The Valuation and Characteristics of Stock

Common Stock
 Corporations are owned by stockholders
 Stockholders choose directors

common

 Most large companies are widely held

 Ownership spread among many investors.

 Investors dont think of a role as owner

 Interested mostly in future cash flows.
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The Return on an Investment in Common Stock

 Income in a stock investment comes from:
  dividends gain or loss on the difference between the purchase and sale price

If you buy a stock for price P0, hold it for one year, receive a dividend of D1, then sell it for price P1, you return, k, would be:

k=

D1+ P1 -P0 P0 or

k=

D1 P0 ,
dividend yield

P1-P0
P
  0
capital gains yield

A capital gain (loss) occurs if you sell the stock for a price greater (lower) than you paid for it.
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The Return on an Investment in Common Stock

 Solve the previous equation for P0, the stocks price today:
kP0 ! D1  P1  P0 P0  kP0 ! D1  P1

1  k P0 ! D1  P1
D1  P1 P0 ! 1  k

The return on a stock investment is the interest rate that equates the present value of the investments expected future cash flows to the amount invested today, the price, P0
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The Nature of Cash Flows from Stock Ownership

Comparison of Cash Flows from Stocks and Bonds For stockholders:
Expected dividends and future selling price are not known with any precision Similarity to bond cash flows is superficial both involve a stream of small payments followed by a larger payment When selling, investor receives money
from another investor

For bondholders:
Interest payments are guaranteed, constant Maturity value is fixed At maturity, the investor receives face value from the issuing company.

The Basis of Value

The basis for stock value is the present value of expected cash inflows even though dividends and stock prices are difficult to forecast
 Make assumptions about future dividends and selling price  Discount these assumptions at an appropriate interest rate
P0 = D1 PVFk,1  D2 PVFk,2    Dn PVFk,n  Pn PVFk,n
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The Basis of Value

Example 8.1

Example

Q: Joe Simmons is interested in the stock of Teltex Corp. He feels it is going to have two very good years because of a government contract, but may not do well after that. Joe thinks the stock will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now. People who have invested in stocks like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex?

The Intrinsic (Calculated) Value and Market Price

 A stocks intrinsic value is based on assumptions about future cash flows made from fundamental analysis of the firm and its industry  Different investors with different cash flow estimates will have different intrinsic values

Growth Models of Common Stock Valuation

 Based on predicted growth rates since forecasting exact future prices and dividends is difficult  More likely to forecast a rate of earnings cash flows growth rather than

Developing Growth-Based Models

 A stocks value today is the sum of the present values of the dividends received while the investor holds it and the price for which it is eventually sold
D1 D2 Dn Pn P0 =    n n 2 1  k 1  k 1  k 1  k

An Infinite Stream of Dividends

Many investors buy a stock, hold for awhile, then sell, as represented in the above equation
Not convenient for valuation purposes

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Developing Growth-Based Models

 A person who buys stock at time n will hold it until period m and then sell it
 Their valuation will look like this:
Dn + 1 Dm Pm Pn = ++ + m-n m-n 1 + k 1 + k 1 + k

Repeating this process until infinity results in:

P0 !
i=1 g

Di

1 + k

Conceptually its possible to replace the final selling price with an infinite series of dividends
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The Constant Growth Model

 If dividends are assumed to be growing at a constant rate forever and the last dividend paid is, D0, then the model is:

D 0 (1  g)i P0 ! (1  k )i i!1
g

This represents a series of fractions as follows D0 1  g D0 1  g D0 1  g P0 =    g 2 3 1  k 1  k 1  k If k>g, the fractions get smaller (approach zero) as exponents get larger
If k>g growth is normal If k<g growth is supernormal
Can occur but lasts for limited time period
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2 3

Working with Growth Rates

Example 8.2

Q. Apex Corp. paid a dividend of $3.50 this year. What are its next three dividends if it is expected to grow at 7%?

Example

A. SOLUTION: In this case D0 = $3.50 and g = .07, so (1+g) = 1.07. Then D1 = D0(1+g) = $3.50(1.07) = $3.75, D2 = D1(1+g) = $3.75(1.07) = $4.01, and D3 = D2(1+g) = $4.01(1.07) = $4.29.

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Constant Normal Growth The Gordon Model

 Constant growth model can be simplified k must be to
D1 P0 ! k g
greater than g.

The Gordon Model is a simple expression for forecasting the price of a stock thats expected to grow at a constant, normal rate
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Constant Normal Growth The Gordon Model

Example 8.3

Q: Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on stocks similar to Atlas is about 11%. What should a share of Atlas Motors sell for today? Example A:

D1 P0 ! k-g $2.25 (1.06) ! .11 - .06 ! $47.70

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The Zero Growth Rate Case A Constant Dividend

 If a stock is expected to pay a constant, non-growing dividend, each dollar dividend is the same  Gordon model simplifies to: A zero growth stock is a perpetuity to the investor
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D P0 ! k

The Expected Return

 Recast Gordon model to focus on the return (k) implied by the constant growth assumption
D1 k! g P0

The expected return reflects investors knowledge of a company

If we know D0 (most recent dividend paid) and P0 (current actual stock price), investors expectations are input via the growth rate assumption

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Two Stage Growth

 At times, a firms future growth may not be expected to be constant
 A new product may lead to temporary high growth

 The two-stage growth model values a stock that is expected to grow at an unusual rate for a limited time
 Use the Gordon model to value the constant portion  Find the present value of the non-constant growth periods
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Two Stage Growth

Example 8.5

Q: Zylon Corporations stock is selling for $48 a share according to The Wall Street Journal. Weve heard a rumor that the firm will make an exciting new product announcement next week. By studying the industry, weve concluded that this new product will support an overall company growth rate of 20% for about two years. After that, we feel growth will slow rapidly and level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company. The rate of return on stocks like Zylon is approximately 10%. Is Zylon a good buy at $48? A: Well estimate what we think Zylon should be worth given our expectations about growth.

