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11/27/19

FINANCIAL MANAGEMENT
THEORY & PRACTICE CHAPTER 8

STOCKS, STOCK VALUATION,


ADAPTED FOR THE THIRD CANADIAN EDITION
BY:
JIMMY WANG
AND STOCK MARKET
LAURENTIAN
EQUILIBRIUM
UNIVERSITY

Copyright © 2017 by Nelson Education Ltd. 8-2

CHAPTER 8 OUTLINE CHAPTER 8 OUTLINE (cont’d)

• 8-1. Legal Rights and Privileges of Common • 8-6. Expected Rate of Return on a Constant
Shareholders Growth Stock
• 8-2. Types of Common Stock • 8-7. Valuing Nonconstant Growth Stocks
• 8-3. Stock Market Reporting • 8-8. Stock Valuation by the Free Cash Flow
• 8-4. Valuing Common Stocks Approach
• 8-5. Valuing a Constant Growth Stock • 8-9. Market Multiple Analysis
• 8-10. Preferred Stock

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CHAPTER 8 OUTLINE (cont’d)

• 8-11. Stock Market Equilibrium


• 8-12. The Efficient Markets Hypothesis

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8-1 Legal Rights and Privileges of Shareholders and Control


Common Shareholders
• Common stock represents ownership. Managers
• Ownership implies control. Appoint
• Stockholders elect directors.
Directors
• Directors hire management.
• Managers are “agents” of shareholders; they Elect
always solicit shareholders’ proxies and
usually succeed. Shareholders

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Legal Rights and Privileges of Common The Preemptive Right


Shareholders: Control of the Firm
• Shareholders’ right to purchase any additional
• Managers of most publicly owned firms can be shares sold by the firm
removed by the shareholders if managers are • Protects the control of the present
not effective. shareholders and also prevents dilution of
• Proxy fight refers to the process that an their value
outside group may solicit the proxies in an
effort to overthrow management and take • Makes it more difficult to raise equity capital
control of the firm. from new large shareholders

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8-2 Types of Common Stock Dual-Class Shares


• Not all common shares are created equally. • Classified stock has special provisions.
• Most firms have only one type of common • Could classify existing stock as founders’
stock. shares, with voting rights but dividend
restrictions (multiple or super-voting shares).
• A system of dual-class shares is used to meet
• New shares might be called “Class A” shares,
the special needs of the company. with voting restrictions but full dividend rights
(restricted or subordinate shares).

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The Market Stock Price vs. Intrinsic


Value
• Intrinsic value incorporates all relevant available
information about expected cash flows and risk.
• In contrast, market prices are based on
investors’ selection and interpretation of
information.
• To the extent that investors don’t select all
relevant information or don’t interpret it
correctly, market prices can deviate from
intrinsic value.
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Market Equilibrium 8-3 Stock Market Reporting


• In the past, tracking stock occurred through the
• When market prices deviate from their business section of a daily newspaper.
intrinsic values, the market forces of demand • Today, we can get quotes all during the day from
and supply would drive the mispriced stocks’ a wide variety of Internet sources (e.g.,
Globeinvestor.com).
prices toward their intrinsic values.
• Compared with once-a-day updates from
• The process continues until market prices newspaper editions, the 20-minute delay with
equal their intrinsic values, then there is the Internet information is nothing.
market equilibrium. • The quote provides the price a buyer would have
to pay (“Ask”) and the price someone can sell the
stock (“Bid”) for.

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8-4 Valuing Common Stocks Stock Value = PV of Expected


Future Dividends
• Most stocks’ expected total return = dividend
yield + capital gains yield. ^ D1 D2 D3 D∞
P0 = + + +… (8-1)
• The intrinsic value of a stock is the present (1+rs)1 (1+rs)2 (1+rs)3 + (1+rs)∞
value of its expected future cash flow stream.
– Dividend growth model What is a constant growth stock?
– Free cash flow approach
– Using the multiples of comparable firms
One whose dividends are expected
to grow forever at a constant rate, g.

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8-5 Valuing a Constant Growth Stock Dividend Growth and PV of Dividends:


P0 = ∑(PV OF DT)
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t

If g is constant and less than rs, then:


^ D0(1+g) D1 (8-2)
P0 = =
rs - g rs - g

Use decimals, not %, in the calculation.


