Chapter 07Stocks & Valuation

ValueStock = + + +D1 D2 D∞

(1 + rs )1 (1 + rs)∞(1 + rs)2

Dividends (Dt)Dividends (Dt)

Market interest rates

Firm’s business riskMarket risk aversion

Firm’s debt/equity mixCost of

equity (rs)

Cost of

equity (rs)

Free cash flow(FCF)

The Big Picture:The Intrinsic Value of Common Stock

...

Facts about common stock

Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of

shareholders, their goal should be: Maximize stock price.

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.

Types of stock market transactions

Secondary market Primary market Initial public offering market (“going

public”)

Different approaches for valuing common stock

Dividend growth model Using the multiples of comparable firms Corporate Valuation Model

Dividend growth model

Value of a stock is the present value of the future dividends expected to be generated by the stock.

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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

D2 = D0 (1+g)2

Dt = D0 (1+g)t If g is constant, the dividend growth formula

converges to:g -r

D

g -r

g)(1D P

s

1

s

00

^

Estimating growth:

g = (retention rate)(return on equity)g = (1-payout rate)(ROE)

Future dividends and their present values

t0t ) g 1 ( DD

tt

t )r 1 (

DPVD

t0 PVDP

$

Years (t)0

Non-constant growth stock

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Zero growth stock

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Sample Problem

ABC Inc is assumed to grow at the rate of 10% a year. This high growth is expected to continue until year-5. Starting year-6 growth is expected to be reduced to 5% indefinitely.

If ABC’s cost of equity is 12% and current (year-0) dividend is $2.00, what’s the stock price?

Sample Problem - AnswerD0 2.00 rs 12.00%g 10.00%g6 5.00%

0 1 2 3 4 5 6Dividen 2.00 2.20 2.42 2.66 2.93 3.22 3.38 Price at 5 48.32 CF 2.00 2.20 2.42 2.66 2.93 51.54 PV 1.96 1.93 1.89 1.86 29.24 Sum PV 36.89

Market Multiple Analysis

Analysts often use the following multiples to value stocks. P / E

P / CF

P / Sales

Stock price EPS P/E ratio

P/CF ratio Market price of common stock

Cash flow per share

P/S ratio Market price of common stock

Sales per share

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Using Stock Price Multiples to Estimate Stock Price

Analysts often use the P/E multiple (the price per share divided by the earnings per share).

Example: Estimate the average P/E ratio of comparable

firms. This is the P/E multiple. Multiply this average P/E ratio by the expected

earnings of the company to estimate its stock price.

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Using Entity Multiples

The entity value (V) is: the market value of equity (# shares of stock multiplied

by the price per share) plus the value of debt.

Pick a measure, such as EBITDA, Sales, Customers, etc.

Calculate the average entity ratio for a sample of comparable firms. For example, V/EBITDA V/Customers

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Using Entity Multiples (Continued)

Find the entity value of the firm in question. For example, Multiply the firm’s sales by the V/Sales multiple. Multiply the firm’s # of customers by the V/Customers

ratio The result is the firm’s total value. Subtract the firm’s debt to get the total value of its

equity. Divide by the number of shares to calculate the

price per share.

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Problems with Market Multiple Methods

It is often hard to find comparable firms. The average ratio for the sample of

comparable firms often has a wide range. For example, the average P/E ratio might be 20,

but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?

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.

p

p0 r

D V

19

Why are stock prices volatile?

P0 = ^ D1

rs – g

rs = rRF + (RPM)bi could change. Inflation expectations Risk aversion Company risk

g could change.

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Consider the following situation.

D1 = $2, rs = 10%, and g = 5%:

P0 = D1/(rs – g) = $2/(0.10 – 0.05) = $40.

What happens if rs or g changes?

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Stock Prices vs. Changes in rs and g

g

rs 4% 5% 6%

9% $40.00 $50.00 $66.67

10% $33.33 $40.00 $50.00

11% $28.57 $33.33 $40.00

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Volatile stock prices and rational pricing

Small changes in expected g and rs cause large changes in stock prices.

As new information arrives, investors continually update their estimates of g and rs.

What is market equilibrium?

In equilibrium, expected returns must equal required returns.

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D r MRFs

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s RFr

Market equilibrium

Expected returns are obtained by estimating dividends and expected capital gains.

Required returns are obtained by estimating risk and applying the CAPM.

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

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.

If stock prices deviate from intrinsic values, investors will quickly take advantage of mispricing.

Prices will be driven to new equilibrium level based on new information.

What is the Efficient Market Hypothesis (EMH)?

Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

Weak-form efficiency

Can’t profit by looking at past trends Evidence supports weak-form EMH, but

“technical analysis” is still used.

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.

Superior analysts sometimes can still profit by finding and using new information

Strong-form efficiency

All information, even inside information, is embedded in stock prices.

Insiders often can gain by trading on the basis of insider information, but that’s illegal.

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.