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valuation & characteristics of stocks
how to value characteristics of stocks

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Characteristics of Stock

Pamela L. Hall, Western Washington University

Common Stock

Background

Stockholders own the corporation, but in

many instances the corporation is widely held

• Stock ownership is spread among a large number

of people

Because of this, most stockholders are only

interested in how much money they will

receive as a stockholder

• Most equity investors aren’t interested in a role as

owners

2

The Return on an Investment in

Common Stock

The future cash flows associated with stock ownership consists of

Dividends

The eventual selling price of the shares

If you buy a share of stock for price P0, hold it for one year during

which time you receive a dividend of D1, then sell it for a price P1,

you return, k, would be:

D1+ P1 -P0

k=

P0 A capital gain (loss) occurs

or if you sell the stock for a

price greater (lower) than

D1 P1-P0

k= + you paid for it.

P P

{0 14 2043

dividend yield capital gains yield

3

The Return on an Investment in

Common Stock

We can solve the previous equation for P0, the stock’s

price today:

kP0 D1 P1 P0

P0 kP0 D1 P1

1 k P0 D1 P1

D1 P1

P0

1 k

The return on our stock investment is the interest rate

that equates the present value of the investment’s

expected future cash flows to the amount invested

today, the price, P0

4

The Nature of Cash Flows from

Stock Ownership

Comparison of Cash Flows from Stocks

and Bonds

The expected receipt of dividends and the

future selling price of stock is similar to

what a bondholder expects in terms of

interest and principal repayment

• However, with bondholders:

• A guarantee is associated with their interest payments

• Interest payments are constant

• The maturity value of a bond is fixed

• When the bond matures, the investor receives contracted

par or face value from the issuing company

• When stock is sold, the investor receives money from another

investor

5

The Basis of Value

The basis for stock value is the present value of

expected cash inflows even though dividends

and stock prices are difficult to forecast

Must make assumptions about what the future

dividends and selling price will be

• Discount these assumptions at an appropriate interest rate

P0 = D1 PVFk,1 D2 PVFk,2 K Dn PVFk,n Pn PVFk,n

6

The Basis of Value—Example

Q: Joe Simmons is interested in the stock of Teltex Corp. He feels it is

going to have two very good years because of a government contract,

but may not do well after that. Joe thinks the stock will pay a dividend

of $2 next year and $3.50 the year after. By then he believes it will be

selling for $75 a share, at which price he'll sell anything he buys now.

People who have invested in stocks like Teltex are currently earning

returns of 12%. What is the most Joe should be willing to pay for a

Example

share of Teltex?

A: Joe shouldn’t pay more than the present value of the cash flows he

expects: $2 at the end of one year and $3.50 plus $75 at the end of

two years.

$2[0.8929] $3.50[0.7972] $75.00[0.7972]

$64.37

7

The Intrinsic (Calculated) Value

and Market Price

A stock’s intrinsic value is based on

assumptions made by a potential investor

Must estimate future expected cash flows

• Need to perform a fundamental analysis of the

firm and the industry

Different investors with different cash flow

estimates will have different intrinsic

values

8

Growth Models of Common

Stock Valuation

Realistically most people tend to forecast

growth rates rather than cash flows

Because forecasting exact future prices and

dividends is very difficult

9

Developing Growth-Based

Models

A stock’s value today is the sum of the present values of

the dividends received while the investor holds it and the

price for which it is eventually sold

D1 D2 Dn Pn

P0 = K

1 k 1 k 2 1 k

n

1 k

n

Many investors buy a stock, hold for awhile, then sell, as

represented in the above equation

• However, this is not convenient for valuation purposes

10

Developing Growth-Based

Models

A person who buys stock at time n will hold it

until period m and then sell it

Their valuation will look like this:

Dn + 1 Dm Pm

Pn = +…+ +

1 + k 1 + k

m-n

1 + k

m-n

Di

P0

1 + k

i

i=1

selling price with an infinite series of dividends

11

Working with Growth Rates

If growth is expected to be 6% next year then

$100 experiencing a 6% growth will increase

by $6, or $100 x 6%

• The ending value after 6% growth will be $106, or

$100 + $6, or $100 x (1.06)

12

The Constant Growth Model

If dividends are assumed to be growing at a constant rate forever

and we know the last dividend paid, D0, then the model simplifies to:

D0 1 i

1

P0

1 + k

i

i=1

D0 1 g D0 1 g D0 1 g

2 3

P0 = K

1 k 1 k

2

1 k

3

get larger

If k>g growth is normal

If k<g growth is supernormal

• Can occur but lasts for limited time period

13

Constant Normal Growth—The

Gordon Model

Constant growth model can be simplified

to

K must be

D1 greater

P0 than g.

k g

expression for forecasting the price of a

stock that’s expected to grow at a

constant, normal rate

14

Constant Normal Growth—The

Gordon Model—Example

Q: Atlas Motors is expected to grow at a constant rate of 6% a year

into the indefinite future. It recently paid a dividends of $2.25 a

share. The rate of return on stocks similar to Atlas is about

11%. What should a share of Atlas Motors sell for today?

