CHAPTER 6b

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 st
ock price

8-2
Social/Ethical Question
 Should management be equally concerned
about employees, customers, suppliers, an
d “the public,” or just the stockholders?
 In an enterprise economy, management sh
ould work for stockholders subject to const
raints (environmental, fair hiring, etc.) and
competition.

8-3
Types of stock market transacti
ons
 Secondary market
 Primary market
 Initial public offering market (“goi
ng public”)

8-4
Different approaches for valuin
g common stock
 Dividend growth model
 Corporate value model
 Using the multiples of comparable firm
s

8-5
Dividend growth model
 Value of a stock is the present value of the future
dividends expected to be generated by the stock.

^ D D D D
1
P
0
1
2
2
3
3
 
...



(1
k
s 
)(1
k 
)(1
s k
) (1
s 
k
)
s

8-6
Constant growth stock
 A stock whose dividends are expected to grow for
ever 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 conv

erges to:
^ D 
(1g)D
0
P  1
0
k
s-g k
s-g
8-7
 Future dividends and their presen
t values
t
$ D
tD
0(
1g
)

D
0.25 PVD
t  t
t
(1k)

0
P 
PVD
t

0 Years (t)
8-8
What happens if g > ks?
 If g > ks, the constant growth formula l
eads to a negative stock price, which do
es 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, wh
at is the required rate of return on the fi
rm’s stock?
 Use the SML to calculate the required ra
te 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%, fin
d the expected dividend stream for th
e 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 valu
e?
 Using the constant growth model:

D1 $2.12
P0  
ks - 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 t
he present value (as of year 1) of D2, D3, D4, e
tc.
^
D $2.247
P  2

k -g 0.13 -0.06
1
s

$32.10
 Could also find expected P1 as:
^
P
1P
0 
(1.06)
$32.10
8-13
What is the expected dividend yield, cap
ital gains yield, and total return during t
he 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 to
day 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
P
0  $15.38
k 0.13

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Supernormal growth:
What if g = 30% for 3 years before ach
ieving long-run growth of 6%?
 Can no longer use just the constant growth
model to find stock value.
 However, the growth does become consta
nt after 3 years.

8-16
 Valuing common stock with non
constant 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 P$ 3   $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, an
d capital gains yield ≠ g.
 After t = 3, the stock has constant growth a
nd dividend yield = 7%, while capital gains
yield = 6%.
8-18
 Nonconstant growth:
What if g = 0% for 3 years before long-r
un 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 P$ 3   $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 gr
owth and dividend yield = 7%, while
capital gains yield = 6%.

8-20
If the stock was expected to have negativ
e growth (g = -6%), would anyone buy th
e stock, and what is its value?

 The firm still has earnings and pays dividends, eve

n though they may be declining, they still have val
ue.

^ D D (1g )
0
P 
1 0
ks -g k s -g

$2.00
(0.94)
$1.88
  $9.89
0.13
-(-0.06)
0.19

8-21
Find expected annual dividend and c
apital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% - (-6.00%) = 19.00%

 Since the stock is experiencing constant gro

wth, dividend yield and capital gains yield a
re constant. Dividend yield is sufficiently lar
ge (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 eq
uals the present value of the firm’s fre
e 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 g
et 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 shar
es outstanding to get intrinsic stock price (value).
 P0 = MV of common stock / # of shares

8-24
Issues regarding the corporat
e value model
 Often preferred to the dividend growth model,
especially when considering number of firms t
hat don’t pay dividends or when dividends a
re hard to forecast.
 Similar to dividend growth model, assumes at
some point free cash flow will grow at a const
ant rate.
 Terminal value (TVn) represents value of firm
at the point that growth becomes constant.
8-25
 Given the long-run gFCF = 6%, and WAC
C of 10%, use the corporate value mode
l 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 ha
s 10 million shares of stock, what is the f
irm’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 sh
ares
= $376.94m / 10m
= $37.69

8-27
Firm multiples method
 Analysts often use the following multiples t
o value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms, esti
mate 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 s
ell.
 In equilibrium, expected returns must equal requi
red returns.
^
D
k1
gkk
(k-
k
)
P
s s RFMRF
0

8-29
Market equilibrium
 Expected returns are obtained by estim
ating dividends and expected capital gai
ns.
 Required returns are obtained by estim
ating risk and applying the CAPM.

8-30
How is market equilibrium establi
shed?
 If expected return exceeds required ret
urn …
 The current price (P0) is “too low” and o
ffers a bargain.
 Buy orders will be greater than sell orde
rs.
 P0 will be bid up until expected return e
quals required return

8-31
Factors that affect stock price
 Required return (ks) could change
 Changing inflation could cause kRF to cha
nge
 Market risk premium or exposure to mark
et 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 Hypo
thesis (EMH)?
 Securities are normally in equilibrium an
d are “fairly priced.”
 Investors cannot “beat the market” e
xcept through good luck or better infor
mation.
 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 futu
re.
 Evidence supports weak-form EMH, b
ut “technical analysis” is still used.

8-34
Semistrong-form efficiency
 All publicly available information is ref
lected in stock prices, so it doesn’t
pay to over analyze annual reports lo
oking for undervalued stocks.
 Largely true, but superior analysts ca
n still profit by finding and using new
information

8-35
Strong-form efficiency
 All information, even inside informati
on, is embedded in stock prices.
 Not true--insiders can gain by tradin
g on the basis of insider information,
but that’s illegal.

8-36
Is the stock market efficient?
 Empirical studies have been conducted to t
est 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 understan
d how individuals and markets respond to
different situations.
8-37
Preferred stock
 Hybrid security
 Like bonds, preferred stockholders rec
eive a fixed dividend that must be pai
d before dividends are paid to commo
n stockholders.
 However, companies can omit preferr
ed dividend payments without fear of
pushing the firm into bankruptcy.

8-38
If preferred stock with an annual dividen
d of $5 sells for $50, what is the preferre
d stock’s expected return?

Vp = D / kp
$50 = $5 / kp

kp = $5 / $50
= 0.10 = 10%

8-39