3/20/2015

Stocks and Their Valuation

BASFIN1

Outline

Features of common stock

Determining common stock values
Efficient markets
Preferred stock

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Introduction

Introduction

The value of any financial asset (a

stock, a bond) is simply the present
value of the cash flows the asset is
expected to produce.
While it is easy to predict the cash flows
received from bonds, forecasting the
cash flows on common stocks is much
more difficult.

However, two fairly straightforward

models can be used to help estimate
the true, or intrinsic, value of a
common stock
The dividend growth model.
The total corporate value model

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The common stockholders are the

owners of a corporation and as such
they have certain rights and privileges

Legal Rights
and Privileges
of Common
Stockholders

Control of the Firm

Common stockholders have the right to
elect firms directors, who, in turn, (hire)
elect the officers who manage the
business.
right to vote
proxy fight.

Common
Stock:
Owners,
Directors, and
Managers

Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are agents of
shareholders, their goal should be:
Maximize stock price.

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The Preemptive Right

Legal Rights
and Privileges
of Common
Stockholders

Types of
Common
Stock

The Preemptive right is the right to

purchase any additional shares sold by
the firm.

There are two primary reasons for the

existence of the preemptive right
maintain control
Prevents a transfer of wealth from current
stockholders to new stockholders

Most firms have only one type of

common stock, in some instances
classified stock and Tracking stock is
used to meet the special needs of the
company.
Classified stock
Tracking stock

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Whats
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.

The dividends of tracking stock are tied

to a particular division, rather than the
company as a whole.

What is
tracking stock?

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.

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Financial markets: allocate funds from surplus

units to deficit units
Classification of Financial Markets:
Based on Transaction Time: Spot Markets / Futures
Markets

Financial
markets

Assets are being bought or sold for on-the-spot

delivery (within few days) versus for delivery at some
future date (six months, a year, etc.)

Based on Maturity: Money Markets / Capital

Markets

Money markets are the markets for short term (one

year or less), highly liquid debt securities (T-Bills,
Commercial Papers, Banker Acceptance, Repos, etc.).
Capital markets are markets for long term debt and
corporate stocks (T-Bonds, Corporate Bonds,
Mortgages, Equity Securities, etc.).

Based on Issuance: Primary Markets /

Secondary Markets

Financial
markets

Primary markets are the markets in which

corporations raise capital by issuing new
securities.
Secondary markets are the markets in
which financial assets are traded among
investors after they have been issued by
corporations.

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Based on Location: Organized Markets

/ OTC Markets

Financial
markets

Organized markets (exchanges) are the

markets, which operate in a visible
marketplace.
OTC (over-the-counter) markets are the
markets, which operate over
telecommunication network.

We can classify stock market

transactions into three distinct types:

Types of Stock
Market
Transactions

Trading in the outstanding shares of

established, publicly owned companies:
the secondary market.
Additional shares sold by established,
publicly owned companies: the primary
market.

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When is a
stock sale an
initial public
offering (IPO)?

What is a
seasoned
equity offering
(SEO)?

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 firms managers, key
employees, and, in many situations,
venture capital providers.

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.

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Common
Stock
Valuation

Definitions of
Terms Used in
Stock
Valuation
Models

Common stock represents an

ownership interest in a corporation, but
to the typical investor a share of
common stock is simply a piece of
paper characterized by two features:
It entitles its owner to dividends, if the
company has earnings and chooses to pay
dividends rather than retaining and
reinvesting all the earnings
Stock can be sold at some future date,
hopefully at a price greater than the
purchase price (capital gain).

Common stocks provide an expected future

cash flow stream.
A stocks value is found in the same manner as
the values of other financial assets, as the
present value of the expected future cash flow
stream
The expected cash flows consist of two
elements:
The dividends expected in each year and
The price investors expect to receive when they
sell the stock.

The expected final stock price includes the

original investment plus an expected capital
gain.

