1 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 CHAPTER 6 Stocks and Their Valuation  6.1 Key Characteristics of Stocks  6.2 Types of Common Stock  6.3 The Market for Common Stock  6.4 Common Stock Valuation 2 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 6.1 Key Characteristics of Stocks 3 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  Represents ownership.  Ownership implies control.  Stockholders elect directors.  Directors hire management.  Since managers are “agents” of shareholders, their goal should be: Maximize stock price. Common Stock: Owners, Directors, and Managers 4 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 6.2 Types of Common Stock 5 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  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. What’s classified stock? How might classified stock be used? 6 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  The dividends of tracking stock are tied to a particular division, rather than the company as a whole. Investors can separately value the divisions. Its easier to compensate division managers with the tracking stock.  But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company. What is tracking stock? 7 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 6.3 The Market for Common Stock 8 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 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. 9 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What is a seasoned equity offering (SEO)?  A seasoned equity offering occurs when a company with public stock issues additional shares.  After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq. 10 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 6.4 Common Stock Valuation 11 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  Dividend growth model  Using the multiples of comparable firms  Free cash flow method Different Approaches for Valuing Common Stock 12 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012                   ssss r D r D r D r D P 1 . . . 111 ˆ 3 3 2 2 1 1 0 One whose dividends are expected to grow forever at a constant rate, g. Stock Value = PV of Dividends What is a constant growth stock? 13 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 For a constant growth stock,       D D g D D g D D g t t t 1 0 1 2 0 2 1 1 1         gr D gr gD P ss      1 0 0 1 ˆ If g is constant, then: 14 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012   D D g t t   0 1   t t t r D PVD   1 !P r,>g 0 If P PVD t0   $ 0.25 Years (t) 0 15 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What happens if g > r s ?  If r s < g, get negative stock price, which is nonsense.  We can’t use model unless (1) g  r s and (2) g is expected to be constant forever. Because g must be a long- term growth rate, it cannot be  r s . .r requires ˆ s 1 0 g gr D P s    16 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Assume beta = 1.2, r RF = 7%, and RP M = 5%. What is the required rate of return on the firm’s stock? r s = r RF + (RP M )b Firm = 7% + (5%) (1.2) = 13%. Use the SML to calculate r s : 17 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 D 0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. r s = 13%. 0 1 2.2472 2 2.3820 3 g=6% 4 1.8761 1.7599 1.6508 D 0 =2.00 13% 2.12 18 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What’s the stock’s market value? D 0 = 2.00, r s = 13%, g = 6%. Constant growth model:   gr D gr gD P ss      1 0 0 1 ˆ = = $30.29. 0.13 - 0.06 $2.12 $2.12 0.07 19 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What is the stock’s market value one year from now, P 1 ?  D 1 will have been paid, so expected dividends are D 2 , D 3 , D 4 and so on. Thus, ^ D 2 P 1 = r s - g = $2.2427 = $32.10 0.07 20 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Find the expected dividend yield and capital gains yield during the first year. Dividend yield = = = 7.0%. $2.12 $30.29 D 1 P 0 CG Yield = = P 1 - P 0 ^ P 0 $32.10 - $30.29 $30.29 = 6.0%. 21 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Find the total return during the first year.  Total return = Dividend yield + Capital gains yield.  Total return = 7% + 6% = 13%.  Total return = 13% = r s .  For constant growth stock: Capital gains yield = 6% = g. 22 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Rearrange model to rate of return form: .r to ˆ 0 1 s 1 0 g P D gr D P s     Then, r s = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. ^ 23 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What would P 0 be if g = 0? The dividend stream would be a perpetuity. 2.00 2.00 2.00 0 1 2 3 r s =13% P 0 = = = $15.38. PMT r $2.00 0.13 ^ 24 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P 0 ? r is still 13%.  Can no longer use constant growth model.  However, growth becomes constant after 3 years. ^ 25 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Nonconstant growth followed by constant growth: 0 2.3009 2.6470 3.0453 46.1135 1 2 3 4 r s =13% 54.1067 = P 0 g = 30% g = 30% g = 30% g = 6% D 0 = 2.00 2.60 3.38 4.394 4.6576 ^ 5371.66$ 06.013.0 6576.4$ P ˆ 3    26 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What is the expected dividend yield and capital gains yield at t = 0? At t = 4? Dividend yield = = = 4.8%. $2.60 $54.11 D 1 P 0 CG Yield = 13.0% - 4.8% = 8.2%. At t = 0: (More…) 27 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  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 r s = 13%, the t = 4 dividend yield = 13% - 6% = 7%. 