CHAPTER 8 Stocks and Their Valuation

8-1

Facts about common stock

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Managements goal: Maximize the stock price
8-2

Legal Rights and Privileges of Common Shareholders

Control of the Firm
Friendly takeover Hostile takeover
Tender Offer Proxy Fight

Preemptive Right
Prevents management from issuing a large number of additional shares and purchasing those shares itself To protect the existing common shareholders from 8-3 dilution.

Types of Common Stock

Classified Stock
Common stock that is given a special designation such as Class A or Class B to meet the special needs of the company

Founders Shares
Stock owned by the firms founders that has sole voting rights but restricted dividends for a specified number of years.

Golden Share
A nominal share which is able to outvote all other shares in certain specified circumstances, often held by a 8-4 government organization.

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.

8-5

Types of stock market transactions

Secondary market Primary market Initial public offering market (going public)

8-6

Stock Price and Intrinsic Value

Stock Price
A perceived value determined by investors (through the law of supply and demand) Represents perceived investor returns, caused by investors perceived risk.

Intrinsic Value
A true value determined by companies Represents true investor returns, caused by true risk.
8-7

Why should investors care about intrinsic value?

By nature, investors would like to buy low, sell high. Thus, investors would buy the stock when it is undervalued and sell the stock when it is overvalued. Overvaluation
When the stock price > intrinsic value

Undervaluation
When stock price < intrinsic value
8-8

Different approaches for valuing common stock

Dividend growth model Corporate value model Using the multiples of comparable firms EVA Approach

8-9

Dividend growth model or Discounted Dividend Model

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

D3 D1 D2 D P0 ... 1 2 3 (1 rs ) (1 rs ) (1 rs ) (1 rs )
^

8-10

Constant growth stock (Gordon Growth Model)

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:

D0 (1 g) D1 P0 rs - g rs - g
^

8-11

What happens if g > rs?

If g > rs, the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if:
rs > g g is expected to be constant forever

8-12

Future dividends and their present values

$

D t D0 ( 1 g )

0.25

Dt PVD t t (1 r )

P0 PVDt
0
Years (t)
8-13

Computing for the Required Rate of Return

If rRF = 7%, rM = 12%, and = 1.2, what is the required rate of return on the firms stock?

Use the SML to calculate the required rate of return (rs):

rs = kRF + (kM kRF) = 7% + (12% - 7%)1.2 = 13%

8-14

Computing for the growth rate

G = Retention Ratio x Return on Equity = RE/NI x NI/Equity or (1 DPO) x NI/Equity
A firm has $1,000,000 of assets and no debt. The expected net income is $100,000. If the company plans to pay out 40% in dividends, how much is the growth rate? G = 60/100 x 100/1,000 = 6%

8-15

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

g = 6%

D0 = 2.00 1.8761 1.7599

1.6509

2.12
rs = 13%

2.247

2.382

8-16

What is the stocks intrinsic value?

Using the constant growth model:

D1 $2.12 P0 rs - g 0.13 - 0.06 $2.12 0.07 $30.29

8-17

What is the expected value of the stock, one year from now?
D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc.
D2 $2.247 P1 rs - g 0.13 - 0.06
^

$32.10

Could also find expected P1 as:

P1 P0 (1.06) $32.10
8-18

What is the expected dividend yield, capital gains yield, and total return during the 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 (rs)

= Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%
8-19

If D0 = $2, RRR is 13%, and g is a constant 0%, find the expected dividend stream for the next 3 years, and their PVs.
The dividend stream would be a perpetuity.
0 1 2 3

rs = 13%

...
2.00 2.00 2.00

PMT $2.00 P0 $15.38 k 0.13

^

8-20

Supernormal Growth
If D0 = $2 and g = 30% for 3 years before achieving long-run growth of 6%, find the intrinsic value of the stock.
Can no longer use just the constant growth model to find stock value. However, the growth does become constant after 3 years.

8-21

Valuing common stock with nonconstant growth

0 k = 13% 1 s
g = 30% g = 30%

2
g = 30%

3
g = 6%

...

D0 = 2.00 2.301 2.647 3.045

2.600

3.380

4.394

4.658

46.114
54.107 = P0
^

$ P3

4.658 0.13 - 0.06

$66.54
8-22

Find expected dividend and capital gains yields during the first year.
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, and capital gains yield g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
8-23

Find expected dividend and capital gains yields during the second year.
Dividend yield (second year)
= $3.38 / $58.54 = 5.77%

Capital gains yield (second year)

= 13.00% - 5.77% = 7.23%

During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
8-24

Find expected dividend and capital gains yields during the third year.
Dividend yield (third year)
= $4.394 / $62.77 = 7%

Capital gains yield (third year)

= 13.00% - 7% = 6%

During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
8-25

If D0 = $2 and g is 0% for 3 years before long run growth of 6%, find the intrinsic value of the stock.

0 k = 13% 1 s
g = 0% g = 0%

2
g = 0%

3
g = 6%

...

D0 = 2.00 1.77 1.57 1.39

2.00

2.00

2.00

2.12

20.99
25.72 = P0
^

$ P3

2.12 0.13 - 0.06

$30.29
8-26

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 growth and dividend yield = 7%, while capital gains yield = 6%.
8-27

If D0 = $2 and g is a constant 6% (negative growth), would anyone buy the stock? What is its intrinsic value?
The firm still has earnings and pays dividends, even though they may be declining, they still have value.