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Definitions of
Terms Used in
Stock
Valuation
Models

Definitions of
Terms Used in
Stock
Valuation
Models

Dt dividend the stockholder expects to receive

at the end of Year t.
D0 is the most recent dividend, which has
already been paid
D1 is the first dividend expected, and it will
be paid at the end of this year.
D2 is the dividend expected at the end of
two years; and so forth.
P0 actual market price of the stock today

Pt expected price of the stock at the end

of each Year t.
P0 is the intrinsic, or fundamental,
value of the stock today as seen by the
particular investor doing the analysis.
P1 is the price expected at the end of
one year ; and so on.

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Definitions of
Terms Used in
Stock
Valuation
Models

g expected growth rate in dividends as

predicted by a marginal investor.
rs minimum acceptable, or required,
rate of return on the stock, considering
both its riskiness and the returns
available on other investments.
rs expected rate of return that an
investor who buys the stock expects to
receive in the future
rs actual, or realized, after-the-fact rate
of return

Stock Valuation

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Value of a stock is the present value of

the future dividends expected to be
generated by the stock.

Dividend
growth model

P0

D3
D1
D2
D

...

(1 k s )1 (1 k s )2 (1 k s )3
(1 k s )

Analysis of a Constant
Growth Stock

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A stock whose dividends are expected to grow

forever at a constant rate, g.
D1 = D0 (1+g)1 - dividend for year 1
D2 = D0 (1+g)2 - dividend for year 2
Dt = D0 (1+g)t - dividend for year t

Constant
growth stock

If g is constant, the dividend growth formula

converges to:
Value of stock is then =
^

P0

Constant
growth stock Example

D 0 (1 g)
D1

ks - g
ks - g

The last dividend, which was just paid, was $1.15; the
stocks last closing price was $23.06; and it is in
equilibrium. Based on an analysis of Allieds history
and likely future, the analyst forecasts that earnings
and dividends will grow at a constant rate of 8.3% per
year and that the stocks price will grow at this same
rate. Moreover, the analyst believes that the most
appropriate required rate of return is 13.7%
D0 = $1.15
P0 = $23.06

g = 8.3%
ks = 13.7%

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D0 = $1.15
P0 = $23.06
g = 8.3%
ks = 13.7%

Constant
growth stock Example

What is the Dividend for Year 2 = D2

D2 = D0 (1+g)2 - dividend for year 2
D2 = $1.15 (1+8.3%)2
D2 = $1.3488
^

P1

D1 (1 g)
D2
$1.3488

$24.97778
ks - g
k s - g 13.7% - 8.3%

D0 = $1.15
P0 = $23.06

g = 8.3%
ks = 13.7%

Constant
growth stock Example

What is the Price next year?

^

P1

D1 (1 g)
D2
$1.3488

$24.97778
ks - g
k s - g 13.7% - 8.3%

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D0 = $1.15

P0 = $23.06
g = 8.3%
ks = 13.7%

What is the Dividend yield?

Constant
growth stock Example

Get Dividend for Year 1 = D1

D1 = D0 (1+g)1

- dividend for year 1

D1 = $1.15 (1+g)1 = $1.24545

Dividend yield = Dt/Pt-1
= D1/P0
= $1.24545 / $23.06
= 5.40%

D0 = $1.15

P0 = $23.06
g = 8.3%
ks = 13.7%

Constant
growth stock Example

What is the Capital gains yield?

= (Pt-Pt-1)/Pt-1
= (Pt-Pt-1)/Pt-1
= (P1-P0)/P0

= ($24.98 - $23.06)/ $23.06

= 8.33%

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D0 = $1.15
P0 = $23.06
g = 8.3%

ks = 13.7%

Constant
growth stock Example

What is the Total Return?

Total Return = Dividend Yield + Capital Gains Yield
Total Return = 5.40%+ 8.33%
Total Return = 13.73%

Future
dividends and
their present
values

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What happens
if g > ks?

If g > ks, the constant growth formula

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

If kRF = 7%, kM = 12%, and = 1.2, what

is the required rate of return on the
firms stock?

