
                1  k 
   The return on our 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
       The expected receipt of dividends and the
        future selling price of stock is similar to
        what a bondholder expects in terms of
        interest and principal repayment
         • However, with bondholders:
            •   A guarantee is associated with their interest payments
            •   Interest payments are constant
            •   The maturity value of a bond is fixed
            •   When the bond matures, the investor receives contracted
                par or face value from the issuing company
                  • When stock is sold, the 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
       Must make assumptions about what the future
        dividends and selling price will be
         • Discount these assumptions at an appropriate interest rate
           P0 = D1 PVFk,1   D2 PVFk,2  
                                             Dn PVFk,n   Pn PVFk,n 
                                                                         




                                                                                6
The Basis of Value—Example
          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?
          A: Joe shouldn’t pay more than the present value of the cash flows he
             expects: $2 at the end of one year and $3.50 plus $75 at the end of
             two years.

             P0 = $2 PVF12%,1   $3.50 PVF12%,2   $75 PVF12%,2 
                                                                
                 $2[0.8929]  $3.50[0.7972]  $75.00[0.7972]
                 $64.37



                                                                                        7
The Intrinsic (Calculated) Value
and Market Price
   A stock’s intrinsic value is based on
    assumptions made by a potential investor
       Must estimate future expected cash flows
         • Need to perform a fundamental analysis of the firm
           and the industry
   Different investors with different cash flow
    estimates will have different intrinsic
    values


                                                            8
Growth Models of Common
Stock Valuation
   Realistically most people tend to forecast
    growth rates rather than cash flows
       Because forecasting exact future prices and
        dividends is very difficult




                                                      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
                     D1      D2                Dn                Pn
            P0 =                                        
                   1 k  1 k  2
                                             1 k 
                                                       n
                                                               1 k 
                                                                         n




   An Infinite Stream of Dividends
       Many investors buy a stock, hold for awhile, then sell, as
        represented in the above equation
         • However, this is 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:
                  Dn + 1          Dm           Pm
        Pn =              +…+            +
                 1 + k      1 + k
                                     m-n
                                           1 + k
                                                  m-n




   Repeating this process until infinity results in:
         
                 Di
    P0  
               1 + k 
                      i
         i=1


   Conceptually it’s possible to replace the final
    selling price with an infinite series of dividends
                                                         11
Working with Growth Rates

   Growth rates work like interest rates
       If growth is expected to be 6% next year then
        $100 experiencing a 6% growth will increase
        by $6, or $100 x 6%
         • The ending value after 6% growth will be $106, or
           $100 + $6, or $100 x (1.06)




                                                           12
The Constant Growth Model
   If dividends are assumed to be growing at a constant rate forever
    and we know the last dividend paid, D0, then the model simplifies to:

                 D0 1  i 
                               1
           
    P0  
                  1 + k 
                           i
           i=1

   Which represents a series of fractions as follows

           D0 1  g              D0 1  g              D0 1  g 
                                                   2                       3

    P0 =                                                                        
               1  k              1  k 
                                               2
                                                            1  k 
                                                                       3


   If k>g the fractions get smaller (approach zero) as the exponents
    get larger
        If k>g growth is normal
        If k<g growth is supernormal
           • Can occur but lasts for limited time period

                                                                                       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
          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?

          A:         D1
Example




               P0 
                    k-g
                    $2.25 (1.06)
                 
                     .11 - .06
                  $47.70



                                                                              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

   Can 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
       For example, a new product may lead to temporary
        high growth
   The two-stage growth model allows us to value
    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

          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

          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:
                       D3        $3.05
                 P2                     $76.25
                      k - g2   .10 - .06


                                                                       20
Two Stage Growth—Example

          Then we take the present value of D1, D2 and P2:
          P0  D1 PVFk, 1  + D2 PVFk, 2  + P2 PVFk, 2 
                                                      
              $2.40 PVF10, 1  + $2.88 PVF10, 2  + $76.25 PVF10, 2 
                                                                   
              $2.40 0.9091 + $2.88 0.8264  + $76.25 0.8264
Example




              $67.57


               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 approximate results
    because the inputs are approximations of reality
       Bond valuation is precise because inputs are exact
         • With bonds future cash flows are contractually guaranteed in
           amount and time
   Actual growth rate can be VERY different from predicted
    growth rates
       Even if growth rates differ only slightly, it can make a big
        difference in our decision
   So, it’s best to allow a margin for error in your
    estimations


