Professional Documents
Culture Documents
1
Topics in Chapter
Features of common stock
Valuing common stock
Preferred stock
Stock market equilibrium
Efficient markets hypothesis
Implications of market efficiency for
financial decisions
2
The Big Picture:
The Intrinsic Value of Common Stock
Free cash flow
(FCF)
Dividends (Dt)
D1 D2 D
ValueStock = + + ... +
(1 + rs )1 (1 + rs)2 (1 + rs)
5
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.
6
Classified Stock
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.
7
Tracking Stock
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.
8
Bonds vs. Stocks
9
Bonds vs. Stocks
11
Why Invest in Stock?
12
Constant Growth Approach to
Equity Valuations
Po = D1 / R g
Discounting the Divids (or CFs) by R-g (return
adjusted for constant growth)
Constant growth model: works when g is constant
rate (%) & R > g
If g > R, then have supernormal or non-constant growth
If so, then look at PVs of CFs generated the stock to determine its
price today
If we need R (reqd return) to use as disct factor, we can
use SML relationship from CAPM
SML: Ri = rRF + (RM - rRF)bi .
13
Stock Value = PV of Dividends
^ D1 D2 D3 D
P0 = + + ++
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
0.25 Dt
PV of Dt =
(1 + r)t
If g > r, P0 = !
Years (t)
16
What happens if g > rs?
rs = rRF + (RPM)bFirm
= 7% + (5%)(1.2)
= 13%.
18
Projected Dividends
D0 = $2 and constant g = 6%
19
Expected Dividends and PVs
(rs = 13%, D0 = $2, g = 6%)
0 g = 6% 1 2 3
1.7599
1.6508
20
Intrinsic Stock Value:
D0 = $2.00, rs = 13%, g = 6%
^ D0(1 + g) D1
P0 = =
rs g rs g
$2.12 $2.12
= = = $30.29.
0.13 0.06 0.07
21
Expected value one year from
now:
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on.
^ D2 $2.2472
P1 = = = $32.10
rs g 0.07
22
Return = Dividend Yield +
Capital Gains Yield
D1
Dividend yield =
P0
^
P1 P0 New - Old
CG Yield = =
P0 Old
23
Expected Dividend Yield and
Capital Gains Yield (Year 1)
D1 $2.12
Dividend yield = = = 7.0%.
P0 $30.29
^
P1 P0 $32.10 $30.29
CG Yield = =
P0 $30.29
= 6.0%.
24
Total Year 1 Return
Total return = Div yield + Cap gains yield.
Total return = 7% + 6% = 13%.
Total return = 13% = rs.
For constant growth stock:
Capital gains yield = 6% = g.
25
Rearrange model to rate of
return form:
^ D1 ^ D1
P0 = to rs = + g.
rs g P0
Then, ^
rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.
26
If g = 0, the dividend stream
is a perpetuity.
0 r = 13% 1 2 3
s
^ PMT $2.00
P0 = = = $15.38.
r 0.13
27
Supernormal Growth Stock I
28
Nonconstant growth followed
by constant growth
0 1 2 3 4
rs = ? %
g=?% g=?% g=?% g=?%
Do=?(1+g) D1=? D2=? D3=? D4=?
?
?
?
^ D4
? P3 =
R-g
^
?? = P0
29
Nonconstant growth followed
by constant growth (D0 = $2):
0 1 2 3 4
rs = 13%
g = 30% g = 30% g = 30% g = 6%
Do=2.00(1+g) D1=2.60 D2=3.38 D3=4.39 D4=4.66
2.30
2.65
3.05
^ $4.66
46.11 P3 = = $66.54
0.13 0.06
^
54.11 = P0
30
Using Cfs
After Determining: Future Divs & gk
terminal value (price)
CFo = Do CFo =0
CF1 = D1 CF1 = 2.60
i=R% =70.93
Po = NPV = ? i = 13 %
Po = NPV = ? = $54.11
31
Expected Dividend Yield and
Capital Gains Yield (t = 0)
Today (@ t =0):
D1 $2.60
Dividend yield = = = 4.81%
P0 $54.11
32
Expected Divd & Cap Gains Yield
(after t = 3)
During nonconstant growth, dividend yield
and capital gains yield are not constant.
If current growth is greater than gk, current
capital gains yield is greater than g.
After year 3 (t = 3), gk = constant = 6%, so
CGY = 6%.
