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chapter 8
Stocks, Stock Valuation, and Stock Equilibrium
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Topics in Chapter
CH8
Features of common stock Determining common stock values Efficient markets Preferred stock
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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
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.
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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.
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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
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.
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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
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.
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CH8
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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.
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CH8
0.25
If g > rs , P0 = !
Years (t)
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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CH8
P0 =
D0(1+g)1 (1+rs)1
D0(1+g)2 (1+rs)2
++
D0(1+rs) (1+rs)
^
(1+g)t (1+rs)t
> 1, and
P0 =
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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.
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CH8
g=6%
2 2.2472
3 2.3820
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CH8
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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)
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$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.
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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
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CH8
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0 r =13% 1 s 2.00
^
2 2.00
3 2.00
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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
1
g = 30%
2
g = 30%
3
g = 6%
3.38
4.394
4.6576
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rs=13% g = 0%
1
g = 0%
2
g = 0%
3
g = 6%
4 2.12
2.00
2.00
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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.
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CH8
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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
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
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
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?
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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.
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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.
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CH8
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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.
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If rs =
^ D
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
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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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.
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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.
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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.
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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!
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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.
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