CHAPTER 8 Stocks and Their Valuation

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CHAPTER 8 Stocks and Their Valuation Powered By Docstoc
					CHAPTER 8
Stocks and Their Valuation

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

                                       8-1
Facts about common stock
   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
    about employees, customers, suppliers,
    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 kRF = 7%, kM = 12%, and β = 1.2,
what is the required rate of return on
the firm’s stock?
   Use the SML to calculate the required
    rate of return (ks):

       ks = kRF + (kM – kRF)β
          = 7% + (12% - 7%)1.2
          = 13%


                                         8-10
  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
                   ks = 13%
  1.7599
  1.6509


                                              8-11
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



                                       8-12
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         
                 k s - g 0.13 - 0.06
                $32.10

   Could also find expected P1 as:
           ^
           P1  P0 (1.06)  $32.10
                                                8-13
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%

                                               8-14
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

                                                8-15
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.




                                            8-16
     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
                                                                   8-17
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%.
                                            8-18
     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
                                                                     8-19
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%.

                                          8-20
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

                                           8-21
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.
                                               8-22
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
                                               8-23
        Applying the corporate value model
   Find the market value (MV) of the firm.
       Find PV of firm’s future FCFs
   Subtract MV of firm’s debt and preferred stock to
    get MV of common stock.
          MV of     = MV of – MV of debt and
        common stock    firm      preferred
   Divide MV of common stock by the number of
    shares outstanding to get intrinsic stock price
    (value).
       P0 = MV of common stock / # of shares
                                                      8-24
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.
                                            8-25
   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

                                                     8-26
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
                 = $416.94m - $40m
                 = $376.94 million
   Value per share = MV of equity / # of shares
                    = $376.94m / 10m
                    = $37.69



                                             8-27
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.
                                                 8-28
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, expected returns must equal
    required returns.
    ^
         D1
    ks     g        k s  k RF  (k M - k RF )
         P0


                                                8-29
Market equilibrium
   Expected returns are obtained by
    estimating dividends and expected
    capital gains.
   Required returns are obtained by
    estimating risk and applying the CAPM.




                                       8-30
How is market equilibrium
established?
   If expected return exceeds required
    return …
       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

                                             8-31
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
                                                8-32
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
                                         8-33
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.


                                         8-34
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

                                           8-35
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.


                                        8-36
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.
                                                    8-37
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.
                                        8-38
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%



                                       8-39