CHAPTER 6

VALUING STOCKS
TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS

6.1 STOCKS AND THE STOCK MARKET

A. Financial markets provide a source of financing for businesses and governments.
They also provide financial investment opportunities for individual and institutional
investors.

B. The initial, funds-raising sale of securities, usually with an investment banker, is in

the primary market; subsequent trading between investors for liquidity, financial
investing, and portfolio rebalancing is in the secondary market.

C. There are two types of primary market issues: an initial offering or IPO and a
seasoned offering. An IPO is the first sale of newly issued stock to “public”
investors. The company receives the funds and investors receive the shares. We say
the company “goes public” when it undertakes an IPO. A seasoned offering is the
sale of additional shares by a company that has already gone public. In a seasoned
offering, the company raises additional equity financing from investors who receive
new shares in return.

Reading the Stock Market Listings

A. Figure 6.1 lists a number of stock quotations. Note that the dividend is
“annualized”. That is, if the company normally pays quarterly dividends, the
reported dividend is four times its quarterly dividend. The dividend yield is the
annualized dividend divided by the closing price.

B. Why do the dividend yields vary? Expected price appreciation and risk.

C. The price-earnings (P/E) multiple is the closing price divided by the earnings per
share. Commonly used in valuation assessment, the ratio indicates the number of
years of current earnings the market is willing to pay to own the stock. For
example, if the current price is $100 and the earnings per share are $10, the P/E
multiple is 10. Given the current earnings per share, it would take 10 years for the
stock to generate earnings equal to the current price, ignoring the time value of
money!

6.2 BOOK VALUES, LIQUIDATION VALUES, AND MARKET VALUES

A. Book value of common shares represents the accounting value of assets less the
accounting value of liabilities.

6-1
Copyright © 2006 McGraw-Hill Ryerson Limited
 B. Book value is biased toward historical or original costs.

C. Liquidation value of common shares represents the proceeds from the quick sale
of individual assets minus liabilities owed.

D. Going concern value represents the difference between a minimum liquidation

value and actual or “true” value (market), the worth of an on-going business by
investors considering, (1) future earning power of existing tangible and intangible
assets and (2) the value of future investment opportunities of the firm.

E. Market value represents the value assigned a firm by investors in a reasonable

market driven by the expected level and variability of cash flows. When the
market/book ratio exceeds one, the economic value of the assets exceeds the
accounting value or the expected rate of return to shareholders exceeds their
minimally acceptable rate of return.

A MARKET-VALUE BALANCE SHEET

Assets Liabilities and Shareholders’ Equity

Assets in place Market value of debt and other obligations
Investment Opportunities Market value of shareholders’ equity

6.3 VALUING COMMON STOCKS

Today’s Price and Tomorrow’s Price

A. The expected and actual realized rate of return to common shareholders comes
from 1) cash dividends, DIV1, and 2) capital gains or losses, P1 - P0.

B. The rate of return is calculated as:

Rate of return = = =

C. If you know what the future dividend and selling price in one year will be, you can
calculate the actual rate of return. With expected dividends and expected future
price, you can calculate the expected rate of return.

D. Taxes reduce the expected and actual rate of return earned on a stock investment.
To calculate the after-tax rate of return, convert both dividends and capital gain to
their after-tax amounts by subtracting the appropriate taxes:

After-tax Rate of return =

E. Investors compare expected returns, based on expected dividends and price

changes, with minimum required returns, comparable returns on similar securities
(opportunity costs).

6-2
Copyright © 2006 McGraw-Hill Ryerson Limited
 F. If expected returns exceed comparable returns elsewhere, investors will want to
purchase the stock, bidding the price up and the expected return down to the
minimum acceptable return.

G. At any market price, expected returns equal that return required by investors.

H. All securities of the same risk are priced to offer the same expected rate of return.

The Dividend Discount Model

A. The dividend discount model, or discounted cash flow model, states that share
value equals the present value of all expected future dividends.

B. With a specific investment time period or horizon, H, the intrinsic share value
(value determined by the evidence) is:

DIV1 DIV2 DIVH PH

P0 = + 2
+ .... H
+
1+ r (1+ r) (1+ r) (1+ r) H

C. The stock price at the horizon date, PH, is the present value of cash dividends
received beyond the horizon date.

D. As the horizon date changes, the present value of the stock will remain the same as
dividends are expected to grow at the rate of “g” (see Example 6.3, Table 6.4, and
Figure 6.2).