Example

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Two Stage Growth

Example 8.5

Well develop a schedule of expected dividend payments: Year 1 Example 2 3 Expected Dividend $2.40 $2.88 $3.05 Growth 20% 20% 6%

Next, well use the Gordon model at the point in time where the growth rate changes and constant growth begins. Thats year 2, so:

D3 $3.05 P2 ! ! ! $76.25 k - g2 .10 - .06

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Two Stage Growth

Example 8.5

Then we take the present value of D1, D2 and P2:

P0 ! D1 PVFk, 1 + D2 PVFk, 2 + P2 PVFk, 2 ! $2.40 PVF10, 1 + $2.88 PVF10, 2 + $76.25 PVF10, 2 ! $2.40 ?0.9091A + $2.88 ?0.8264A + $76.25 ?0.8264A ! $67.57

Example

Compare $67.57 to the listed price of $48.00. If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy Zylons stock.

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Practical Limitations of Pricing Models

 Stock valuation models give estimated results since the inputs are approximations of reality  Actual growth rate can be VERY different from predicted growth rates
 Even if growth rates differ slightly, it can be a big difference in the decision  Allow for a margin for error in estimations
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Practical Limitations of Pricing Models

Comparison to Bond Valuation  Bond valuation is precise because the inputs are precise.  Future cash flows are guaranteed in amount and time, unless firm defaults. Stocks That Dont Pay Dividends Have value because of expectation that they will someday pay them. Some firms dont pay dividends even if they are profitable
Firms are growing and using profits to finance the growth

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Some Institutional Characteristics of Common Stock

Corporate Organization and Control
 Controlled by Board of Directors
 elected by stockholders

 Board appoints top management who appoint middle/lower management  Board consists of top managers and outside directors (may include major stockholders)  In widely held corporations, top management in control
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Stockholders Claim on Income And Assets

 Stockholders have a residual claim on income and assets  What is not paid out as dividends is retained for reinvestment in the business (retained earnings)  Common stockholders are last in line, they bear more risk than other investors

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Preferred Stock
 A hybrid security with characteristics of common stock and bonds
 Pays a constant dividend forever  Specifies the initial selling price and the dividend  No provision for the return of capital to the investor

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Valuation of Preferred Stock

 Since securities are worth the present value of their future cash flows, preferred stock is worth the present value of the indefinite stream of dividends.

D
k

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Preferred Stock
Example 8.6

Q: Roman Industries $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Romans preferred sell for today? Example A: Just substitute the new market interest rate into the preferred stock valuation model to determine todays price:

P0 !

$6 .09

! $66.67

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Characteristics of Preferred Stock

 Cumulative Feature - cant pay common dividends unless cumulative preferred dividends are current  Never returns principal  Stockholders cannot force bankruptcy  Receives preferential treatment over common stock in bankruptcy
 Lower priority than bondholders

 No voting rights  Dividend payments not tax deductible to the firm

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Securities Analysis
The art and science of selecting investments  Fundamental analysis looks at a companys business to forecast value on  Technical analysis bases value the pattern of past prices and volume  The Efficient Market Hypothesis (EMH) financial markets are efficient since new information is instantly disseminated
 Impossible to consistently beat the market
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Options and Warrants

Options and warrants make it possible to invest in stocks without holding shares
Options
 Gives the holder the temporary right to buy or sell an asset at a fixed price Speculate on price changes without holding the asset

Warrants
Similar but less common

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Stock Options
Stock options speculate on stock movements  Trade in financial markets  Call option option to buy  Put option option to sell  Options are Derivative Securities price

 Derive value from prices of underlying securities  Provide leverage amplifying returns
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Writing Options
 People write options for the premium income, hoping that the option will never be exercised  Option writers give up what option buyers make  Covered option writer owns underlying stock  Naked option writer does not own the underlying stock
 Purchase it at the current price if exercised

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Warrants
Options
Trade between investors, not between the companies that issue the underlying stocks Secondary market instruments

Warrants
Issued by underlying company When exercised new stock is issued and company receives the exercise price Primary market instruments while options are secondary market instruments

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Warrants
 Similar to calls with a longer expiration period (several years vs. months)  Issued as a sweetener (especially for risky bonds)  Can generally be detached from another issue and sold separately

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Employee Stock Options

 More like warrants than traded options
 Expire after several years  Strike price set far out of the money  May receive options in lieu of salary increases

 Wanted if future expectations are good  Companies offering options may pay lower salaries
 Attract employees not otherwise affordable
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Employee Stock Options

Executive Stock Option Problem  Senior executives may receive most of the stock options  Provide an incentive for executives to misstate financial statements and inflate stock prices
 Negatively impacts a firms pension plan if heavily invested in its own stock  As a result of overhauling financial reporting, companies must recognize employee stock options as expenses when they are issued
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