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Long-Term or Short-Term Maturity of Companies


• If most of a stock’s value is due to long-term • The constant growth model is often
cash flows, why do so many managers focus appropriate for mature companies.
on quarterly earnings?
• The growth rate is generally expected to be at
• Sometimes changes in quarterly earnings are about the rate of GDP growth.
a signal of future changes in cash flows. This
would affect the current stock price. • A zero growth stock can be valued by setting g
• Sometimes managers have bonuses tied to = 0, that is,
quarterly earnings.
^ D0(1 + 0) D0 (8-3)
P0 = =
rs - 0 rs

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What Happens If g > rS? Projected Dividends

^ D0(1 + g)1 D0(1 + g)2 D0(1 + rs)∞ • D0 = $2 and constant g = 6% = 0.06


P0 = + +…+
(1 + r )1
s (1 + rs)2 (1 + rs)∞
• D1 = D0(1 + g) = 2(1.06) = $2.12
If g > rs, then (1+g)t ^
> 1, and P0 = ∞ • D2 = D1(1 + g) = 2.12(1.06) = $2.2472
(1 + • D3 = D2(1 + g) = 2.2472(1.06) = $2.3820
rs)t
So g must be less than rs to use the
constant growth model.

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Expected Dividends and PVs Intrinsic Stock Value

Constant growth model:


0 g = 6% 1 2 3 4

2.12 2.2472 2.3820 ^ D0(1 + g) D1


P0 = =
1.8761 13 % rs – g rs – g
1.7599
$2.12 $2.12
1.6508 = = $30.29
0.13 – 0.06 0.07

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Expected Dividend Yield and Capital


Expected Value 1 Year from Now
Gains Yield (Year 1)
• D1 will have been paid, so expected dividends
are D2, D3, D4, and so on. D1 $2.12
Dividend yield = = = 7.0%
P0 $30.29

^ D2 $2.2427 ^
P1 = = P1 – P0 $32.10 – $30.29
rs – g 0.07 CG Yield = =
P0 $30.29
= $32.10 = $30.29(1 + 0.06)
= 6.0%

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Total Year-1 Return 8-6 Expected Rate of Return on a


Constant Growth Stock
• Total return = Dividend yield + Capital gains yield
• Total return = 7% + 6% = 13%
^ D1 ^ D
• Total return = 13% = rs P0 = to rs = 1 +g (8-4)
rs – g P0
• For constant growth stock:
– Capital gains yield = 6% = g
^
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%

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If g = 0, the Dividend Stream 8-7 Valuing Nonconstant Growth


is a Perpetuity Stocks
• A typical firm goes through life cycles:
0 r = 13% 1 2 3 supernormal growth during its early years,
s
normal growth in the middle age, and slow
2.00 2.00 2.00 constant growth in the end.
• The constant growth model can no longer be
^ PMT $2.00 used for the whole but can be used for the
P0 = = = $15.38 constant growth stage:
rs 0.13
• Horizon value = PN = DN+1/(rs – g)
= DN(1 + g)/(rs – g) (8-5)
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Nonconstant Growth Followed By


Constant Growth (D0 = $2):
0 1 2 3 4
rs= 13%

g = 30% g = 30% g = 30% g = 6%


2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
^ $4.6576
46.1135 P3 = = $66.5371
54.1067 = ^P0 0.13 – 0.06

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Suppose g = 0 for t = 1 to 3, and If g = –6%, Would Anyone


Then g Is a Constant 6% Buy the Stock? If So, at What Price?
0 1 2 3 4
rs = 13% Firm still has earnings and still pays
g = 0% g = 0% g = 0% g = 6% ^
2.00 2.00 2.00 2.12 dividends, so P0 > 0:
^ D0(1 + g) D1
1.7699 P0 = =
1.5663 rs – g rs – g
1.3861 2.12
20.9895 P3 ! = = 30.2857 $2.00(0.94) $1.88
25.7118 0.07 = = = $9.89
0.13 – (–0.06) 0.19