A: D1

Example

P0

k-g

$2.25 (1.06)

.11 - .06

$47.70

15

The Zero Growth Rate Case—

A Constant Dividend

If a stock is expected to pay a constant,

non-growing dividend, each dollar

dividend is the same

Gordon model simplifies to:

D

P0

k

A zero growth stock is a perpetuity to the

investor

16

The Expected Return

Can recast Gordon model to focus on the return

(k) implied by the constant growth assumption

D1

k g

P0

The expected return reflects investors’

knowledge of a company

If we know D0 (most recent dividend paid) and P0

(current actual stock price), investors’ expectations

are input via the growth rate assumption

17

Two Stage Growth

At times a firm’s future growth may not be

expected to be constant

For example, a new product may lead to temporary

high growth

The two-stage growth model allows us to value

a stock that is expected to grow at an unusual

rate for a limited time

Use the Gordon model to value the constant portion

Find the present value of the non-constant growth

periods

18

Two Stage Growth—Example

The Wall Street Journal. We’ve heard a rumor that the firm will

make an exciting new product announcement next week. By

studying the industry, we’ve concluded that this new product will

support an overall company growth rate of 20% for about two

years. After that, we feel growth will slow rapidly and level off at

Example

which can be expected to grow with the company. The rate of

return on stocks like Zylon is approximately 10%. Is Zylon a

good buy at $48?

expectations about growth.

19

Two Stage Growth—Example

Expected

Year Dividend Growth

1 $2.40 20%

2 $2.88 20%

Example

3 $3.05 6%

Next, we’ll use the Gordon model at the point in time where the

growth rate changes and constant growth begins. That’s year 2,

so:

D3 $3.05

P2 $76.25

k - g2 .10 - .06

20

Two Stage Growth—Example

P0 D1 PVFk, 1 + D2 PVFk, 2 + P2 PVFk, 2

$2.40 PVF10, 1 + $2.88 PVF10, 2 + $76.25 PVF10, 2

$2.40 0.9091 + $2.88 0.8264 + $76.25 0.8264

Example

$67.57

we are correct in our assumptions, Zylon

should be worth about $20 more than it is

selling for in the market, so we should buy

Zylon’s stock.

21

Practical Limitations of Pricing

Models

Stock valuation models give approximate results

because the inputs are approximations of reality

Bond valuation is precise because inputs are exact

• With bonds future cash flows are contractually guaranteed in

amount and time

Actual growth rate can be VERY different from predicted

growth rates

Even if growth rates differ only slightly, it can make a big

difference in our decision

So, it’s best to allow a margin for error in your

estimations

22

Practical Limitations of Pricing

Models

Stocks That Don’t Pay Dividends

Some firms don’t pay dividends even if they are

profitable

Many companies claim they never intend to pay

dividends

• These firms can still have a substantial stock price

Firms of this type typically are growing and are using

their profits to finance their growth

• However rapid growth won’t last forever

• When growth slows, the firm will begin paying dividends

• It’s these distant dividends that impart value

23

Some Institutional Characteristics

of Common Stock

Corporate Organization and Control

Controlled by Board of Directors (elected by stockholders)

Board appoints top management who then appoint middle/lower

management

Board consists of: top management and outside members

(major stockholders, top executives at other firms, former

presidents, etc.)

In widely held corporations, top management is effectively in

control of the firm because no stockholder group has enough

power to remove them

Preemptive Rights

If firm issues new shares, existing shareholders have right to

purchase pro rata share of new issue

Common, but not required by law

24

Voting Rights and Issues

vote in the election of directors, which is

usually cast by proxy

A proxy fight occurs if parties with conflicting

interests solicit proxies at the same time

25

Majority and Cumulative Voting

Majority voting gives the larger group control of

the company

Cumulative voting gives minority interest a

chance at some representation on the board

Shares With Different Voting Rights

Different classes of stock can be issued with different

rights

• Some stock may be issued with limited or no voting rights

26

Stockholders’ Claim on Income

And Assets

Stockholders have claim on the firm’s net

income

What is not paid out as dividends is retained

(Retained Earnings) for investment in new

projects

Leads to future growth

Common stockholders are last in line to receive

income or assets, and bear more risk than other

investors

However, residual interest is large when firm does

well

27

Preferred Stock

hybrid between common stock and bonds

because:

No maturity date (like common stock)

Fixed dividend payment (similar to bond

interest payment)

28

Valuation of Preferred Stock

dividends, so growth rate equals 0

The dividend at time 1 is the same as the

dividend at time 0, so there is usually no time

period associated with the numerator

Valuation is that of a perpetuity

D

P

p

p

k

29

Preferred Stock—Example

rates on similar issues are now 9%. What should Roman’s

preferred sell for today?

