Chapter 8 STOCKS AND THEIR VALUATION

Chapter 8 STOCKS AND THEIR VALUATION

9-1 CHAPTER 9 Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock Copyright 2001 by Harcourt, Inc. All rights reserved. 9-2 Facts about Common Stock Represents ownership. Ownership implies control. Stockholders elect directors. Directors elect management.

Managements goal: Maximize stock price. Copyright 2001 by Harcourt, Inc. All rights reserved. 9-3 Social/Ethical Question Should management be equally concerned about employees, customers, suppliers, the public, or just the stockholders? In enterprise economy, work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition. Copyright 2001 by Harcourt, Inc. All rights reserved. 9-4

Whats classified stock? How might classified stock be used? Classified stock has special provisions. Could classify existing stock as founders shares, with voting rights but dividend restrictions. New shares might be called Class A shares, with voting restrictions but full dividend rights. Copyright 2001 by Harcourt, Inc. All rights reserved. 9-5 When is a stock sale an initial public offering (IPO)? A firm goes public through an IPO when the stock is first offered to the public.

Copyright 2001 by Harcourt, Inc. All rights reserved. 9-6 Average Initial Returns on IPOs in Various Countries 100% 75% 50% Copyright 2001 by Harcourt, Inc. a C an ad U St nit at ed

es Ja pa n Sw ed e n al il B ra z Po rt

ug M al ay s ia 25% All rights reserved. 9-7 Different Approaches for Valuing Common Stock Dividend growth model Free cash flow method Using the multiples of comparable

firms Copyright 2001 by Harcourt, Inc. All rights reserved. 9-8 Stock Value = PV of Dividends P 0 D1 1 D2 1 k 1 k s s

2 D3 1 k s 3 . . . D 1 k s

What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g. Copyright 2001 by Harcourt, Inc. All rights reserved. 9-9 For a Constant Growth Stock D1 = D0(1 + g)1 D2 = D0(1 + g)2 Dt = Dt(1 + g)t If g is constant, then: D0(1 + g) D1 P0 = = . ks - g ks - g ^

Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 10 $ D t D0 1 g t Dt PVD t t 1 k 0.25 P0 PVD t

0 Copyright 2001 by Harcourt, Inc. If g > k, P0 ! Years (t) All rights reserved. 9 - 11 What happens if g > ks? D1 P0 requires k s g. ks g If ks< g, get negative stock price, which is nonsense. We cant use model unless (1) ks> g and (2) g is expected to be constant forever. Copyright 2001 by Harcourt, Inc.

All rights reserved. 9 - 12 Assume beta = 1.2, kRF = 7%, and kM = 12%. What is the required rate of return on the firms stock? Use the SML to calculate ks: ks= kRF + (kM kRF)bFirm = 7% + (12% 7%) (1.2) = 13%. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 13 D0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. ks = 13%.

0 g = 6% 1 D0 = 2.00 2.12 13% 1.8761 1.7599 1.6509 Copyright 2001 by Harcourt, Inc. 2 2.247 3 2.382 All rights reserved. 9 - 14

Whats the stocks market value? D0 = 2.00, ks = 13%, g = 6%. Constant growth model: D1 $2.12 P0 = = ks g 0.13 0.06 = $2.12 0.07 Copyright 2001 by Harcourt, Inc. = $30.29. All rights reserved.

9 - 15 What is the stocks market value one ^ ? year from now, P 1 D1 will have been paid, so expected dividends are D2, D3, D4 and so on. Thus, D2 $2.247 P1 = = ks g 0.13 0.06 = $32.10. ^ ^

Could also find P1 as follows: ^ P1 = P0(1.06) = $32.10. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 16 Find the expected dividend yield, capital gains yield, and total return during the first year. D1 $2.12 Dividend yld = = = 7.0%. P0 $30.29 ^ P 1 P0

$32.10 $30.29 Cap gains yld = = $30.29 P0 = 6.0%. Total return = 7.0% + 6.0% = 13.0%. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 17 Rearrange model to rate of return form: D D 1 1

g. P0 to k s ks g P0 ^ Then, ks = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 18 ^ What would P0 be if g = 0? The dividend stream would be a perpetuity. 0

13% 1 2 3 2.00 2.00 2.00 ... PMT $2.00 P0 = = = $15.38. k

0.13 ^ Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 19 If we have supernormal growth of 30% for 3 years, then a long-run constant ^ g = 6%, what is P 0? k is still 13%. Can no longer use constant growth model. However, growth becomes constant after 3 years. Copyright 2001 by Harcourt, Inc. All rights reserved.

