5 -1 CHAPTER 5 Basic Stock Valuation n

5 -2 Facts about Common Stock n Represents ownership. n Ownership implies control. n Stockholders elect directors. n Directors hire management. n Management’s goal: Maximize stock price. Copyright © 2002 South-Western

5 -3 What’s classified stock? How might classified stock be used? n Classified stock has special provisions. n Could classify existing stock as founders’ shares, with voting rights but dividend restrictions. n New shares might be called “Class A” shares, with voting restrictions but full dividend rights. Copyright © 2002 South-Western

5 -4 When is a stock sale an initial public offering (IPO)? n A firm “goes public” through an IPO when the stock is first offered to the public. n Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers. Copyright © 2002 South-Western

5 -5 Average Initial Returns on IPOs in Various Countries 100% 75% 50% da

5 -6 Different Approaches for Valuing Common Stock n Dividend growth model n Using

5 -7 Stock Value = PV of Dividends What is a constant growth stock?

5 -8 For a constant growth stock, If g is constant, then: Copyright ©

5 -9 $ 0. 25 0 Copyright © 2002 South-Western Years (t)

5 - 10 What happens if g > ks? n If ks< g, get negative stock price, which is nonsense. n We can’t use model unless (1) g ks and (2) g is expected to be constant forever. Because g must be a longterm growth rate, it cannot be ks. Copyright © 2002 South-Western

5 - 11 Assume beta = 1. 2, k. RF = 7%, and k. M = 12%. What is the required rate of return on the firm’s stock? Use the SML to calculate ks: ks = k. RF + (k. M - k. RF)b. Firm = 7% + (12% - 7%) (1. 2) = 13%. Copyright © 2002 South-Western

5 - 12 D 0 was $2. 00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. ks = 13%. 0 g=6% 1 D 0=2. 00 2. 12 13% 1. 8761 1. 7599 1. 6508 Copyright © 2002 South-Western 2 2. 2472 3 2. 3820 4

5 - 13 What’s the stock’s market value? D 0 = 2. 00, ks

5 - 14 What is the stock’s market value one ^ year from now,

5 - 15 Find the expected dividend yield and capital gains yield during the first year. D 1 $2. 12 Dividend yield = = = 7. 0%. P 0 $30. 29 ^ P 1 - P 0 $32. 10 - $30. 29 CG Yield = = P 0 $30. 29 = 6. 0%. Copyright © 2002 South-Western

5 - 16 Find the total return during the first year. n Total return = Dividend yield + Capital gains yield. n Total return = 7% + 6% = 13%. n Total return = 13% = ks. n For constant growth stock: Capital gains yield = 6% = g. Copyright © 2002 South-Western

5 - 17 Rearrange model to rate of return form: ^ Then, ks =

5 - 18 What would P 0 be if g = 0? The dividend

5 - 19 If we have supernormal growth of 30% for 3 years, then a long-run ^ constant g = 6%, what is P 0? k is still 13%. n Can no longer use constant growth model. n However, growth becomes constant after 3 years. Copyright © 2002 South-Western

5 - 20 Nonconstant growth followed by constant growth: 0 k =13% s 1 g = 30% D 0 = 2. 00 2 g = 30% 2. 60 2. 3009 2. 6470 3. 0453 46. 1135 54. 1067 ^ = P 0 Copyright © 2002 South-Western 3 g = 30% 3. 38 4 g = 6% 4. 394 4. 6576

5 - 21 What is the expected dividend yield and capital gains yield at t = 0? At t = 4? At t = 0: D 1 $2. 60 Dividend yield = = = 4. 8%. P 0 $54. 11 CG Yield = 13. 0% - 4. 8% = 8. 2%. (More…) Copyright © 2002 South-Western

5 - 22 n During nonconstant growth, dividend yield and capital gains yield are not constant. n If current growth is greater than g, current capital gains yield is greater than g. n After t = 3, g = constant = 6%, so the t t = 4 capital gains yield = 6%. n Because ks = 13%, the t = 4 dividend yield = 13% - 6% = 7%. Copyright © 2002 South-Western

5 - 23 Is the stock price based on short-term growth? n The current stock price is $54. 11. n The PV of dividends beyond year 3 is ^ $46. 11 (P 3 discounted back to t = 0). n The percentage of stock price due to “long-term” dividends is: $46. 11 $54. 11 = 85. 2%. Copyright © 2002 South-Western

5 - 24 If most of a stock’s value is due to longterm cash flows, why do so many managers focus on quarterly earnings? n Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. n Sometimes managers have bonuses tied to quarterly earnings. Copyright © 2002 South-Western

5 - 25 Suppose g = 0 for t = 1 to 3, and then g ^ is a constant 6%. What is P 0? 0 ks=13% g = 0% 1 2 g = 0% 2. 00 1. 7699 1. 5663 1. 3861 20. 9895 25. 7118 Copyright © 2002 South-Western 3 g = 0% 2. 00 4 g = 6% 2. 00 . . . 2. 12 30. 2857 P 3 0. 07

5 - 26 What is dividend yield and capital gains yield at t = 0 and at t = 3? D 1 2. 00 t = 0: P $25. 72 7. 8%. 0 CGY = 13. 0% - 7. 8% = 5. 2%. t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%. Copyright © 2002 South-Western

5 - 27 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays ^ > 0: dividends, so P 0 $2. 00(0. 94) $1. 88 = = = $9. 89. 0. 13 - (-0. 06) 0. 19 Copyright © 2002 South-Western

5 - 28 What are the annual dividend and capital gains yield? Capital gains yield = g = -6. 0%. Dividend yield = 13. 0% - (-6. 0%) = 19. 0%. Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield. Copyright © 2002 South-Western

5 - 29 Using the Multiples of Comparable Firms to Estimate Stock Price n Analysts often use the following multiples to value stocks: l P/E l P/CF or P/EBITDA l P/Sales l P/Customer n Example: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. Copyright © 2002 South-Western

5 - 30 What is market equilibrium? 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. (More…) Copyright © 2002 South-Western

5 - 31 In equilibrium, expected returns must equal required returns: ^ ks =

5 - 32 How is equilibrium established? ^ ^ If ks = D 1 + g > ks, then P 0 is “too low. ” P 0 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, and D 1/P 0 falls until ^ D 1/P 0 + g = ks. Copyright © 2002 South-Western

5 - 33 Why do stock prices change? ^ n ki = k. RF

5 - 34 What’s 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. (More…) Copyright © 2002 South-Western

5 - 35 1. Weak-form EMH: Can’t 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 © 2002 South-Western

5 - 36 2. Semistrong-form EMH: All publicly available information is reflected in stock prices, so it doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true. Copyright © 2002 South-Western

5 - 37 3. Strong-form EMH: 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’s illegal. Copyright © 2002 South-Western

5 - 38 Markets are generally efficient because: 1. 100, 000 or so trained analysts--MBAs, CFAs, and Ph. Ds--work for firms like Fidelity, Merrill, Morgan, and Prudential. 2. These analysts have similar access to data and megabucks to invest. 3. Thus, news is reflected in P 0 almost instantaneously. Copyright © 2002 South-Western

5 - 39 Preferred Stock n Hybrid security. n Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. n However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy. Copyright © 2002 South-Western