D0 ( 1 g ) D1 P0 ks - g ks - g
^

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

8-28

Find expected annual dividend and capital gains yields.

Capital gains yield
= g = -6.00%

Dividend yield
= 13.00% - (-6.00%) = 19.00%

Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.
8-29

Corporate value model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firms free cash flows. Remember, free cash flow is the firms aftertax operating income less the net capital investment
FCF = NOPAT Net capital investment (-or-) FCF = (EBIT(1-T) + Depreciation and Amortization) (CAPEX + change in NWC)
8-30

Applying the corporate value model

Find the market value (MV) of the firm.
Find PV of firms future FCFs

Subtract MV of firms debt and preferred stock to get 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 shares outstanding to get intrinsic stock price (value).
P0 = MV of common stock / # of shares
8-31

Issues regarding the corporate value model

Often preferred to the dividend growth model, especially when considering number of firms that dont pay dividends or when dividends are hard to forecast. Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. Terminal value (TVn) represents value of firm at the point that growth becomes constant.

8-32

Given the long-run gFCF = 6% after year 3, and WACC of 10%, use the corporate value model to find the firms intrinsic value, if the FCF for Years 1, 2, and 3 are -5m, 10m, and 20m, respectively.

0 k = 10%

1
-5

2
10

3
20
g = 6%

...

21.20

-4.545 8.264 15.026 398.197 416.942

21.20

530 =

0.10 - 0.06

= TV3
8-33

If the firm has $40 million in debt and has 10 million shares of stock, what is the firms 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 shares = $376.94m / 10m = $37.69

8-34

Firm multiples method

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

EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.
8-35

EVA Approach
It is an estimate of a firms economic profit. It is the value created in excess of the required return of the companys investors. EVA = (Equity Capital) x (ROE Cost of Equity Capital) Market value of equity = Book value + PV of all future EVAs Intrinsic Value = MV of equity / # of common shares outstanding
8-36

EVA Approach
Consider the following table below:
2011 Equity capital 100,000 2012 120,000 2013 150,000

Net income
Cost of equity Number of shares outstanding

20,000
12% 10,000

25,000
12% 12,000

30,000
12% 10,000

What is the intrinsic value of the stock for the year 2011?
8-37

What is market equilibrium?

In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. In equilibrium, expected returns must equal required returns.

D1 rs g P0
^

rs rRF (rM - rRF )

8-38

Market equilibrium
Expected returns are obtained by estimating dividends and expected capital gains. Required returns are obtained by estimating risk and applying the CAPM.

8-39

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

8-40

Factors that affect stock price

Required return (rs) could change
Changing inflation could cause rRF to change Market risk premium or exposure to market risk () could change

Growth rate (g) could change

Due to economic (market) conditions Due to firm conditions
8-41

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. Levels of market efficiency
Weak-form efficiency Semistrong-form efficiency Strong-form efficiency
8-42

Weak-form efficiency
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.

8-43

Semistrong-form efficiency
All publicly available information is reflected in stock prices, so it doesnt pay to over analyze annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information
8-44

Strong-form efficiency
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.

8-45

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.
8-46

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.
8-47

If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stocks expected return? Vp = D / rp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%

8-48

Exercises:
A stock, which currently does not pay a dividend, is expected to pay its first dividend of $1.00 per share in five years (D5 = $1.00). After the dividend is established, it is expected to grow at an annual rate of 25 percent per year for the following three years (D8 = $1.953125) and then grow at a constant rate of 5 percent per year thereafter. Assume that the riskfree rate is 5.5 percent, the market risk premium is 4 percent, and that the stocks beta is 1.2. What is the expected price of the stock today?
8-49

Exercises:
The Textbook Production Company has been hit hard due to increased competition. The companys analysts predict that earnings (and dividends) will decline at a rate of 5 percent annually forever. Assume that rs = 11 percent and D0 = $2.00. What will be the price of the companys stock three years from now?

8-50

Exercises:
A stock is expected to pay a $2.50 dividend at the end of the year. The dividend is expected to grow at a constant rate of 6 percent a year. The stocks beta is 1.2, the risk-free rate is 4 percent, and the market risk premium is 5 percent. What is the expected stock price eight years from today?

8-51

Exercises:
Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm maintains a 30 percent payout ratio, and this years retained earnings net of dividends were $1.4 million. The firms beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is 4 percent. If the market is in equilibrium, what is the market value of the firms common equity (1 million shares outstanding)?
8-52

Exercises:
During the past few years, Swanson Company has retained, on the average, 70 percent of its earnings in the business. The future retention rate is expected to remain at 70 percent of earnings, and long-run earnings growth is expected to be 10 percent. If the risk-free rate, rRF, is 8 percent, the expected return on the market, rM, is 12 percent, Swansons beta is 2.0, and the most recent dividend was $1.50, what is the most likely market price and P/E ratio (P0/E1) for Swansons stock today?
8-53

Exercises:
Conner Corporation has a stock price of $32.35 per share. The last dividend was $3.42. The long-run growth rate for the company is a constant 7 percent. What is the companys capital gains yield and dividend yield?

8-54