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8-8 Stock Valuation by the Free Cash 8-9 Market Multiple Analysis
Flow Approach
• Analysts often use the P/E multiple (the price
• Firm value is the present value of its future
expected free cash flows (FCF) discounted at the per share divided by the earnings per share).
WACC. • Example:
• Both the constant growth model – Estimate the average P/E ratio of comparable firms.
This is the P/E multiple.
FCF (1 + g )
V= (8-7) – Multiply this average P/E ratio by the expected
WACC - g earnings of the company to estimate its stock price.
• and the nonconstant growth model can be
applied to FCF.
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Using Entity Multiples Using Entity Multiples (cont’d)


• The entity value (V) is: • Find the entity value of the firm in question. For
– The market value of equity (number of shares example,
multiplied by the price per share) – Multiply the firm’s sales by the V/Sales multiple
– Plus the value of debt. – Multiply the firm’s number of customers by the
• Pick a measure, such as EBITDA, sales, customers, V/Customers ratio
eyeballs, etc. • The result is the total value of the firm.
• Calculate the average entity ratio for a sample of • Subtract the firm’s debt to get the total value of
comparable firms. For example, equity.
– V/EBITDA • Divide by the number of shares to get the price
– V/Customers per share.

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Problems with Market Multiple 8-10 Preferred Stock


Methods
• Hybrid security
• It is often hard to find comparable firms.
• Similar to bonds in that preferred stockholders
• The average ratio for the sample of receive a fixed dividend that must be paid
comparable firms often has a wide range. before dividends can be paid on common stock
– For example, the average P/E ratio might be 20, • However, unlike bonds, preferred stock
but the range could be from 10 to 50. How do you
know whether your firm should be compared to dividends can be omitted without fear of
the low, average, or high performers? pushing the firm into bankruptcy.

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Preferred Stock Valuation Expected Return on Preferred Stock


• Similar to the valuation of perpetual bonds
DPS $5
VPS = (8-8)
rPS Vps = $50 =
^
• A preferred stock pays a quarterly dividend of rps
$1.25 ($5 per year) with a required return of
^ $5
10%. Its value is rps = = 0.10 = 10.0%
D 4($1.25) $5 $50
VPS = PS = = = $50
rPS 0.1 0.1

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Stock Price Volatility 8-11 Stock Market Equilibrium


• Are volatile stock prices consistent with rational
pricing? • In equilibrium, stock prices are stable. There is
no general tendency for people to buy versus
• Small changes in expected g and rs cause large
changes in stock prices.
sell.
^
• As new information arrives, investors continually • The expected price, P , must equal the actual
update their estimates of g and rs. price, P.
• If stock prices are not volatile, then this means • In other words, the fundamental value must
there is not a good flow of information. be the same as the price.

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In Equilibrium, Expected Returns Must How Is Equilibrium Established?


Equal Required Returns:
^ ^
If rs = D1 + g > rs, then P0 is “too low.”
^ P0
rs = D1/P0 + g = rs = rRF + (rM – rRF)b
If the price is lower than the fundamental
value, then the stock is a “bargain.” Buy
orders will exceed sell orders; the price
will be bid up until:
^
D1/P0 + g = rs = rs

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Markets Are Generally


8-12 The Efficient Markets Hypothesis
Efficient Because:
• Securities are normally in equilibrium and are • 100,000 or so trained analysts––MBAs, CFAs,
“fairly priced.” and PhDs––work for firms such as Fidelity,
• Investors cannot “beat the market” except Merrill, Morgan, and Prudential.
through good luck or inside information. • These analysts have similar access to data and
• The prices of securities fully reflect available megabucks to invest.
information. They will adjust immediately to • Thus, news is reflected in P0 almost
any new development. instantaneously.

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Weak-Form EMH Semistrong-Form EMH


• Investors buying bonds and stocks cannot • All publicly available information is reflected in
profit by looking at past trends. stock prices.
• A recent decline is no reason to think stocks • So it does not pay to pore over annual reports
will go up (or down) in the future. looking for undervalued stocks.
• Evidence supports weak-form EMH, but • Largely true
“technical analysis” is still used.