E. At extreme horizon dates the present value of PH becomes insignificant; thus the
dividend discount model share value equals the present value of future, expected
dividends.

6.4 SIMPLIFYING THE DIVIDEND DISCOUNT MODEL

The Dividend Discount Model with No Growth

A. When all earnings are paid as cash dividends, no growth is possible (reinvestment
= depreciation to maintain the current stock of capital).

B. The stock value of a no-growth firm is the expected dividend capitalized

(perpetuity) at the required rate of return or:

DIV1
P0 =
r

C. Assuming all earnings are paid as dividends,

6-3
Copyright © 2006 McGraw-Hill Ryerson Limited
 EPS1
P0 =
r

where EPS1 represents next year’s earnings per share.

The Constant-Growth Dividend Discount Model

A. The Constant-Growth Discount Model is an arithmetic expression calculating

the present value of a perpetual stream of cash flows, DIV, growing at a constant
rate of growth, g, and discounted at a required rate of return, r:

DIV1
P0 =
r-g

B. With a sustained positive growth rate in the economy and business activity, the
Gordon Model and its assumptions are reasonable.

C. DIV1 represents the dividend received at the end of period one.

D. The constant-growth formula is valid only when “g” is less than “r.”

E. P0 is directly related to DIV1 and g; inversely related to r.

Estimating Expected Rates of Return

A. In constant-growth business situations, if g is capitalized in the market in higher

stock prices, r may be a proxy for the market expected rate of return on similar
risk situations.

B. The expected rate of return is a combination of the dividend yield, DIV1/P0, and
capital appreciation rate, g, or:

DIV1
r= +g
P0

C. The required rate of return, r, is a market-determined rate related to the risk-free

rate adjusted upward for risk, given expectations of DIV1 and g. The stock price,
P0, adjusts to equate the market-expected rate with the required rate of return.

Non-constant Growth

A. The no-growth and constant-growth dividend discount models above assume two
patterns of cash flows while reality presents the analyst with many variations. The
dividend discount model is easily adapted.
6-4
Copyright © 2006 McGraw-Hill Ryerson Limited
 B. Changing future dividend patterns from non-growth to constant-growth to
variable-growth rates over a given horizon requires that the analyst estimate the
stock price by forecasting the cash-flow patterns and discounting the cash flows at
the market-required rate of return.

C. The terminal value, PH, represents the present value of the cash flows beyond the
horizon.

6.5 GROWTH STOCKS AND INCOME STOCKS

A. Income stock returns are derived from the dividend yield, DIV/price, and are
associated with businesses with a high payout ratio, the fraction of earnings paid
out as dividends.

B. Growth stock returns are derived from a combination of no or relatively small

dividend yields (low payout ratio) and a high plowback ratio or earnings retention
ratio (the proportion of current period earnings or free cash flow retained in firm),
and earning high asset returns, in excess of that required by the market, on
reinvested earnings.

C. The sustainable growth rate, g, discussed in the constant-growth rate discussion

above, relates to the expected asset returns on reinvested capital adjusted for the
proportion of earnings plowed back into the firm. Dividends (payout ratio) limit
the level of reinvested capital and the growth potential of future earnings and
dividends.

g = return on equity x plowback ratio,

where the return on equity is the expected return on equity capital plowed back
into earning assets.

D. Similar stock prices ($41.67) will result from a 100 percent payout ratio and any
less payout where the plowed back earnings earn just the required rate of return.

E. When rates of return on reinvested capital exceed the required rate of return,
added value, often called “value added” or the present value of growth
opportunities or (PVGO), is capitalized in the market price of the stock.

The Price-Earnings Ratio

A. Higher price-earnings ratios are associated with higher expected growth

opportunities and lower earnings-price ratios (earnings yield), reflecting that some
portion of the required rate of return is expected to be derived from growth
opportunities.

B. Expected future earnings are expected cash flows less any reinvestment associated
6-5
Copyright © 2006 McGraw-Hill Ryerson Limited
 with the economic depreciation of earning assets or earnings (cash flow) above
that needed to maintain the earning power of the firm.