Example

A: Just substitute the new market interest rate into the preferred

stock valuation model to determine today’s price:

$6

P0 $66.67

.09

30

Characteristics of

Preferred Stock

Cumulative Feature

Common dividends can’t be paid unless the dividends on cumulative

preferred are current

Preferred stock never returns principal (like a bond does upon

maturity)

Preferred stockholders cannot force a firm into bankruptcy (like

bondholders)

Preferred stockholders received preferential treatment over

common stockholders in the event of bankruptcy, but have a lower

priority than bondholders

Preferred stockholders do not have voting rights (like common

stockholders do)

Dividend payments to preferred stockholders are not tax deductible

to the firm

31

Securities Analysis

Securities analysis is the art and science of

selecting investments

Fundamental analysis looks at a company and

its business to forecast value

Technical analysis bases value on the pattern of

past prices and volumes

The Efficient Market Hypothesis says

information moves so rapidly in financial

markets that price changes occur immediately,

so it is impossible to consistently beat the

market to bargains

32

Options and Warrants

Option gives the option holder the temporary right to buy

(or sell) an asset from another party at a fixed price

For instance, a company may be interested in building a

new factory on a tract of land, but it is still unsure if it

wants to build the factory

However, it plans to make a final decision in six months

The company could buy an option contract giving it the right to

buy the land at a fixed price by the end of the six months

• If the company pursues the factory project, it would exercise the

option

• If the company decided not to go ahead with the factory project it

would not have to exercise the option

• But what if the value of the land had risen substantially above the price

fixed by the option—it could exercise the option and sell the land for a

profit thus benefiting even though it didn’t own the land during the

period of the option

33

Stock Options

on stock price movements

Can be traded in financial markets

Call option (call)—an option to buy a stock

Put option (put)—an option to sell stock

Known as a derivative—derives its value

from the price of an underlying security

34

Call Option

Gives owner the right to buy stock at a fixed

price (called the exercise or strike price) for a

specified time period

• Usually 3, 6 or 9 months

Option expires at the end of the time period

Price of the option is less than the price of the

underlying stock

35

Figure 7-3: Basic Call Option

Concepts

$63 the option could be exercised and the stock immediately

sold, resulting in a profit of $3 less the price of the option

contract (a $2 profit on a $1 investment, or a 200% return). If the

stock price doesn’t exceed $60 before the option expires, the $1

is lost (a 100% loss).

36

Call Options

more attractive the option

The stock’s price is more likely to exceed the

strike price before the option expires

The longer the time until expiration the

more attractive the option

The stock’s price is more likely to exceed the

strike price before the option expires

37

The Call Option Writer

creates the contract

Agrees to sell the stock at the strike price if

the option is exercised

The original writer must stand ready to

deliver on the contract regardless of how

many times the option is sold

Call writer hopes stock price will remain

the same

38

Intrinsic Value

difference between the underlying stock’s

current price and the option’s strike price

If the option is out-of-the-money then the

intrinsic value is zero

Option will always sell for intrinsic value or

above

Difference between option’s intrinsic value

and price is known as time value

39

Figure 7-4: The Value of a Call

Option

40

Options and Leverage

Financial leverage

Technique that amplifies return on investment

• Improves positive returns and worsens negative

returns

Options offer leveraging potential due to

the lower price at which you can buy an

option compared to the price of the

underlying stock

The higher the price of the option the less the

leverage potential

41

Options that Expire

expire after a limited time

If the option was purchased out-of-the-

money and the stock price never exceeds

the strike price prior to the expiration date

the option will expire worthless

Resulting in a 100% loss

As the expiration date approaches an

option’s time value approaches zero

42

Trading in Options

Options can be bought and sold at any time prior to

expiration

Chicago Board Options Exchange (CBOE) is the largest, oldest

and best known options exchange

Price volatility in the options market

As the price of the underlying stock changes the price of the

option changes but by a greater relative movement due to the

lower price of the option compared to the stock

Options are rarely exercised before expiration

If the call option owner believes a stock is unlikely to increase

further he is likely to sell the option rather than exercise it as he

would lose any time premium if he were to exercise the option

43

Writing Options

People write options for the premium income,

hoping that the option will never be exercised

Option writers lose whatever option buyers win

Take the opposite side of a bet

Covered option—the writer owns the underlying

stock

Naked option—the writer does not own the

underlying stock and must purchase it at the

current price should the option be exercised

44

Option Example

The following information refers to a three-month call option on

the stock of Oxbow, Inc.