9 - 20 Nonconstant growth followed by constant growth: 0 k = 13% 1 s g = 30% D0 = 2.00 2 g = 30% 2.600 3 g = 30% 3.380 4

g = 6% 4.394 ... 4.658 2.301 2.647 3.045 46.116 54.109 ^ = P0 Copyright 2001 by Harcourt, Inc. P 3

4.658 . $66.54 0 .13 0.06 All rights reserved. 9 - 21 What is the expected dividend yield and capital gains yield at t = 0? At t = 4? $2.60 Div. yield0 = = 4.81%. $54.11 Cap. gain0 = 13.00% 4.81% = 8.19%. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 22

During nonconstant growth, D/P and capital gains yield are not constant, and capital gains yield is less than g. After t = 3, g = constant = 6% = capital gains yield; k = 13%; so D/P = 13% 6% = 7%. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 23 Suppose g = 0 for t = 1 to 3, and then g ^ is a constant 6%. What is P0? 0 ks=13% g = 0%

2.00 1 2 g = 0% 2.00 1.77 1.57 1.39 20.99 25.72 Copyright 2001 by Harcourt, Inc. 3 g = 0% 2.00 4

g = 6% 2.00 ... 2.12 2.12 30.29. P 3 0.07 All rights reserved. 9 - 24 What is D/P and capital gains yield at t = 0 and at t = 3? t = 0:

D1 $2.00 = = 7.78%. P0 $25.72 CGY = 13% 7.78% = 5.22%. t = 3: Now have constant growth with g = capital gains yield = 6% and D/P = 7%. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 25 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P0 > 0:

g D 1 D 0 1 0 = = P ks g ks g $2.00(0.94) $1.88 = = = $9.89. 0.13 (-0.06) 0.19 Copyright 2001 by Harcourt, Inc. All rights reserved.

9 - 26 What is the annual D/P and capital gains yield? Capital gains yield = g = -6.0%, Dividend yield= 13.0% (-6.0%) = 19%. D/P and cap. gains yield are constant, with high dividend yield (19%) offsetting negative capital gains yield. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 27 Free Cash Flow Method The free cash flow method suggests that the value of the entire firm equals the present value of the firms free cash flows (calculated on an after-tax basis).

Recall that the free cash flow in any given year can be calculated as: NOPAT Net capital investment. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 28 Using the Free Cash Flow Method Once the value of the firm is estimated, an estimate of the stock price can be found as follows: MV of common stock (market capitalization) = MV of firm MV of debt and preferred stock. ^P = MV of common stock/# of shares. Copyright 2001 by Harcourt, Inc. All rights reserved.

9 - 29 Issues Regarding the Free Cash Flow Method Free cash flow method is often preferred to the dividend growth model--particularly for the large number of companies that dont pay a dividend, or for whom it is hard to forecast dividends. (More...) Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 30 FCF Method Issues Continued Similar to the dividend growth model, the free cash flow method generally assumes that at some point in time, the growth rate in free cash flow will

become constant. Terminal value represents the value of the firm at the point in which growth becomes constant. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 31 FCF estimates for the next 3 years are -$5, $10, and $20 million, after which the FCF is expected to grow at 6%. The overall firm cost of capital is 10%. 0 k = 10% 1 2

3 4 g = 6% -5 -4.545 8.264 15.026 398.197 416.942 10 20 ... 21.20 21.20 530 =

= *TV3 0.04 *TV3 represents the terminal value of the firm, at t = 3. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 32 If the firm has $40 million in debt and has 10 million shares of stock, what is the price per share? Value of equity = Total value Value of debt = $416.94 $40 = $376.94 million. Price per share = Value of equity/# of shares = $376.94/10 = $37.69. Copyright 2001 by Harcourt, Inc.

All rights reserved. 9 - 33 Using the Multiples of Comparable Firms to Estimate Stock Price Analysts often use the following multiples to value stocks: P/E P/CF P/Sales P/Customer Example: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 34

What is market equilibrium? In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. In equilibrium, expected returns must equal required returns: ^ ks = D1/P0 + g = ks = kRF + (kM kRF)b. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 35 Expected returns are obtained by estimating dividends and expected capital gains (which can be found using any of the three common stock valuation approaches).

Required returns are obtained from the CAPM. ^ ks = D1/P0 + g = ks = kRF + (kM kRF)b. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 36 How is equilibrium established? D1 If ks = + g > ks, then P0 ^ P0 is too low (a bargain). Buy orders > sell orders; P0 bid up; D1/P0 falls until

^ D1/P0 + g = ks = ks. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 37 Why do stock prices change? D1 P0 = ki g ^ 1. ki could change: ki = kRF + (kM kRF )bi. kRF = k* + IP. 2. g could change due to economic or firm situation. Copyright 2001 by Harcourt, Inc.

All rights reserved. 9 - 38 Whats the Efficient Market Hypothesis? EMH: Securities are normally in equilibrium and are fairly priced. One cannot beat the market except through good luck or better information. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 39 1. Weak-form EMH: Cant 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. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 40 2. Semistrong-form EMH: All publicly available information is reflected in stock prices, so doesnt pay to pore over annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information. Copyright 2001 by Harcourt, Inc.

All rights reserved. 9 - 41 3. Strong-form EMH: All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but thats illegal. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 42 Markets are generally efficient because: 1. 15,000 or so trained analysts; MBAs,

CFAs, Technical PhDs. 2. Work for firms like Merrill, Morgan, Prudential, which have a lot of money. 3. Have similar access to data. 4. Thus, news is reflected in P0 almost instantaneously. Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 43 Preferred Stock Hybrid security. Similar to bonds in that preferred stockholders receive a fixed dividend that must be paid before dividends can be paid on common stock. However, unlike interest payments on bonds, companies can omit dividend payments on preferred stock without fear of pushing the firm into bankruptcy.

Copyright 2001 by Harcourt, Inc. All rights reserved. 9 - 44 Whats the expected return of preferred stock with Vp = $50 and annual dividend = $5? $5 Vp $50 k p $5 k p 0.10 10.0%. $50 Copyright 2001 by Harcourt, Inc. All rights reserved.

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