Required
Return
Example

Use the SML to calculate the required

rate of return (ks):

ks = kRF + (kM kRF)

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

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If D0 = $2 and g is a constant 6%, find

the expected dividend stream for the
next 3 years, and their PVs.

Stocks Market
Value Example

What is the stocks market value?

Using the constant growth model:

Stocks Market
Value Example

P0

D1
$2.12

k s - g 0.13 - 0.06

$2.12
0.07
$30.29

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What is the expected market price of the stock,

one year from now?

Stocks
Expected
Market Price
Example

D1 will have been paid out already. So, P1 is the

present value (as of year 1) of D2, D3, D4, etc.

Could also find expected P1 as:

^

P1 P0 (1.06) $32.10

What is the expected dividend yield,

capital gains yield, and total return during
the first year?

Expected
dividend yield,
capital gains
yield, and total
return
Example

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 (ks)

= Dividend Yield + Capital Gains Yield

= 7.0% + 6.0% = 13.0%

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What would the expected price today

be, if g = 0?
The dividend stream would be a
perpetuity.

Expected Price
Example

ks = 13%

...
2.00

P0

2
2.00

2.00

PMT $2.00

$15.38
k
0.13

What if g = 30% for 3 years before

achieving long-run growth of 6%?

Supernormal
growth

Can no longer use just the constant

growth model to find stock value.
However, the growth does become
constant after 3 years.

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Valuing common
stock with nonconstant growth

Find expected dividend and capital gains

yields during the first and fourth years.

Valuing
common stock
with
nonconstant
growth

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%.

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Nonconstant
growth
example

Find expected dividend and capital

gains yields during the first and fourth
years.

Expected
Dividend and
Capital Gains

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%.

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If the stock was expected to have

negative growth (g = -6%), would anyone
buy the stock, and what is its value?

Stock Value
Example

The firm still has earnings and pays

dividends, even though they may be
declining, they still have value.
^

P0

D (1 g )
D1
0
ks - g
ks - g
$2.00 (0.94) $1.88

$9.89
0.13 - (-0.06) 0.19

Find expected annual dividend and capital

gains yields.

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.

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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
after-tax operating income less the net
capital investment
FCF = NOPAT Net capital investment

Find the market value (MV) of the firm.

Find PV of firms future FCFs

Applying the
corporate
value model

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

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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.

Given the long-run gFCF = 6%, and

WACC of 10%, use the corporate value
model to find the firms intrinsic value.

Firms intrinsic
value

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If the firm has $40 million in debt and has

10 million shares of stock, what is the
firms intrinsic value per share?

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

Analysts often use the following multiples to

value stocks.

Firm multiples
method

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.

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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.
^

ks

Market
equilibrium

D1
g
P0

k s k RF (k M k RF )

Expected returns are obtained by

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

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If expected return exceeds required

return

How is market
equilibrium
established?

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

Factors that
affect stock
price

Required return (ks) could change

Changing inflation could cause kRF 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

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What is the
Efficient
Market
Hypothesis
(EMH)?

Weak-form
efficiency

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

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.

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Semistrongform efficiency

Strong-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

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.

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Empirical studies have been conducted to

test the three forms of efficiency. Most of
which suggest the stock market was:

Is the stock
market
efficient?

Preferred
stock

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.

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.

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If preferred stock with an annual

dividend of $5 sells for $50, what is the
preferred stocks expected return?

preferred
stocks
expected
return

Vp = D / k p
$50 = $5 / kp
kp = $5 / $50
= 0.10 = 10%

More Examples

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Dividend yield
= D 1 / P0

The
Discounted
Dividend
Model:
Dividend Yield

Dividend = $1
Price - $20
= $1/$20
= 0.05 = 5.00%

Capital gains yield

= (P1 P0) / P0

The
Discounted
Dividend
Model:
Expected
Capital Gains

P0 = $20.00
Expected to rise
P1 = $21.00
= (21 20) / 20
= 1/20
= 0.05 = 5%

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Total return (ks)

