Chapter 6

Chapter 7 in the 5th edition

Stocks and the Stock Market

Book Values, Liquidation Values, and Market
Values
Valuing Common Stocks
Simplifying the Dividend Discount Model
Growth Stocks and Income Stocks
Market Efficiency Theories
Market Anomalies and Behavioural Finance
 Stocks and Stock Market
Some Definitions
Primary Market: Place where the sale of new stock
first occurs.
Secondary Market: Market in which already issued
securities are traded by investors.
Initial Public Offering (IPO): First offering of stock to
the general public.
Seasoned Issue: Sale of new shares by a firm that
has already been through an IPO.
Common Stock: Ownership shares in a publicly held
corporation.
 Stocks and Stock Market

Dividend: Periodic cash distribution from the

firm to the shareholders.
Dividends represent a share of the firms
profits that are distributed.

Profits that are retained in the firm and

reinvested in its operations are called
retained earnings.
 Book Values, Liquidation Values,
and Market Values
There are three methods used for valuing a companys
shares:

Book Value: Net worth of the firm according to the balance

sheet.

Liquidation Value: Net proceeds that would be realized by

selling the firms assets and paying off its creditors.

Market Value Balance Sheet: Financial statement that

uses market value of assets and liabilities.
 Valuing Common Stocks
Expected Return: The percentage yield that an investor
forecasts from a specific investment over a set period of
time.
Div P P
Expected Return r 1 1 0
P
0
Div1 P1 P0
Expected Return r
P0 P0
Dividend Yield Capital Gains
Yield
 Valuing Common Stocks
Example: Assume that XYZs shares are selling for
$70 now. They are expected to pay $3 dividends
during the year and is to be sold at $80 at the end of
the year. What is the expected return from XYZs
shares?
Expected Return = D1 + P1 P0
P0
= $3 + 80 70
$70
= 0.186 = 18.6%
 Valuing Common Stocks
we can also report the expected return in this form:

Expected return = Dividend Yield + Capital Gain

= D1 + P1 P0
P0 P0
= $3 + $80 - $70
$70 $70
= 4.3% + 14.3%
= 18.6%
 Valuing Common Stocks
The Dividend Discount Model: Share value equals
the present value of all expected future
dividends. Thus, if the discount rate is r, we can
write:

Div1 Div2 Div H PH

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

The value today of any financial asset equals the

present value of all of its future cash flows.
 Valuing Common Stocks
Example of dividend discount model: XYZ Company is
expected to pay dividends of $3, $3.24, and $3.50 over
the next three years, respectively. At the end of three
years you anticipate selling your stock at a market price of
$94.48. What is the expected price of the stock given a
12% expected return?
3.00 3.24 3.50 94.48
PV
(1 0.12)1 (1 0.12) 2 (1 0.12)3
PV $75.00
 Simplifying the Dividend Discount
Model
Zero Growth Case: If the dividend paid by the
corporation is not expected to change, then we
treat the dividend as a perpetuity. The present
value of all dividends, then, is

Div
P 1
0 r
 Simplifying the Dividend Discount
Model
Constant Growth Case: If the dividend paid by
the stock is expected to grow at a constant rate,
then the cash flows are treated like perpetual
flows with a growth rate. In that case, the PV of
the cash flow will be

Div1
P0
rg
 Simplifying the Dividend Discount
Model
An Example: Calculate the price of XYZ shares if:
Next years dividend (D1) will be $3, dividends
will grow at 8% in perpetuity. The discount rate
is 12%. Div 1
Price of stock today = r-g
$3.00
=
0.12 0.08
= $75.00
 Simplifying the Dividend
Discount Model
Expected Rate of Return from the DDM:
rearranging the constant growth DDM
formula gives us:
D1
r = + g
P0
$3
= + .08 Dividend Yield Growth Rate
$75

= .04 + .08 = 4% + 8% = 12%

 Simplifying the Dividend
Discount Model
Non-Constant Growth Case: Many
companies grow at rapid or irregular rates for
several years before finally settling down.

- Before the growth rate settles down, we have to calculate each

dividends separately.

- When the growth rate does settle down, we can find the future stock
price using the constant growth formula.

