Stocks and Their Valuation

8-1
 Common stock
Security representing ownership in a
corporation
Common stockholders have a final claim on
the firms assets and earnings after the firm
has met its obligations to creditors and
preferred stockholders.

8-2
 Facts about common stock

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

8-3
 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.

8-4
Legal Rights and Privileges of Common
Shareholders
Control of the Firm
Friendly takeover
Hostile takeover
Preemptive Right
Right of current stockholders to maintain their proportionate
ownership. This is done through rights offering
Prevents management from issuing a large number of additional
shares and purchasing those shares itself
To protect the existing common shareholders from dilution.

8-5
 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
government organization. 8-6
Types of stock market transactions

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

8-7
 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.
8-8
 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 8-9
 Different approaches for valuing
common stock

Dividend growth model

Corporate value model
Multiplier models

8-10
 Dividend growth model or Discounted
Dividend Model
Valuation model for common stock that discounts future
dividends.
Value of a stock is the present value of the future dividends
expected to be generated by the stock.
^ D1 D2 D3 D
P0 ...
(1 rs ) (1 rs )
1 2
(1 rs ) 3
(1 rs )

8-11
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
8-12
 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

8-13
Future dividends and their present values

t
$ D t D0 ( 1 g )

Dt
0.25 PVD t
(1 r ) t

P0 PVDt

0 Years (t)
8-14
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%
8-15
 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%
8-16
If D0 = $2 and g is a constant 6%, find the expected
dividend stream for the next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

8-17
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

8-18
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
8-19
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%

8-20
If D0 = $2, rs 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

8-21
 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.

8-22
 Valuing common stock with
nonconstant growth

0 k = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P$ 3 $66.54
^ 0.13 - 0.06
54.107 = P0
8-23
 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%.

8-24
 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%.

8-25
 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%.

8-26
 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 2 3 4
s
...
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P$ 3 $30.29
^ 0.13 - 0.06
25.72 = P0
8-27
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%.

8-28
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.

^ D1 D0 ( 1 g )
P0
ks - g ks - g
$2.00 (0.94) $1.88
$9.89
0.13 - (-0.06) 0.19

8-29
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.

8-30
 Exercise 1
You are considering an investment in Jolimark Holdings
Limiteds stock, which is expected to pay a dividend of
$A2.20 a share at the end of the year (D1 = $2.20) and
has a beta of 0.88. The risk free rate is 6% and the
market risk premium is 6%. Jolimark currently sells for
$25.00 a share, and its dividend is expected to grow at
some constant rate g. Assuming the market is in
equilibrium, what does the market believe will be the
stock price at the end of 3 years?

8-31
 Exercise 2
Quaypoint Corporation is expanding rapidly and
currently needs to retain all of its earnings; hence, it
does not pay dividends. However, investors expect
Quaypoint to begin paying dividends, beginning with a
dividend of $1.00 coming 3 years from today. The
dividend should grow rapidly at a rate of 0% per year
during Years 4 and 5; but after Year 5, growth should be
a constant 8% pre year. If the required return on
Quaypoint is 14%, what is the value of the stock today?

8-32
 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 (-or-)
FCF = (EBIT(1-T) + Depreciation and Amortization)
(CAPEX + change in NWC)
8-33
 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

8-34
 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.

8-35
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 2 3 4
...
g = 6%
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = = TV3
0.10 - 0.06
416.942

8-36
 If the firm has $30 million in debt, $10 million in
preferred stock, 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

8-37
 Exercise 3
Barrett Industries invests a large sum of money in R&D; as a result, it
retains and reinvests all of its earnings. In other words, Barrett does not
pay any dividends and it has no plans to pay dividends in the near
future. A major pension fund is interested in purchasing Barretts stock.
The pension fund manager has estimated Barretts free cash flows for
the next 4 years as follows: $3 million, $6 million, $10 million, and $15
million. After the fourth year, free cash flow is projected to grow at a
constant 7%. Barretts WACC is 12%, its debt and preferred stock total
$60 million, and it has $10 million shares of common stock outstanding.
Requirement 1: What is the present value of the free cash flows
projected during the next 4 years?
Requirement 2: What is the firms terminal value?
Requirement 3: What is the firms total value today?
Requirement 4: What is an estimate of Barretts price per share?
8-38
 Exercise 10-22
Assume that today is December 2014, and that the following
information applies to SA Inc.
After tax operating income for 2015 is expected to be $500 million.
The depreciation expense for 2015 is expected to be $100 million.
The capital expenditures for 2015 are expected to be $200 million.
No change is expected in net working capital.
The free cash flow is expected to grow at a constant rate of 6% per
year.
The required return on equity is 14%.
The WACC is 10%.
The market value of the companys debt is $3 billion.
200 million shares are outstanding.
Using the corporate valuation model approach, what should be SAs
stock price today? 8-39
 Multiplier Models:
Analysts often use the following multiples to value
stocks.
P/E
P / CF
P / Sales
EXAMPLE: If earnings are $2.45 and the appropriate
multiple or P/E ratio is 13, what is the value of the
stock? If the stock price is $35, is the stock
undervalued, properly valued, or overvalued?
Should the stock be purchased?

8-40
 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 rs rRF (rM - rRF )
P0

8-45
 Market equilibrium
Expected returns are obtained by estimating
dividends and expected capital gains.
Required returns are obtained by estimating
risk and applying the CAPM.

8-46
 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

8-47
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

8-48
 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.

8-49
 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%

8-50
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

8-51
 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.

8-52
 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

8-53
 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.

8-54
 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.
8-55
OTHER EXERCISES

8-56
 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 risk-
free 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?

8-57
 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?

8-58
 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?

8-59
 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)?
8-60
 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?

8-61
 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?

8-62