You are on page 1of 46

PowerPoint Presentation

prepared by

Traven Reed Canadore College

chapter 8
Stocks, Stock Valuation, and Stock Equilibrium

Corporate Valuation and Stock Risk


CH8

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-3

Topics in Chapter
CH8

Features of common stock Determining common stock values Efficient markets Preferred stock

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-4

Common Stock: Owners, Directors, and Managers


CH8

Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Managers are agents of shareholders, they always solicit shareholders proxies and usually succeed.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-5

Control of the Firm


CH8

Shareholders often have the right (i.e. preemptive right) to purchase any additional shares sold by the firm This preemptive right protects the control of the present shareholders and also prevents dilution of their value The preemptive right makes it more difficult to raise equity capital from new large shareholders
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-6

Types of Common Stock


CH8

Not all common shares are created equally Most firms have only one type of common stock A system of dual-class shares is used to meet the special needs of the company
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-7

Classified Stock
CH8

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.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-8

Stock Market Reporting


CH8

In the past, tracking stock is through the business section of a daily newspaper. Today, we can get quotes all during the day from a wide variety of Internet sources (e.g. Globeinvestor.com). Comparing with once a day from the newspaper prints, the 20-minute delay with the Internet information is nothing. The quote provides the price a buyer would have to pay (Ask) and the price someone can sell the stock (Bid) for.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-9

Different Approaches for Valuing Common Stock


CH8

Most stocks expected total return = dividend yield + capital gains yield Intrinsic value of a stock is the present value of its expected future cash flow stream
Dividend growth model Free cash flow approach Using the multiples of comparable firms
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-10

Stock Value = PV of expected future dividends


CH8

P0 =

D1 (1+rs)1

D2 (1+rs)2

D3 (1+rs)3

++

(1+rs)

What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-11

For a constant growth stock:


CH8

D1 = D0(1+g)1 D2 = D0(1+g)2 Dt = D0(1+g)t

If g is constant and less than rs, then:


^ D0(1+g) P0 = rs - g D1 = rs - g

Use decimals, not % in the calculation


Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-12

CH8

Dividend and Earnings Growth


Growth in dividends occurs primarily as a result of growth in EPS. Earnings growth results from a number of factors: (1) inflation, (2) reinvested profit, and (3) ROE. Firms cannot increase stock price by just raising the current dividend. There is a tradeoff between current dividends and future dividends.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-13

Intrinsic Stock Value vs. Quarterly Earnings


CH8

If most of a stocks value is due to longterm cash flows, why do so many managers focus on quarterly earnings? Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes managers have bonuses tied to quarterly earnings.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-14

CH8

Dividend Growth and PV of Dividends: P0 = (PVof Dt)


$ Dt = D0(1 + g)t Dt PV of Dt = (1 + rS)t

0.25

If g > rs , P0 = !
Years (t)
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-15

CH8

What happens if g > rs?


^

P0 =

D0(1+g)1 (1+rs)1

D0(1+g)2 (1+rs)2

++

D0(1+rs) (1+rs)
^

If g > rs, then

(1+g)t (1+rs)t

> 1, and

P0 =

So g must be less than rs to use the constant growth model.


Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-16

Projected Dividends
CH8

D0 = $2 and constant g = 6% = 0.06 D1 = D0(1+g) = 2(1.06) = $2.12 D2 = D1(1+g) = 2.12(1.06) = $2.2472 D3 = D2(1+g) = 2.2472(1.06) = $2.3820
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-17

CH8

Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)


0 1 2.12 1.8761 1.7599 1.6508
13 %

g=6%

2 2.2472

3 2.3820

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-18

CH8

Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6%


Constant growth model:
^ D0(1+g) P0 = rs - g D1 = rs - g

$2.12 $2.12 = = $30.29 0.13 - 0.06 0.07


Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-19

Expected value one year from now:


CH8

D1 will have been paid, so expected dividends are D2, D3, D4 and so on.
D2 ^ $2.2427 P1 = = rs - g 0.07 = $32.10 = $30.29(1+0.06)

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-20

Expected Dividend Yield and Capital Gains Yield (Year 1)


CH8

$2.12 D1 Dividend yield = = = 7.0% $30.29 P0 ^ P1 - P0 $32.10 - $30.29 CG Yield = = P0 $30.29 = 6.0%
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-21