                                                                          22
Practical Limitations of Pricing
Models
   Stocks That Don’t Pay Dividends
       Some firms don’t pay dividends even if they are
        profitable
       Many companies claim they never intend to pay
        dividends
         • These firms can still have a substantial stock price
       Firms of this type typically are growing and are using
        their profits to finance their growth
         • However rapid growth won’t last forever
         • When growth slows, the firm will begin paying dividends
             • It’s these distant dividends that impart value




                                                                     23
Some Institutional Characteristics
of Common Stock
   Corporate Organization and Control
       Controlled by Board of Directors (elected by stockholders)
       Board appoints top management who then appoint middle/lower
        management
       Board consists of: top management and outside members
        (major stockholders, top executives at other firms, former
        presidents, etc.)
       In widely held corporations, top management is effectively in
        control of the firm because no stockholder group has enough
        power to remove them
   Preemptive Rights
       If firm issues new shares, existing shareholders have right to
        purchase pro rata share of new issue
       Common, but not required by law


                                                                         24
Voting Rights and Issues

   Each share of common stock has one
    vote in the election of directors, which is
    usually cast by proxy
       A proxy fight occurs if parties with conflicting
        interests solicit proxies at the same time




                                                           25
Majority and Cumulative Voting

   Majority voting gives the larger group control of
    the company
   Cumulative voting gives minority interest a
    chance at some representation on the board
   Shares With Different Voting Rights
       Different classes of stock can be issued with different
        rights
         • Some stock may be issued with limited or no voting rights




                                                                       26
Stockholders’ Claim on Income
And Assets
   Stockholders have claim on the firm’s net
    income
   What is not paid out as dividends is retained
    (Retained Earnings) for investment in new
    projects
       Leads to future growth
   Common stockholders are last in line to receive
    income or assets, and bear more risk than other
    investors
       However, residual interest is large when firm does
        well

                                                             27
Preferred Stock

   Preferred stock is often referred to as a
    hybrid between common stock and bonds
    because:
     No maturity date (like common stock)
     Fixed dividend payment (similar to bond
      interest payment)




                                                28
Valuation of Preferred Stock

   There is no growth rate in preferred stock
    dividends, so growth rate equals 0
   The dividend at time 1 is the same as the
    dividend at time 0, so there is usually no time
    period associated with the numerator
       Valuation is that of a perpetuity

                
                    D   p
        P   p
                    k




                                                      29
Preferred Stock—Example

          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
             P0            $66.67
                  .09




                                                                                30
Characteristics of
Preferred Stock
   Cumulative Feature
        Common dividends can’t be paid unless the dividends on cumulative
         preferred are current
   Preferred stock never returns principal (like a bond does upon
    maturity)
   Preferred stockholders cannot force a firm into bankruptcy (like
    bondholders)
   Preferred stockholders received preferential treatment over
    common stockholders in the event of bankruptcy, but have a lower
    priority than bondholders
   Preferred stockholders do not have voting rights (like common
    stockholders do)
   Dividend payments to preferred stockholders are not tax deductible
    to the firm



                                                                             31
Securities Analysis
   Securities analysis is the art and science of
    selecting investments
   Fundamental analysis looks at a company and
    its business to forecast value
   Technical analysis bases value on the pattern of
    past prices and volumes
   The Efficient Market Hypothesis says
    information moves so rapidly in financial
    markets that price changes occur immediately,
    so it is impossible to consistently beat the
    market to bargains
                                                   32
Options and Warrants
   Option gives the option holder the temporary right to buy
    (or sell) an asset from another party at a fixed price
   For instance, a company may be interested in building a
    new factory on a tract of land, but it is still unsure if it
    wants to build the factory
       However, it plans to make a final decision in six months
       The company could buy an option contract giving it the right to
        buy the land at a fixed price by the end of the six months
         • If the company pursues the factory project, it would exercise the
           option
         • If the company decided not to go ahead with the factory project it
           would not have to exercise the option
             • But what if the value of the land had risen substantially above the price
               fixed by the option—it could exercise the option and sell the land for a
               profit thus benefiting even though it didn’t own the land during the
               period of the option