Because rs = 13%, after yr 3 div yld =
13% 6% = 7%.
33
Is stock price based on
short-term growth?
The current stock price is $54.11.
The PV of dividends beyond Year 3 is:
=terminal
^
or horizon value in year 3 (P3) discounted
to present by reqd Return (R=13%) = $46.11
35
Intrinsic Stock Value vs.
Quarterly Earnings
Sometimes changes in quarterly
earnings are a signal of future changes
in cash flows. This affects current
stock price (Po).
Sometimes managers have bonuses
tied to quarterly earnings.
36
Supernormal Growth Stock II
Supernormal growth of 30% for Year 0
to Year 1, 25% for Year 1 to Year 2,
15% for Year 2 to Year 3, and then
long-run constant g = 6%.
Can no longer use constant growth
model.
However, growth becomes constant
after 3 years.
37
38
Nonconstant growth followed
by constant growth (D0 = $2):
0 1 2 3 4
rs = 13%
g = 30% g = 25% g = 15% g = 6%
2.6000 3.2500 3.7375 3.9618
2.3009
2.5452
2.5903
^ $3.9618
39.2246 P3 = = $56.5971
0.13 0.06
^
46.6610 = P0
39
Expected Dividend Yield and
Capital Gains Yield (t = 0)
At t = 0:
D1 $2.60
Dividend yield = = = 5.6%
P0 $46.66
(More)
40
Expected Dividend Yield and
Capital Gains Yield (after t = 3)
During nonconstant growth, dividend yield
and capital gains yield are not constant.
If current growth is greater than g, current
capital gains yield is greater than g.
After t = 3, g = constant = 6%, so the
capital gains yield = 6%.
Because rs = 13%, after t = 3 dividend
yield = 13% 6% = 7%.
41
Is the stock price based on
short-term growth?
The current stock price is $46.66.
The PV of dividends beyond Year 3 is:
^
P3 / (1+rs)3 = $39.22
0 1 2 3 4
rs = 13%
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
1.7699
1.5663
1.3861 ^ = 2.12
20.9895 P3 = 30.2857
25.7118 0.07
43
Dividend Yield and Capital
Gains Yield (t = 0)
Dividend Yield = D1/P0
Dividend Yield = $2.00/$25.72
Dividend Yield = 7.8%
44
Dividend Yield and Capital
Gains Yield (after t = 3)
Now have constant growth, so:
Capital gains yield = g = 6%
Dividend yield = rs g
Dividend yield = 13% 6% = 7%
45
Suppose negative growth:
If g = -6%, would anyone buy stock?
If so, at what price?
$2.00(1-.06) $1.88
= = = $9.89.
0.13 (-0.06) 0.19
46
Annual Dividend and Capital
Gains Yields
48
Uses of Free Cash Flows
Pay interest on debt
Repay principal on debt
Pay dividends to equityholders
Repurchase stock from equityholders
Buy mrktbl securities or other non-
operating assets
49
Equity Valuation using FCFs
50
Equity Valuation using FCFs
0 1 2 3 4
rs = 10%
g=6%
FCFo=<1> FCF1=<5> FCF2=10 FCF3=20 *(1+g) FCF4=?
?
?
?
^ FCF4
? P3 =
R-g
^
?? = P 0
51
Using Cfs for FCFs Equity Valuation
After Determining: Future Divs & gk
terminal value (price)
CFo = FCFo CFo =0
CF1 = FCF1 CF1 = <5>
i=R% i = 10 %
52
Equity Valuation using FCFs
Value of firm = $416.94
- Debt 40.00
=Value of equity $376.94 / 10 mil shrs
53
Market Cap (Capitalization)
= Market Value of firms equity
= (price/sh)*(#shs outstanding)
54
Enterprise Value
56
Using Stock Price Multiples to
Estimate Stock Price
Analysts often use the P/E multiple (the
price per share divided by the earnings
per share).
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 to
estimate its stock price.
57
Multiples Approach I
Auto Industry Pinto Car Co
Industry P/E = 5 Pinto EPS = $1.50/sh
Industry Pinto
5/1 = P/E = ?/$1.50
So Pinto relative price per
share (P) = $7.50
59
Using Entity Multiples
(Continued)
Find the entity value of the firm in question. For
example,
Multiply the firms sales by the V/Sales multiple.