- At the end, we have to find the present values of all the dividends and
the future price.
 Simplifying the Dividend Discount
Model
An Example of non-constant growth stock:

A firm is expected to increase dividends by 20% in

year one and by 15% in two years. After that
dividends will increase at a rate of 5% per year
indefinitely. If the last dividend was $1 and the
required return is 20%, what is the price of the
stock?
 Simplifying the Dividend
Discount Model
Compute the dividends until growth levels off
D1 = 1(1.2) = $1.20
D2 = 1.20(1.15) = $1.38
D3 = 1.38(1.05) = $1.449
Find the expected future price
P2 = D3 / (R g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future cash
flows
P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
 Capital Gains Yield
a)Suppose a stock has just paid a $5 per share dividend. The
dividend is projected to grow at 5% per year indefinitely. If the
required return is 9%, then the price today is ?
b) What will the price be in a year?
c) By what percentage does P1 exceed P0? Why?

a) What will the price be?

P0 = D1/(r - g) = $5 ( 1.05 )/( 0.09 - 0.05 )= $5.25/.04
= $131.25 per share
b) Price in a year?
Pt = Dt+1/(r - g) = ($5 1.052)/(0.09 - 0.05) = $137.8125
c) By what percentage does P1 exceed P0? Why?

P1 exceeds P0 by 5% -- the capital gains yield.

 Growth Stocks and Income
Stocks
The fraction of earnings retained by the firm is
called the retention ratio.

The fraction of earnings a company pays out in

dividends is called the payout ratio.

Calculating g (growth rate)

The growth rate for a company can be computed
by multiplying the return on equity by the
retention ratio:
g = ROE x Retention ratio
 Growth Stocks and Income
Stocks
Example: Our company forecasts to pay a $5.00 dividend
next year, which represents 100% of its earnings. This
will provide investors with a 12% expected return.
Instead, we decide to retain 40% of the earnings at the
firms current return on equity of 20%.
Calculate the value of the stock before and after the
retention decision?

Thus, we have :
D1 = $5.00
r = 12%
Return on equity = 20%
 Growth Stocks and Income
Stocks
(a) Without the growth, the price is:

P0 = DIV1/r = 5/0.12 = $41.67

(b) With growth, the situation is:

g = ROE x retention ratio = 0.20 x 0.40 = 0.08 =

8%

P0 = DIV1/(r g) = 3/(0.12 0.08) = $75

 Growth Stocks and Income
Stocks
Thus, growth accounts for $33.33 [=$75-$41.67] of the $75
price. In other words, the Present Value of Growth
Opportunities (PVGO) is $33.33.

The Present Value of Growth Opportunities (PVGO) -

The net present value of a firms future investments.

Sustainable Growth Rate - Steady rate at which a firm

can grow: retention ratio X return on equity.

Price-Earning Ratio: Stock price/EPS

 Types of Analysis
Definitions
Technical Analysis Attempting to identify
undervalued stock by searching for patterns in past
stock prices.
Random Walk Security prices change randomly,
with no predictable trends or patterns.
Fundamental Analysis Attempting to find
mispriced securities by analyzing fundamental
information, such as accounting data and business
prospects.
 Efficient Market Hypothesis
Efficient Market: A market where prices reflect all
available information. No free lunches.

Weak Form Efficiency: A market where prices rapidly

reflect all information contained in the history of past
prices and volumes.
Semi-Strong Form Efficiency: A market where prices
rapidly reflect all publicly available information.
Strong Form Efficiency: A market where prices reflect all
information that could be used to determine true value of
assets.
 Fundamental Analysis
How do we identify mispriced securities ?

A quick look at ratios

1. P/E
2. P/Book
3. P/CF
4. Dupont etc
 Market Anomalies & Behavioural
Finance
Market Anomalies: There are always some puzzles or
apparent exceptions of the efficient market theory.

Earning Announcement Puzzle: Studies found that stock

prices apparently did not reflect all available information
at the ends of the earnings announcement days.

News Issue Puzzle: Researchers found that early gains

from buying IPOs often turn into losses.
 Market Anomalies &
Behavioural Finance
Behavioural Finance: The dot-com bubble of the nineties
led many to believe that investors are not 100% rational
all the time. The behavioural psychology issues gained
ground and led to the development of behavioural
finance.
Attitude Toward Risk: When making risky decisions,
people are particularly loath to incur losses, even if those
losses are small.
Beliefs About Probabilities: Investors are often tempted
to project recent success into the future, but forget about
the losses from distant past. They tend to be
overconfident.