28 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  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: Is the stock price based on short-term growth? ^ = 85.2%. $46.11 $54.11 29 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 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. 30 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P 0 ? 0 1.7699 1.5663 1.3861 20.9895 1 2 3 4 r s =13% 25.7118 g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 2.12 .  P 3 0 07 30.2857   ^ 31 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 What is dividend yield and capital gains yield at t = 0 and at t = 3? t = 0: D 1 P 0 CGY = 13.0% - 7.8% = 5.2%.   2.00 $25.72 7.8%. t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%. 32 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0:   gr D gr gD P ss      1 0 0 1 ˆ ^ = = = $9.89. $2.00(0.94) 0.13 - (-0.06) $1.88 0.19 33 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 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. 34 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks.  Example: Estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. Using the Stock Price Multiples to Estimate Stock Price 35 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  The entity value (V) is: the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt.  Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc.  Calculate the average entity ratio for a sample of comparable firms. For example, V/EBITDA V/Customers Using Entity Multiples 36 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  Find the entity value of the firm in question. For example, Multiply the firm’s sales by the V/Sales multiple. Multiply the firm’s # of customers by the V/Customers ratio  The result is the total value of the firm.  Subtract the firm’s debt to get the total value of equity.  Divide by the number of shares to get the price per share. Using Entity Multiples (Continued) 37 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  It is often hard to find comparable firms.  The average ratio for the sample of comparable firms often has a wide range. For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers? Problems with Market Multiple Methods 38 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Why are stock prices volatile? gr D 0 P s 1    r s = r RF + (RP M )b i could change.  Inflation expectations  Risk aversion  Company risk  g could change. ^ 39 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Stock value vs. changes in r s and g D 1 = $2, r s = 10%, and g = 5%: P 0 = D 1 / (r s -g) = $2 / (0.10 - 0.05) = $40. What if r s or g change? g g g r s 4% 5% 6% 9% 40.00 50.00 66.67 10% 33.33 40.00 50.00 11% 28.57 33.33 40.00 40 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 Are volatile stock prices consistent with rational pricing?  Small changes in expected g and r s cause large changes in stock prices.  As new information arrives, investors continually update their estimates of g and r s .  If stock prices aren’t volatile, then this means there isn’t a good flow of information. [...]... > rs, then P0 is “too low.” P0 B02022 – Chapter 6 - Stocks and Their Valuation B02022 – Chapter 6 - Stocks and Their Valuation  g could change 43 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 44 What’s the Efficient Market Hypothesis (EMH)? 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 Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information (More…) 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 45 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 46 3 Strong-form EMH: All information, even inside information, is embedded in stock... 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 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 47 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 48 Markets are generally efficient because: Preferred Stock Hybrid security Similar to bonds in that preferred stockholders... 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 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 49 What’s the expected return on preferred stock with Vps = $50 and annual dividend = $5? V ps  $50  $5... expected return on preferred stock with Vps = $50 and annual dividend = $5? V ps  $50  $5  r ps  r ps  23/8/2012 $5  0.10  10.0% $50 B02022 – Chapter 6 - Stocks and Their Valuation 51 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 50 ... (More…) 23/8/2012 B02022 – Chapter 6 - Stocks and Their Valuation 41 23/8/2012 How is equilibrium established? ^ P0  If the price is lower than the fundamental value, then the stock is a “bargain.” D1 ri  g  ri = rRF + (rM - rRF )bi could change  Inflation expectations  Risk aversion  Company risk Buy orders will exceed sell orders, the price will be bid up, and D1/P0 falls until D1/P0 + g = ^s . 6.4 Common Stock Valuation 2 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 6.1 Key Characteristics of Stocks 3 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012. 1 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 CHAPTER 6 Stocks and Their Valuation  6.1 Key Characteristics of Stocks  6.2 Types of Common Stock  6.3. NYSE or Nasdaq. 10 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012 6.4 Common Stock Valuation 11 B02022 – Chapter 6 - Stocks and Their Valuation 23/8/2012  Dividend growth