= Dividend Yield + Capital Gains Yield

The
Discounted
Dividend
Model:
Expected Total
Return

Looking at the previous examples answers

Dividend Yield = 5%
Capital Gains Yield = 5%

Total return (ks)

= 5% + 5% = 10%

D1 = $2.00
P0 = $40.00
g = 6%

Board work

What is the:
Dividend yield
Capital gains yield
Total return

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Examples

Constant
growth stock Examples

Firm A is expected to pay a dividend of

$1.00 at the end of the year. The
required rate of return is rs = 11%.
Other things held constant, what
would the stocks price be if the growth
rate was 5%? What if g was 0%?
D0 = $1
g = 5.0%

ks = 11%

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Firm A is expected to pay a dividend of $1.00 at the

end of the year. The required rate of return is rs =
11%. Other things held constant, what would the
stocks price be if the growth rate was 5%? What if g
was 0%?
D1 = $1

Constant
growth stock Examples

g = 5.0%
ks = 11%

D 0 (1 g)
D1
$1

$16.67
ks - g
k s - g 11% - 5%
^
D (1 g)
D1
$1
P0 0

$9.09
ks - g
k s - g 11% - 0%

If g = 5%

If g = 0%

P0

Firm B has a 12% ROE. Other things held constant,

what would its expected growth rate be if it paid out
25% of its earnings as dividends? 75%?

ROE = 12%

Dividends
Versus Growth
- Examples

Dividend Payout Ratio = 25% of earnings

Growth rate = (1 - Payout ratio) ROE
If 25%

= (1 0.25)*.12
= 9%
Growth rate = (1 - Payout ratio) ROE

If 75%

= (1 0.75)*.12
= 3%

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Supernormal (Nonconstant) Growth - The part of the

firms life cycle in which it grows much faster than
the economy as a whole.

Non-Constant
Growth Stocks
- Examples

required rate of return = 13.4%

gs = 8%

gs = 30% for 3 years

D0 = $1.15

PV of D1 + D2
Step 1:
Get dividends and PV
of dividends for 3
years
Step 2:
Get PV of Year 3
Price

D1 = D0 (1 +g)1 = $1.15 (1 +g)1 = $1.4950

PV of $1.495 = $1.495/(1+13.4%)^1 = $1.3183

D2 = D0 (1 +g)2 = $1.15 (1 +g)2= $1.9435

PV of $1.9435 = $1.9435/(1+13.4%)^2 = $1.5113
D3 = D2 (1 +g)3 = $1.15 (1 +g)3= $2.5265
PV of $2.5265 = $2.5265/(1+13.4%)^3 = $1.7326

Supernormal (Nonconstant) Growth - The part of the

firms life cycle in which it grows much faster than
the economy as a whole.

Non-Constant
Growth Stocks
- Examples

required rate of return = 13.4%

gs = 8%

gs = 30% for 3 years

D0 = $1.15

Horizon Value is the value/price of a

stock as of a particular time
Step 1:
Get dividends and PV
of dividends for 3
Horizon Value = P3 Horizon Value as of Year 3
years
^
D (1 g)
D (1 g) * (1 g)
Step 2:
P3 3
2
k
g
ks - g
Get PV of Year 3
s
Price
$1.9435(1 0.30) * (1 0.08)

13.4% - 8%

$50.5310

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Supernormal (Nonconstant) Growth - The part of the

firms life cycle in which it grows much faster than
the economy as a whole.

Non-Constant
Growth Stocks
- Examples

required rate of return = 13.4%

gs = 8%

gs = 30% for 3 years

D0 = $1.15
PV of Dividends (check previous slides)
= $1.3183 + $1.5113 + $1.7326

Step 3:
PV of Year 3 Price (P3= $50.5310)
Add PV of dividends for
= $50.5310/(1+13.4%)^3
Years 1 -3
= $34.65123591
+ PV of Price for Year 3
= $1.3183 + $1.5113 + $1.7326 + $34.65123591

= $39.21343591

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