chap 4c-stock and their valuation [compatibility mode]
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7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]
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CHAPTER 4
Stocks and Their Valuation
8-1
Features of common stock Determining common stock values Efficient markets Preferred stock
Facts about common stock
Represents ownership
Ownership implies control
8-2
oc o ers e ec rec ors
Directors elect management
Managements goal: Maximize thestock price
Social/Ethical Question
Should management be equally concernedabout employees, customers, suppliers,
and the public, or just the stockholders?
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In an enterprise economy, managementshould work for stockholders subject toconstraints (environmental, fair hiring,etc.) and competition.
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7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]
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Types of stock markettransactions
Secondary market Primary market
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(going public)
Different approaches forvaluing common stock
Dividend growth model
Corporate value model
8-5
s ng e mu p es o compara efirms
Dividend growth model
Value of a stock is the present value of thefuture dividends expected to be generated
by the stock.
8-6
+++
++
++
+=
)k(1
D...
)k(1
D
)k(1
D
)k(1
DP
s3
s
3
2s
2
1s
10
^
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7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]
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Constant growth stock
A stock whose dividends are expected to
grow forever at a constant rate, g.
D1 = D0 (1+g)1
8-7
D2 = D0 (1+g)2
Dt = D0 (1+g)t
If g is constant, the dividend growth formulaconverges to:
g-k
D
g-k
g)(1DP
s
1
s
00
^
=+
=
Future dividends and theirpresent values
t0t )g1(DD +=
$
8-8
t
tt
)k1(
DPVD
+=
t0 PVDP =
0.25
Years (t)0
What happens if g > ks?
If g > ks, the constant growth formulaleads to a negative stock price, which
does not make sense.
8-9
The constant growth model can only
be used if:
ks > g
g is expected to be constant forever
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7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]
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If kRF = 7%, kM = 12%, and = 1.2,what is the required rate of return onthe firms stock?
Use the SML to calculate the requiredrate of return (ks):
8-10
ks = kRF + (kM kRF)
= 7% + (12% - 7%)1.2
= 13%
If D0 = $2 and g is a constant 6%,find the expected dividend stream forthe next 3 years, and their PVs.
g = 6%0 1 2 3
8-11
1.8761
1.7599
D0 = 2.00
1.6509
ks = 13%
2.247 2.3822.12
What is the stocks marketvalue?
Using the constant growth model:
$2.12
DP ==
1
8-12
$30.29
0.07
$2.12
.-.g-s
=
=
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What is the expected market priceof the stock, one year from now?
D1 will have been paid out already. So,P1 is the present value (as of year 1) ofD2, D3, D4, etc.
8-13
Could also find expected P1 as:
$32.10
0.06-0.13
$2.247
g-k
DP
s
2^
1
=
==
$32.10(1.06)PP 0^
1 ==
What is the expected dividend yield,capital gains yield, and total returnduring the first year?
Dividend yield= D1/ P0 = $2.12 / $30.29 = 7.0%
Ca ital ains ield
8-14
= (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%
What would the expected pricetoday be, if g = 0?
The dividend stream would be aperpetuity.
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2.00 2.002.00
ks = 13% ...
$15.380.13
$2.00
k
PMTP
^
0 ===
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Supernormal growth:What if g = 30% for 3 years beforeachieving long-run growth of 6%?
Can no longer use just the constantgrowth model to find stock value.
However, the growth does become
8-16
constant after 3 years.
Valuing common stock withnonconstant growth
ks = 13%
g = 30% g = 30% g = 30% g = 6%
0 1 2 3 4...
8-17
P =
0.06
$66.5434.658
0.13
=
2.301
2.647
3.045
46.114
54.107 = P0^
0 = . . . . .
Find expected dividend and capital gainsyields during the first and fourth years.
Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
Capital gains yield (first year)
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= 13.00% - 4.81% = 8.19%
During nonconstant growth, dividend yieldand capital gains yield are not constant,and capital gains yield g.
After t = 3, the stock has constant growthand dividend yield = 7%, while capitalgains yield = 6%.
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7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]
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Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?
ks = 13%
g = 0% g = 0% g = 0% g = 6%
0 1 2 3 4...
8-19
0.06
$30.29P32.12
0.13=
=
1.77
1.57
1.39
20.99
25.72 = P0^
0 = . . . . .
Find expected dividend and capital gainsyields during the first and fourth years.
Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
8-20
= 13.00% - 7.78% = 5.22%
After t = 3, the stock has constantgrowth and dividend yield = 7%,while capital gains yield = 6%.
negative growth (g = -6%), wouldanyone buy the stock, and what is itsvalue?
The firm still has earnings and paysdividends, even though they may be
declining, they still have value.