                                                                                      33
Stock Options

 Stock options are purchased to speculate
  on stock price movements
 Can be traded in financial markets
 Call option (call)—an option to buy a stock
 Put option (put)—an option to sell stock
 Known as a derivative—derives its value
  from the price of an underlying security


                                            34
Call Option

   Basic call option
       Gives owner the right to buy stock at a fixed
        price (called the exercise or strike price) for a
        specified time period
         • Usually 3, 6 or 9 months
     Option expires at the end of the time period
     Price of the option is less than the price of the
      underlying stock



                                                        35
Figure 7-3: Basic Call Option
Concepts




  If the option is selling for $1 and the stock’s price increased to
   $63 the option could be exercised and the stock immediately
      sold, resulting in a profit of $3 less the price of the option
 contract (a $2 profit on a $1 investment, or a 200% return). If the
 stock price doesn’t exceed $60 before the option expires, the $1
                          is lost (a 100% loss).



                                                                       36
Call Options

   The more volatile the stock’s price the
    more attractive the option
       The stock’s price is more likely to exceed the
        strike price before the option expires
   The longer the time until expiration the
    more attractive the option
       The stock’s price is more likely to exceed the
        strike price before the option expires


                                                     37
The Call Option Writer

   The option writer is the person who
    creates the contract
       Agrees to sell the stock at the strike price if
        the option is exercised
 The original writer must stand ready to
  deliver on the contract regardless of how
  many times the option is sold
 Call writer hopes stock price will remain
  the same
                                                          38
Intrinsic Value

 A call option’s intrinsic value is the
  difference between the underlying stock’s
  current price and the option’s strike price
 If the option is out-of-the-money then the
  intrinsic value is zero
 Option will always sell for intrinsic value or
  above
       Difference between option’s intrinsic value
        and price is known as time value
                                                      39
Figure 7-4: The Value of a Call
Option




                                  40
Options and Leverage

   Financial leverage
       Technique that amplifies return on investment
         • Improves positive returns and worsens negative
           returns
   Options offer leveraging potential due to
    the lower price at which you can buy an
    option compared to the price of the
    underlying stock
       The higher the price of the option the less the
        leverage potential

                                                            41
Options that Expire

 Option investing is risky because options
  expire after a limited time
 If the option was purchased out-of-the-
  money and the stock price never exceeds
  the strike price prior to the expiration date
  the option will expire worthless
       Resulting in a 100% loss
   As the expiration date approaches an
    option’s time value approaches zero
                                              42
Trading in Options
   Options can be bought and sold at any time prior to
    expiration
       Chicago Board Options Exchange (CBOE) is the largest, oldest
        and best known options exchange
   Price volatility in the options market
       As the price of the underlying stock changes the price of the
        option changes but by a greater relative movement due to the
        lower price of the option compared to the stock
   Options are rarely exercised before expiration
       If the call option owner believes a stock is unlikely to increase
        further he is likely to sell the option rather than exercise it as he
        would lose any time premium if he were to exercise the option




                                                                            43
Writing Options

   People write options for the premium income,
    hoping that the option will never be exercised
   Option writers lose whatever option buyers win
       Take the opposite side of a bet
   Covered option—the writer owns the underlying
    stock
   Naked option—the writer does not own the
    underlying stock and must purchase it at the
    current price should the option be exercised


                                                     44
Option Example
             The following information refers to a three-month call option on
             the stock of Oxbow, Inc.
                   Price of the underlying stock: $30
                   Strike price of the three-month call: $25
                   Market price of the option: $8
Example




          Q: What is the intrinsic value of the option?
          A: The intrinsic value represents by how much the option is in-the-
             money. Since the stock price is $30 and the call option’s strike
             price is $25, the option is in-the-money by $5, which is the
             intrinsic value.
          Q: What is the option’s time premium at this price?
          A: The time premium represents the difference between the
             market price of the option and the intrinsic value, or $8 - $5 =
             $3.


