Stocks and Their Valuation: Features of Common Stock Determining Common Stock Values Efficient Markets Preferred Stock

10 - 1
CHAPTER 10
Stocks and Their Valuation
 Features of common stock

 Determining common stock
values
 Efficient markets
 Preferred stock
Copyright © 2002 Harcourt, Inc. All rights reserved.

10 - 2
Facts about Common Stock
 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Management’s goal: Maximize
stock price.
10 - 3
What’s 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.
10 - 4
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.
 Prior to an IPO, shares are typically
owned by the firm’s managers, key
employees, and, in many situations,
venture capital providers.

10 - 5
Average Initial Returns on IPOs in

Various Countries
100%
75%
50%
25%
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10 - 6
Different Approaches for Valuing

Common Stock
 Dividend growth model

 Using the multiples of comparable
firms
 Free cash flow method (covered in
Chapter 12)

10 - 7
Stock Value = PV of Dividends
 = D1 D2 D3 D∞
P + + +. . .+
0
(1 + k ) (1 + k ) (1 + k )
s
1
s
2
s
3
(1 + k ) s
∞
What is a constant growth stock?
One whose dividends are expected to

grow forever at a constant rate, g.
10 - 8
For a constant growth stock,
D1 = D 0 (1 + g)
1
D 2 = D 0 (1 + g)
2
D t = D t (1 + g)
t
If g is constant, then:
P = D 0 (1 + g) =
D1
0
ks − g ks − g
10 - 9
$
D t = D 0 (1 + g)
t
0.25 Dt
PVD t =
(1 + k ) t
If g > k, P0 = ∞!
P0 = ∑ PVD t
0 Years (t)
10 - 10
What happens if g > ks?
 D
P0 = 1
requires k s > g.
ks − g
 If ks< g, get negative stock price,
which is nonsense.
 We can’t use model unless (1) g < ks
and (2) g is expected to be constant
forever. Because g must be a long-
term growth rate, it cannot be > ks.
10 - 11
Assume beta = 1.2, kRF = 7%, and kM =

12%. What is the required rate of
return on the firm’s stock?
Use the SML to calculate ks:
ks = kRF + (kM - kRF)bFirm

= 7% + (12% - 7%) (1.2)
= 13%.

10 - 12
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 2 3 4
D0=2.00 2.12 2.2472 2.3820

1.8761 13%
1.7599
1.6508

10 - 13
What’s the stock’s market value?
D0 = 2.00, ks = 13%, g = 6%.
Constant growth model:
P 0 =
D 0 (1 + g) =
D1
ks − g ks − g
$2.12 $2.12
= = $30.29.
0.13 - 0.06 0.07
10 - 14
What is the stock’s 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
P̂1 =
ks − g
$2.2472
= = $32.10.
0.07

10 - 15
Find the expected dividend yield and

capital gains yield during the first year.
D1 $2.12
Dividend yield = = = 7.0%.
P0 $30.29
^
P1 - P 0 $32.10 - $30.29
CG Yield = =
P0 $30.29
= 6.0%.
10 - 16
Find the total return during the

first year.
 Total return = Dividend yield +

Capital gains yield.
 Total return = 7% + 6% = 13%.
Total return = 13% = ks.
 For constant growth stock:
Capital gains yield = 6% = g.
10 - 17
Rearrange model to rate of return form:
 D  D
P0 = 1
to k s = 1
+ g.
ks − g P0
^
Then, ks = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.

10 - 18
What would P0 be if g = 0?
The dividend stream would be a

perpetuity.
0 k =13% 1 2 3
s
2.00 2.00 2.00
^ PMT $2.00
P0 = = = $15.38.
k 0.13
10 - 19
If we have supernormal growth of

30% for 3 years, then a long-run
^
constant g = 6%, what is P0? k is
still 13%.
 Can no longer use constant growth

model.
 However, growth becomes constant
after 3 years.

10 - 20
Nonconstant growth followed by constant

growth:
0 k =13% 1 2 3 4
s
g = 30% g = 30% g = 30% g = 6%

D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
$4.6576
P̂3 = = $66.5371
46.1135 0.13 − 0.06
^
54.1067 = P0
10 - 21
What is the expected dividend yield and

capital gains yield at t = 0? At t = 4?
At t = 0:
D1 $2.60
Dividend yield = = = 4.8%.
P0 $54.11
CG Yield = 13.0% - 4.8% = 8.2%.
(More…)
10 - 22
 During nonconstant growth, dividend

yield and capital gains yield are not
constant.
 If current growth is greater than g,
current capital gains yield is greater
than g.
 After t = 3, g = constant = 6%, so the t
t = 4 capital gains gains yield = 6%.
 Because ks = 13%, the t = 4 dividend
yield = 13% - 6% = 7%.
10 - 23
Is the stock price based on

short-term growth?
 The current stock price is $54.11.
 The PV of dividends beyond year 3 is
$46.11 (P
^ 3 discounted back to t = 0).
 The percentage of stock price due to
“long-term” dividends is:
$46.11
$54.11 = 85.2%.
10 - 24
If most of a stock’s value is due to long-

term cash flows, why do so many
managers focus on quarterly earnings?
 Sometimes changes in quarterly

earnings are a signal of future
changes in cash flows. This would
affect the current stock price.
 Sometimes managers have bonuses
tied to quarterly earnings.