8-21
$9.890.19
$1.88
(-0.06)-0.13
(0.94)$2.00
g-k
)g1(D
g-k
DP
s
0
s
1^
0
===
+==
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7/29/2019 Chap 4C-Stock and Their Valuation [Compatibility Mode]
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Find expected annual dividend andcapital gains yields.
Capital gains yield= g = -6.00%
Dividend yield
8-22
= 13.00% - (-6.00%) = 19.00%
Since the stock is experiencing constantgrowth, dividend yield and capital gainsyield are constant. Dividend yield issufficiently large (19%) to offset anegative capital gains.
Corporate value model
Also called the free cash flow method.Suggests the value of the entire firme uals the resent value of the firms
8-23
free cash flows.
Remember, free cash flow is the firmsafter-tax operating income less the netcapital investment
FCF = NOPAT Net capital investment
Applying the corporate value model
Find the market value (MV) of the firm. Find PV of firms future FCFs
Subtract MV of firms debt and preferred stock to
8-24
ge o common s oc . MV of = MV of MV of debt and
common stock firm preferred
Divide MV of common stock by the number ofshares outstanding to get intrinsic stock price(value). P0 = MV of common stock / # of shares
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Issues regarding thecorporate value model
Often preferred to the dividend growthmodel, especially when considering numberof firms that dont pay dividends or when
8-25
ivi en s are ar to orecast.
Similar to dividend growth model, assumesat some point free cash flow will grow at aconstant rate.
Terminal value (TVn) represents value of firmat the point that growth becomes constant.
Given the long-run gFCF = 6%, andWACC of 10%, use the corporate valuemodel to find the firms intrinsic value.
k = 10%0 1 2 3 4
8-26
g = 6%21.20-5 10 20
...
416.942
-4.5458.264
15.026398.197
21.20
530 = = TV30.10 0.06-
If the firm has $40 million in debt andhas 10 million shares of stock, what isthe firms intrinsic value per share?
MV of equity = MV of firm MV of debt
= $416.94m - $40m
=
8-27
.
Value per share = MV of equity / # of shares
= $376.94m / 10m
= $37.69
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Firm multiples method
Analysts often use the following multiplesto value stocks.
P / E
8-28
P / CF
P / Sales
EXAMPLE: Based on comparable firms,estimate the appropriate P/E. Multiply thisby expected earnings to back out anestimate of the stock price.
What is market equilibrium?
In equilibrium, stock prices are stable andthere is no general tendency for people tobuy versus to sell.
8-29
n equ r um, expec e re urns mus equarequired returns.
+==+= )k(kkkgP
Dk
RFMRFs
0
1^
s
Market equilibrium
Expected returns are obtained byestimating dividends and expected
ca ital ains.
8-30
Required returns are obtained by
estimating risk and applying the CAPM.
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How is market equilibriumestablished?
If expected return exceeds requiredreturn
The current rice P is too low and
8-31
offers a bargain.
Buy orders will be greater than sellorders.
P0 will be bid up until expected returnequals required return
Factors that affect stock price
Required return (ks) could change
Changing inflation could cause kRF tochan e
8-32
Market risk premium or exposure tomarket risk () could change
Growth rate (g) could change
Due to economic (market) conditions
Due to firm conditions
What is the Efficient MarketHypothesis (EMH)?
Securities are normally in equilibriumand are fairly priced.
Investors cannot beat the market
8-33
except through good luck or betterinformation.
Levels of market efficiency Weak-form efficiency
Semistrong-form efficiency
Strong-form efficiency
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Weak-form efficiency
Cant profit by looking at past trends.A recent decline is no reason to thinkstocks will o u or down in the
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future.
Evidence supports weak-form EMH,but technical analysis is still used.
Semistrong-form efficiency
All publicly available information isreflected in stock prices, so itdoesnt a to over anal ze annual
8-35
reports looking for undervaluedstocks.
Largely true, but superior analystscan still profit by finding and using
new information
Strong-form efficiency
All information, even insideinformation, is embedded in stock
rices.
8-36
Not true--insiders can gain by
trading on the basis of insiderinformation, but thats illegal.
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Is the stock market efficient? Empirical studies have been conducted to
test the three forms of efficiency. Most ofwhich suggest the stock market was: Highly efficient in the weak form.
8-37
Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders
could and did make abnormal (and sometimesillegal) profits.
Behavioral finance incorporateselements of cognitive psychology tobetter understand how individuals andmarkets respond to different situations.
Preferred stock
Hybrid security
Like bonds, preferred stockholdersreceive a fixed dividend that must be
8-38
paid before dividends are paid tocommon stockholders.
However, companies can omitpreferred dividend payments withoutfear of pushing the firm into
bankruptcy.
If preferred stock with an annualdividend of $5 sells for $50, what is thepreferred stocks expected return?
Vp = D / kp$50 = $5 / k
p
8-39
kp = $5 / $50
= 0.10 = 10%
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