Valuing Entire Businesses

A. The valuation of a share can be extended to the valuation of the equity of a

company. Either discount the company's total dividend payout by required rate of
return to equity less the dividend growth rate or multiply the share price by the
number of shares outstanding.

6.6 THERE ARE NO FREE LUNCHES ON WALL STREET OR BAY STREET

A. Does knowing how to value a stock allow an investor to make an instant fortune
on the stock market? No, because the market is an excellent processor of
information.

B. Investors, seeking to find stocks that will earn superior returns, use various ways
to analyze stocks.

Method 1: Technical Analysis

A. Technical analysts attempt to find patterns in security price movements and trade
accordingly. Their trading tends to quickly offset any price trend and keep the
markets efficient.

B. Research has shown time and again that security market price changes are
unrelated to prior price changes with no predictable trends or patterns. The prices
tend to be a random walk over time. See Figure 6.4.

Method 2: Fundamental Analysis

A. Fundamental analysts attempt to find under- or over-valued securities by

analyzing “fundamental” information, such as earnings, asset values, etc., to
uncover yet undiscovered information about the future of a business. They attempt
to forecast the impact of the information; technical analysts are studying past
prices, looking for predictable patterns.

B. Unfortunately, with so many investors following the news, it is very difficult to

consistently make superior returns by buying or selling stock after the
announcement of news.

C. Trading on corporate information before the news is released to the market may be
a successful strategy to beat the market. However, if the information is from an
insider of the company, including managers, employees and others with a close
relationship to the company, it is inside information and illegal to trade on.
6-6
Copyright © 2006 McGraw-Hill Ryerson Limited
 Penalties for insider trading can be very heavy, including large fines and jail time.

A Theory to Fit the Facts

A. The stock market is an efficient market, where security prices rapidly reflect all
relevant information, currently available, about asset values.

B. Investors react quickly to new information, trying to take advantage of it. In the
process, stock prices quickly adjust to the new information and eliminate the profit
opportunities.

C. The efficient-market theory implies that portfolio managers work in a very

competitive market with little or no added advantage over the next portfolio
manager. They make few extraordinary returns, not because they are incompetent,
but because the markets are so competitive and there are few easy profits. There
are no free lunches on Wall Street or Bay Street.

D. The efficient market theory implies that security market prices represent fair value.
Fair market value changes with new information about the future cash flows
associated with a security.

E. The three degrees of efficiency are defined relative to three types of information.

F. The first form of market efficiency is weak-form efficiency, where market prices
rapidly reflect all information contained in the history of past prices. Past price
movements are random; the past cannot predict future price changes. Technical
analysis is valueless in a weak-form efficient market.

G. A second form of market efficiency, semi-strong form efficiency, is a market

situation in which market prices reflect all publicly available information. See
Figure 6.7. New information is quickly reflected in the price of the stock, and
investors were not able to earn superior returns by buying or selling after the
announcement date.

H. A third form of market efficiency, strong-form efficiency, is a situation in which

prices rapidly reflect all information that could be used to determine true value. In
this market-pricing situation, all securities would always be fairly priced and no
investor would be able to make superior, accurate forecasts of future price
changes. Even professional portfolio managers do not consistently outperform the
market, thus supporting the creation of “index” portfolios, assembled to match
popular market indices.

Some Puzzles and Anomalies

A. Though the efficient markets hypothesis is well supported by research, there are
unexplained events and exceptions.

6-7
Copyright © 2006 McGraw-Hill Ryerson Limited
 B. Stock prices appear to underreact to unexpectedly good earnings announcements.

C. The long-run underperformance of new equity issues is a puzzle.

6.7 BEHAVIOURAL FINANCE AND THE RISE AND FALL OF THE

DOT.COMS

A. Behavioural finance, a relatively new field of finance, attempts to explain stock

market performance using behavioural psychology.

B. This approach rejects the notion of rational market investors. Instead investors'
attitudes towards risk and beliefs about probabilities lead them to "irrational
exuberance" and an over-valued stock market.

C. Whether behavioural finance will help to better understand the stock market is still
to be seen. In the mean time, it is difficult for investment managers and corporate
management to spot mispriced securities.

6-8
Copyright © 2006 McGraw-Hill Ryerson Limited