Total Year-1 Return


CH8

Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13% Total return = 13% = rs For constant growth stock:
Capital gains yield = 6% = g

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-22

CH8

Expected Rate of Return on a Constant Growth Stock


D1 ^ to P0 = rs - g ^ D1 rs = P0 +g

^ Then, rs = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-23

If g = 0, the dividend stream is a perpetuity


CH8

0 r =13% 1 s 2.00
^

2 2.00

3 2.00

PMT $2.00 P0 = = = $15.38 r 0.13


Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-24

Supernormal (Non-constant) Growth Stock


CH8

Supernormal growth of 30% for 3 years, and then long-run constant g = 6%. Can no longer use constant growth model. However, growth becomes constant after 3 years.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-25

CH8

Nonconstant growth followed by constant growth (D0 = $2):


0
rs=13% g = 30%

1
g = 30%

2
g = 30%

3
g = 6%

2.60 2.3009 2.6470 3.0453 46.1135 54.1067 ^ = P0

3.38

4.394

4.6576

$4.6576 ^ P3 = = $66.5371 0.13 0.06


Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-26

Dividend Growth Rates


CH8

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-27

Suppose g = 0 for t = 1 to 3, and then g is a constant 6%


CH8

rs=13% g = 0%

1
g = 0%

2
g = 0%

3
g = 6%

4 2.12

2.00 1.7699 1.5663 1.3861 20.9895 25.7118

2.00

2.00

2.12 ! 30.2857 P3 ! 0.07


Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-28

If g = -6%, would anyone buy the stock? If so, at what price?


CH8

Firm still has earnings and still pays ^ > 0: dividends, so P0 D0(1+g) D1 ^ P0 = = rs - g rs - g $2.00(0.94) $1.88 = = = $9.89 0.13 - (-0.06) 0.19
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-29

CH8

Stock Valuation: FCF Approach


Firm value is the present value of its future expected free cash flows (FCF) discounted at the WACC. Since PV (FCF) is the present value of a growing annuity, we have
FCF (1  g ) V ! WACC  g
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-30

Using Stock Price Multiples to Estimate Stock Price


CH8

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.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-31

Using Entity Multiples


CH8

The entity value (V) is:


the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt.

Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example,
V/EBITDA V/Customers
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-32

Using Entity Multiples (contd)


CH8

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 total value of the firm. Subtract the firms debt to get the total value of equity. Divide by the number of shares to get the price per share.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-33

Problems with Market Multiple Methods


CH8

It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range.
For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-34

Preferred Stock
CH8

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 the firm into bankruptcy.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-35

Preferred Stock Valuation


CH8

Similar to the valuation of perpetual bonds DPS


VPS ! rPS

A preferred stock pays a quarterly dividend of $1.25 ($5 per year) with a required return of10%. Its value DPS 4($1.25) $5 is
VPS ! rPS ! 0.1 ! 0.1 ! $50
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-36

Expected return: given Vps = $50 and annual dividend = $5


CH8

Vps = $50 = $5 ^ rps = $50

$5 ^ rps = 0.10 = 10.0%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-37

CH8

Stock Price Volatility for changes in rS and g


Are volatile stock prices consistent with rationing 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 are not volatile, then this means there is not a good flow of information.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-38

Stock Market Equilibrium


CH8

In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-39

In equilibrium, expected returns must equal required returns:


CH8

rs = D1/P0 + g = rs = rRF + (rM - rRF)b

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-40

How is equilibrium established?


CH8

If rs =

^ D

P0

+ g > rs, then P0 is too low.

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
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-41

Efficient Market Hypothesis


CH8

Securities are normally in equilibrium and are fairly priced. Investors cannot beat the market except through good luck or inside information. The prices of securities fully reflect available information. They will adjust immediately to any new development.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-42

Weak-form EMH
CH8

Investors buying bonds and stocks cannot 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.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-43

Semistrong-form EMH
CH8

All publicly available information is reflected in stock prices, so it does not pay to pore over annual reports looking for undervalued stocks. Largely true.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-44

Strong-form EMH
CH8

All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that is illegal!

Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-45

Markets are generally efficient because:


CH8

100,000 or so trained analysts-MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential. These analysts have similar access to data and megabucks to invest. Thus, news is reflected in P0 almost instantaneously.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

8-46

You might also like