                                                                            45
Option Example
          Q: If an investor writes and sells a covered call option, acquiring
             the covering stock now, how much has he invested?
          A: The premium ($8) that the writer receives for the option will
             offset some of the purchase price of the stock ($30), therefore
             the investor has invested $30 - $8 = $22.
          Q: What is the most the buyer of the call can lose?
Example




          A: The buyer can lose, at most, 100% of his investment which is
             the purchase price of the option of $8.
          Q: What is the most the writer of a naked call option on this stock
             can lose?
             In theory since the stock price can rise to any price the writer
             can lose an infinite amount. However, a prudent writer would
             limit his losses by purchasing the stock once it started to rise in
             value.


                                                                               46
Option Example
          Just before the option’s expiration Oxbow is selling for $32.
          Q: What is the profit or loss from buying the call?
          A: The buyer would exercise the option paying $25 for the stock and
             simultaneously selling the stock for $32, resulting in a gain of $7.
             However, this gain would be offset by the $8 premium paid for the
             option, resulting in an overall loss of $1.
Example




          Q: What is the profit or loss from writing the call naked?
          A: A naked writer would have to buy the stock for $32 and sell it to the
             option owner for $25, resulting in a loss of $7. However, this loss would
             be offset by the premium received on the writing of the option of $8,
             resulting in an overall gain of $1.
          Q: What is the profit or loss from writing the call covered if the covering
             stock was acquired at the time the call was written?
          A: The call writer bought the stock for $30 and sold it for $25, resulting in a
             loss of $5, but the loss is offset by the $8 premium received for writing
             the option. The overall gain is $3.


                                                                                      47
Put Options

 An option to sell an underlying asset at a
  specified price by a specified date
 Would buy a put if you thought the price of
  the underlying asset were going to fall
 Intrinsic value is how much the option is
  in-the-money
 Option is in-the-money if the strike price is
  lower than the current stock price

                                              48
Figure 7.5: Basic Put Option
Concepts




                               49
Figure 7.6: The Value of a Put
Option




                                 50
Option Pricing Models

   Option pricing model is more difficult than
    pricing models for stocks and bonds
   Fischer Black and Myron Scholes developed the
    Black-Scholes Option Pricing Model
       Determines option’s price based on
         •   Price of underlying stock
         •   Strike price of option
         •   Time remaining until expiration of option
         •   Volatility of underlying stock’s market price
         •   Risk-free interest rate



                                                             51
Warrants

 Options trade between investors, not
  between the companies that issue the
  underlying stocks
 Warrants are issued by the underlying
  companies
       When the warrant is exercised the company
        issues new stock and receives the exercise
        price
         • Thus, warrants are primary market instruments
           while options are secondary market instruments


                                                            52
Warrants

 Similar to call options but have a longer
  expiration period (several years vs.
  months)
 Usually issued as a “sweetener” (for
  bonds, for instance)
 Warrants can generally be detached from
  another issue and sold separately


                                              53
Employee Stock Options
   More like warrants than traded options
       Don’t expire for several years
       Strike prices are set far out of the money
       Employees who receive options generally receive a
        lower salary than they would otherwise
   If a company is expected to have a good future
    employees may want to receive options
   Companies like paying with options because
    they can pay the employees a lower salary
       Argue that options allow up-and-coming companies
        to attract talented employees that they couldn’t
        otherwise afford


                                                            54
The Executive Stock Option
Problem
 Senior executives are usually the people
  who receive the most stock options
 Tactic has been criticized recently
       May cause executive to try to increase stock
        price in unethical ways
         • Manipulating financial results driving the stock
           price higher
            • Market should eventually realize the problem and drive
              the stock down but executives have already exercised
              their stock options and sold the stock at the inflated price


                                                                        55
The Executive Stock Option
Problem
   This can negatively impact a firm’s pension plan if it is
    heavily invested in its firm’s own stock
   In the early 2000s investors realized that auditors
    couldn’t (or wouldn’t) always report financial
    manipulations
       Enron, WorldCom, Tyco
       Resulted in a loss of investor confidence in corporate
        management
   One result of the overhaul of financial reporting is the
    requirement that companies recognize employee stock
    options as expenses at the time they are issued
       Problem is that no one knows how high the stock will rise in
        value at the time the options are issued


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