Multiply the firms # of customers by the V/Customers
ratio
The result is the firms total value.
Subtract the firms debt to get the total value of its
equity.
Divide by the number of shares to calculate the
price per share.
60
Problems w/ Market Multiple Methods
So, Po = D1 /rs
And return = D1 / Po
Its a perpetuity
62
Preferred Stock
Hybrid security.
Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends
can be paid on common stock.
However, unlike bonds, preferred stock
dividends can be omitted without fear
of pushing firm into bankruptcy.
63
Expected return =?,
given Preferred stock share trading at $50
& pays annual dividend = $5
Vps = $50 = $5
^
rps
^
rps = $5
= 0.10 = 10.0%
$50
64
A determinant of Growth
65
Why are stock prices volatile?
^ D1
P0 =
rs g
67
Stock Prices vs. Changes in rs
and g
g
rs 4% 5% 6%
9% $40.00 $50.00 $66.67
10% $33.33 $40.00 $50.00
68
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 arent volatile, then
this means there isnt a good flow of
information.
69
What is market equilibrium?
In equilibrium, the intrinisic price must equal
the actual price.
If the actual price is lower than the
fundamental value, then the stock is a
bargain. Buy orders will exceed sell orders,
the actual price will be bid up. The opposite
occurs if the actual price is higher than the
fundamental value.
(More)
70
Intrinsic Values and Market Stock Prices
Managerial Actions, the Economic
Environment, and the Political Climate
Stocks Stocks
Intrinsic Value Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
In equilibrium, expected returns
must equal required returns:
^
rs = D1/P0 + g = rs = rRF + (rM rRF)b.
72
Expected Return vs. Required Return
73
How is equilibrium established?
^
^ D1
If rs = + g > rs, then P0 is too low.
P0
If the price is lower than the fundamental
value, then the stock is a bargain. Buy
orders will exceed sell orders, the price will
be bid up until:
D1/P0 + g = ^rs = rs.
74
Whats the Efficient Market
Hypothesis (EMH)?
Securities are normally in equilibrium
and are fairly priced. One cannot
beat the market except through good
luck or inside information.
EMH does not assume all investors are
rational.
EMH assumes that stock market prices
track intrinsic values fairly closely.
(More)
75
EMH (continued)
If stock prices deviate from intrinsic
values, investors will quickly take
advantage of mispricing.
Prices will be driven to new equilibrium
level based on new information.
It is possible to have irrational investors
in a rational market.
76
Weak-form EMH
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.
77
Semistrong-form EMH
All publicly available information is
reflected in stock prices, so it doesnt
pay to pore over annual reports looking
for undervalued stocks. Largely true.
78
Strong-form EMH
All information, even inside
information, is embedded in stock
prices. Not trueinsiders can gain
by trading on the basis of insider
information, but thats illegal.
79
Markets are generally
efficient because:
100,000 or so trained analystsMBAs,
CFAs, and PhDswork for firms like
Fidelity, Morgan, and Prudential.
These analysts have similar access to
data and megabucks to invest.
Thus, news is reflected in P0 almost
instantaneously.
80
Market Efficiency
For most stocks, for most of the time,
it is generally safe to assume that the
market is reasonably efficient.
However, periodically major shifts can
and do occur, causing most stocks to
move strongly up or down.
81
Implications of Market Efficiency
for Financial Decisions
82
Implications of Market Efficiency
for Financial Decisions
Important implications for stock issues,
repurchases, and tender offers.
If the market prices stocks fairly,
managerial decisions based on over- and
undervaluation might not make sense.
Managers have better information but
they cannot use for their own advantage
and cannot deliberately defraud
investors.
83
Rational Behavior vs. Animal Spirits,
Herding, and Anchoring Bias
Stock market bubbles of 2000 and 2008
suggest that something other than pure
rationality in investing is alive and well.
People anchor too closely on recent events
when predicting future events.
When market is performing better than average,
they tend to think it will continue to perform better
than average.
Other investors emulate them, following like a
herd of sheep.
84
Conclusions
Markets are rational to a large extent, but at
time they are also subject to irrational behavior.
One must do careful, rational analyses using the
tools and techniques covered in the book.
Recognize that actual prices can differ from
intrinsic values, sometimes by large amounts
and for long periods.
Good news! Differences between actual prices
and intrinsic values provide wonderful
opportunities for those able to capitalize on
them. 85