10 - 25
Suppose g = 0 for t = 1 to 3, and then g

is a constant 6%. What is ^P0?
0 1 2 3 4
ks=13%
...
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
1.7699
1.5663
P = 2.12 = 30.2857
1.3861
20.9895 3
25.7118 0.07
10 - 26
What is dividend yield and capital

gains yield at t = 0 and at t = 3?
D1 2.00
t = 0: P = $25.72= 7.8%.
0
CGY = 13.0% - 7.8% = 5.2%.
t = 3: Now have constant growth

with g = capital gains yield = 6% and
dividend yield = 7%.
10 - 27
If g = -6%, would anyone buy the

stock? If so, at what price?
Firm still has earnings and still pays

^
dividends, so P0 > 0:
D 0 ( 1 + g) D1
P̂0 = =
ks − g ks − g
$2.00(0.94) $1.88
= = = $9.89.
0.13 - (-0.06) 0.19
10 - 28
What are the annual dividend

and capital gains yield?
Capital gains yield = g = -6.0%.
Dividend yield = 13.0% - (-6.0%)

= 19.0%.
Both yields are constant over time, with

the high dividend yield (19%) offsetting
the negative capital gains yield.
10 - 29
Using the Multiples of Comparable

Firms to Estimate Stock Price
 Analysts often use the following multiples to
value stocks:
P/E
P/CF or P/EBITDA
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.
10 - 30
What is market equilibrium?
In equilibrium, stock prices are stable.

There is no general tendency for
people to buy versus to sell.
^
The expected price, P, must equal the
actual price, P. In other words, the
fundamental value must be the same as
the price.
(More…)
10 - 31
In equilibrium, expected returns must

equal required returns:
^
ks = D1/P0 + g = ks = kRF + (kM - kRF)b.

10 - 32
How is equilibrium established?
^
^ D
If ks = 1 + g > ks, then P0 is “too low.”
P0
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, and D1/P0 falls until
D /P + g = k = k .
10 - 33
Why do stock prices change?
^ = D1
P0
ki − g
 ki = kRF + (kM - kRF )bi could change.

 Inflation expectations
 Risk aversion
 Company risk
 g could change.
10 - 34
What’s the Efficient Market

Hypothesis (EMH)?
Securities are normally in

equilibrium and are “fairly priced.”
One cannot “beat the market”
except through good luck or inside
information.
(More…)
10 - 35
1. Weak-form EMH:
Can’t 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.

10 - 36
2. Semistrong-form EMH:
All publicly available
information is reflected in
stock prices, so it doesn’t pay
to pore over annual reports
looking for undervalued
stocks. Largely true.

10 - 37
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 that’s
illegal.

10 - 38
Markets are generally efficient

because:
1. 100,000 or so trained analysts--MBAs,

CFAs, and PhDs--work for firms like
Fidelity, Merrill, Morgan, and
Prudential.
2. These analysts have similar access to
data and megabucks to invest.
3. Thus, news is reflected in P0 almost
instantaneously.
10 - 39
Preferred Stock
 Hybrid security.
 Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends
can be paid on common stock.
 However, unlike bonds, preferred
stock dividends can be omitted without
fear of pushing the firm into
bankruptcy.
10 - 40
What’s the expected return on

preferred stock with Vps = $50 and
annual dividend = $5?
$5
Vps = $50 = 
k
ps
 $5
k ps = = 0.10 = 10.0%.
$50

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10 - 1

 Features of common stock

Copyright © 2002 Harcourt, Inc. All rights reserved.

Facts about Common Stock

What’s classified stock? How might

 Classified stock has special provisions.

When is a stock sale an initial public

 A firm “goes public” through an IPO

Copyright © 2002 Harcourt, Inc. All rights reserved.

Average Initial Returns on IPOs in

Copyright © 2002 Harcourt, Inc. All rights reserved.

Different Approaches for Valuing

 Dividend growth model

Copyright © 2002 Harcourt, Inc. All rights reserved.

Stock Value = PV of Dividends

What is a constant growth stock?

One whose dividends are expected to

For a constant growth stock,

What happens if g > ks?

Assume beta = 1.2, kRF = 7%, and kM =

Use the SML to calculate ks:

ks = kRF + (kM - kRF)bFirm

Copyright © 2002 Harcourt, Inc. All rights reserved.

D0 was $2.00 and g is a constant 6%.

D0=2.00 2.12 2.2472 2.3820

Copyright © 2002 Harcourt, Inc. All rights reserved.

Constant growth model:

What is the stock’s market value one

 D1 will have been paid, so expected

Copyright © 2002 Harcourt, Inc. All rights reserved.

Find the expected dividend yield and

Find the total return during the

 Total return = Dividend yield +

Rearrange model to rate of return form:

Copyright © 2002 Harcourt, Inc. All rights reserved.

The dividend stream would be a

2.00 2.00 2.00

If we have supernormal growth of

 Can no longer use constant growth

Copyright © 2002 Harcourt, Inc. All rights reserved.

Nonconstant growth followed by constant

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

What is the expected dividend yield and

CG Yield = 13.0% - 4.8% = 8.2%.

 During nonconstant growth, dividend

Is the stock price based on

If most of a stock’s value is due to long-

 Sometimes changes in quarterly

Copyright © 2002 Harcourt, Inc. All rights reserved.

Suppose g = 0 for t = 1 to 3, and then g

What is dividend yield and capital

CGY = 13.0% - 7.8% = 5.2%.

t = 3: Now have constant growth

If g = -6%, would anyone buy the

Firm still has earnings and still pays

What are the annual dividend

Capital gains yield = g = -6.0%.

Dividend yield = 13.0% - (-6.0%)

Both yields are constant over time, with

Using the Multiples of Comparable

What is market equilibrium?

In equilibrium, stock prices are stable.