7 - 1 CHAPTER 7 Stocks and Their Valuation  Features of common stock  Determining common stock values  Efficient markets  Preferred stock 7 - 2  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 7 - 3  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? 7 - 4  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 - 5 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. 7 - 6 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. 7 - 7  Dividend growth model  Using the multiples of comparable firms  Free cash flow method (covered in Chapter 15) Different Approaches for Valuing Common Stock 7 - 8 ( ) ( ) ( ) ( ) ∞ ∞ + ++ + + + + + = 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? 7 - 9 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: 7 - 10 ( ) 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 [...]... (RPM)bi could change  Inflation expectations  Risk aversion  Company risk  g could change 7 - 35 Stock value vs changes in rs and g D1 = $2, rs = 10%, and g = 5%: P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40 What if rs or g change? g g g rs 9% 10% 11% 4% 40.00 33.33 28.57 5% 50.00 40.00 33.33 6% 66.67 50.00 40.00 7 - 36 Are volatile stock prices consistent with rational pricing?  Small changes in... years, and their PVs rs = 13% 0 g=6% 1 D0=2.00 2.12 1.8761 13% 1.7599 1.6508 2 2.2472 3 2.3820 4 7 - 14 What’s the stock’s market value? D0 = 2.00, rs = 13%, g = 6% Constant growth model: ˆ = D0 ( 1 + g ) = D1 P0 rs − g rs − g $2.12 $2.12 = = $30.29 0.13 - 0.06 0 .07 7 - 15 What is the stock’s market value one year from now, ^ 1? P  D1 will have been paid, so expected dividends are D2, D3, D4 and so... 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 7 - 26 Suppose g = 0 for t = 1 to 3, and then g is a constant 6% What is ^ 0? P 0 rs=13% g = 0% 1 2 g = 0% 2.00 1.7699 1.5663 1.3861 20.9895 25.7118 3 g = 0% 2.00 4 g = 6% 2.00 2.12  = 2.12 = 30.2857 P3 0 .07 7 - 27... = 2.12 = 30.2857 P3 0 .07 7 - 27 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% 7 - 28 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays ^ > 0: dividends, so P0 ˆ = D0 ( 1 + g )... negative stock price, which is nonsense  We can’t use model unless (1) g < rs and (2) g is expected to be constant forever Because g must be a longterm growth rate, it cannot be > rs 7 - 12 Assume beta = 1.2, rRF = 7%, and RPM = 5% What is the required rate of return on the firm’s stock? Use the SML to calculate rs: rs = rRF + (RPM)bFirm = 7% + (5%) (1.2) = 13% 7 - 13 D0 was $2.00 and g is a constant... 5% 50.00 40.00 33.33 6% 66.67 50.00 40.00 7 - 36 Are volatile stock prices consistent with rational pricing?  Small changes in expected g and rs cause large changes in stock prices  As new information arrives, investors continually update their estimates of g and rs  If stock prices aren’t volatile, then this means there isn’t a good flow of information ...  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... - 15 What is the stock’s market value one year from now, ^ 1? P  D1 will have been paid, so expected dividends are D2, D3, D4 and so on Thus, D2 P1 = rs - g = $2.2427 = $32.10 0 .07 7 - 16 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% 7 - 17 Find the total return during... 3.0453 46.1135 54.1067 ^ = P0 ˆ = $4.6576 = $66.5371 P3 0.13 − 0.06 7 - 22 What is the expected dividend yield and capital gains yield at t = 0? At t = 4? At t = 0: $2.60 D1 Dividend yield = = = 4.8% P0 $54.11 CG Yield = 13.0% - 4.8% = 8.2% (More…) 7 - 23  During nonconstant growth, dividend yield and capital gains yield are not constant  If current growth is greater than g, current capital gains yield... its stock price 7 - 31 Using Entity Multiples  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 7 - 32 Using Entity Multiples (Continued)  Find . 7 - 1 CHAPTER 7 Stocks and Their Valuation  Features of common stock  Determining common stock values  Efficient. secondary market, such as the NYSE or Nasdaq. 7 - 7  Dividend growth model  Using the multiples of comparable firms  Free cash flow method (covered in Chapter 15) Different Approaches for Valuing. management.  Since managers are “agents” of shareholders, their goal should be: Maximize stock price. Common Stock: Owners, Directors, and Managers 7 - 3  Classified stock has special provisions.  Could