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Market Bubbles and


Strong-Form EMH
Market Efficiency
• All information, even inside information, is • Market bubbles:
embedded in stock prices. ─ Prices climb rapidly to heights that would have
• Not true––insiders can gain by trading on the been considered extremely unlikely before the run-
basis of insider information, but that is illegal! up.
─ Trading volume is unusually high.
─ Many new investors (or speculators?) eagerly enter
the market.
─ Prices suddenly fall precipitously.
• What does this imply about the EMH?
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Is the Stock Market Efficient?


Bubbles Are Hard to Puncture
The Empirical Evidence
• Choose a trading strategy and implement it over a large
• If there is a bubble, why don’t traders take
sample.
positions that make big profits when the
• Pick an asset pricing model, e.g., the CAPM, and
bubble bursts? measure the required return of the strategy’s
─ It is hard to recognize a bubble until after it investments.
bursts—then it seems obvious! • Measure the actual return
─ Trading strategies expose traders to possible ─ Actual > required? Reject EMH
big negative cash flows if the bubble is slow • Notice that this is a “joint” test of the EMH and the
to burst. particular asset model—if the test rejects the EMH, it
could be that the asset pricing model is wrong.

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Weak-Form EMH: Semistrong-Form EMH:


Empirical Evidence Empirical Evidence
• Most empirical evidence supports weak-form • Most empirical evidence supports the
EMH because very few trading strategies semistrong-form EMH.
consistently earn in excess of the CAPM ─ In fact, the vast majority of portfolio
prediction. managers do not consistently have returns in
• Two exceptions with small excess returns: excess of CAPM predictions
─ Short-term momentum • Two exceptions that earn excess returns:
─ Long-term reversals ─ Small companies
─ Companies with high book-to-market ratios

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Strong-Form EMH: Implications of EMH for Financial


Empirical Evidence Decisions
• No evidence has been found to support the
strong-form EMH. • Many investors have given up trying to beat
• Those who possessed inside information could the market as evidenced by the growing
and have (illegally) made abnormal profits popularity of indexed funds.
(and have gone to jail!). • Managerial decisions based on the premise
that a stock is undervalued or overvalued
might not make sense.

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Summary Summary (cont’d)


• The common shareholders are the owners of a
corporation, and as such they have certain • Sometimes dual-class stock is used to meet the
rights and privileges. special needs of the company, such as permitting
multiple votes per share for some groups of
• They have the right to elect its directors. If
shareholders or limiting voting rights of others.
shareholders are dissatisfied with the firm’s
performance, an outside group may launch a • Closely held stock is owned by a few individuals
associated with the firm’s management, while
proxy fight to take control of the business.
publicly owned stock is owned by a relatively large
• Shareholders often have the preemptive right to number of individuals not actively involved in the
protect their control of the firm and prevent firm’s management.
dilution of their ownership.
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Summary (cont’d) Summary (cont’d)


• The expected rate of return on a constant growth
• The intrinsic value of a share of stock is stock can be expressed as: D
^

rs = 1
+g
calculated as the present value of the stream of P0
dividends that the stock is expected to provide • A zero growth stock is one whose future
in the future. dividends are not expected to grow at all.
• The intrinsic value of a constant growth stock is • A supernormal growth stock is one whose
calculated as earnings and dividends are expected to grow
^
D1 much faster than the economy as a whole over
P0 = r some specified time period and then to grow at
s -g
the “normal” rate.
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Summary (cont’d) Summary (cont’d)


• Preferred stock is a hybrid security having some • The marginal investor is a representative of
characteristics of debt and some of equity. investors currently trading a stock. It is the
marginal investor who determines a stock’s price.
• Most preferred stocks are perpetuities and
their values can be found as the dividend • Equilibrium is the condition under which the
divided by the required rate of return. expected return on a security as seen by the
marginal investor is just equal to its required
• Preferred stock with a finite maturity is
return.
evaluated with a formula identical to bond
valuation. • Equilibrium also means that the stock’s intrinsic
value equals its market price.
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Summary (cont’d)
• The Efficient Market Hypothesis (EMH) holds
(1) that stocks are always in equilibrium and (2)
that it is impossible for an investor without
inside information to consistently “beat the
market.”
• According to the EMH, stocks are always fairly
valued and all stocks’ expected returns plot on
the SML.

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