Price of the underlying stock: $30

Strike price of the three-month call: $25

Market price of the option: $8

Q: What is the intrinsic value of the option?

Example

money. Since the stock price is $30 and the call option’s strike

price is $25, the option is in-the-money by $5, which is the

intrinsic value.

Q: What is the option’s time premium at this price?

A: The time premium represents the difference between the

market price of the option and the intrinsic value, or $8 - $5 =

$3.

45

Option Example

Q: If an investor writes and sells a covered call option, acquiring

the covering stock now, how much has he invested?

A: The premium ($8) that the writer receives for the option will

offset some of the purchase price of the stock ($30), therefore

the investor has invested $30 - $8 = $22.

Q: What is the most the buyer of the call can lose?

Example

the purchase price of the option of $8.

Q: What is the most the writer of a naked call option on this stock

can lose?

In theory since the stock price can rise to any price the writer

can lose an infinite amount. However, a prudent writer would

limit his losses by purchasing the stock once it started to rise in

value.

46

Option Example

Just before the option’s expiration Oxbow is selling for $32.

Q: What is the profit or loss from buying the call?

A: The buyer would exercise the option paying $25 for the stock and

simultaneously selling the stock for $32, resulting in a gain of $7.

However, this gain would be offset by the $8 premium paid for the

option, resulting in an overall loss of $1.

Example

A: A naked writer would have to buy the stock for $32 and sell it to the

option owner for $25, resulting in a loss of $7. However, this loss would

be offset by the premium received on the writing of the option of $8,

resulting in an overall gain of $1.

Q: What is the profit or loss from writing the call covered if the covering

stock was acquired at the time the call was written?

A: The call writer bought the stock for $30 and sold it for $25, resulting in a

loss of $5, but the loss is offset by the $8 premium received for writing

the option. The overall gain is $3.

47

Put Options

specified price by a specified date

Would buy a put if you thought the price of

the underlying asset were going to fall

Intrinsic value is how much the option is

in-the-money

Option is in-the-money if the strike price is

lower than the current stock price

48

Figure 7.5: Basic Put Option

Concepts

49

Figure 7.6: The Value of a Put

Option

50

Option Pricing Models

Option pricing model is more difficult than

pricing models for stocks and bonds

Fischer Black and Myron Scholes developed the

Black-Scholes Option Pricing Model

Determines option’s price based on

• Price of underlying stock

• Strike price of option

• Time remaining until expiration of option

• Volatility of underlying stock’s market price

• Risk-free interest rate

51

Warrants

Options trade between investors, not

between the companies that issue the

underlying stocks

Warrants are issued by the underlying

companies

When the warrant is exercised the company

issues new stock and receives the exercise

price

• Thus, warrants are primary market instruments

while options are secondary market instruments

52

Warrants

expiration period (several years vs.

months)

Usually issued as a “sweetener” (for

bonds, for instance)

Warrants can generally be detached from

another issue and sold separately

53

Employee Stock Options

More like warrants than traded options

Don’t expire for several years

Strike prices are set far out of the money

Employees who receive options generally receive a

lower salary than they would otherwise

If a company is expected to have a good future

employees may want to receive options

Companies like paying with options because

they can pay the employees a lower salary

Argue that options allow up-and-coming companies

to attract talented employees that they couldn’t

otherwise afford

54

The Executive Stock Option

Problem

Senior executives are usually the people

who receive the most stock options

Tactic has been criticized recently

May cause executive to try to increase stock

price in unethical ways

• Manipulating financial results driving the stock

price higher

• Market should eventually realize the problem and drive

the stock down but executives have already exercised

their stock options and sold the stock at the inflated price

55

The Executive Stock Option

Problem

This can negatively impact a firm’s pension plan if it is

heavily invested in its firm’s own stock

In the early 2000s investors realized that auditors

couldn’t (or wouldn’t) always report financial

manipulations

Enron, WorldCom, Tyco

Resulted in a loss of investor confidence in corporate

management

One result of the overhaul of financial reporting is the

requirement that companies recognize employee stock

options as expenses at the time they are issued

Problem is that no one knows how high the stock will rise in

value at the time the options are issued

56

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