7 -1 CHAPTER 7 Stocks and Their Valuation

7 -1 CHAPTER 7 Stocks and Their Valuation n Features of common stock n Determining common stock values n Efficient markets n Preferred stock

7 -2 Common Stock: Owners, Directors, and Managers n Represents ownership. n Ownership implies control. n Stockholders elect directors. n Directors hire management. n Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

7 -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.

What is tracking stock? 7 -4 n The dividends of tracking stock are tied to a particular division, rather than the company as a whole. l. Investors can separately value the divisions. l. Its easier to compensate division managers with the tracking stock. n But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company.

7 -5 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.

7 -6 What is a seasoned equity offering (SEO)? n A seasoned equity offering occurs when a company with public stock issues additional shares. n After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.

7 -7 Different Approaches for Valuing Common Stock n Dividend growth model n Using the multiples of comparable firms n Free cash flow method (covered in Chapter 15)

7 -8 Stock Value = PV of Dividends What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g.

7 -9 For a constant growth stock, If g is constant, then:

7 - 10 $ 0. 25 0 Years (t)

7 - 11 What happens if g > rs? n If rs< g, get negative stock price, which is nonsense. n We can’t use model unless (1) g rs and (2) g is expected to be constant forever. Because g must be a longterm growth rate, it cannot be rs.

7 - 12 Assume beta = 1. 2, r. RF = 7%, and RPM = 5%. What is the required rate of return on the firm’s stock? Use the SML to calculate rs: rs = r. RF + (RPM)b. Firm = 7% + (5%) (1. 2) = 13%.

7 - 13 D 0 was $2. 00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. rs = 13%. 0 g=6% 1 D 0=2. 00 2. 12 13% 1. 8761 1. 7599 1. 6508 2 2. 2472 3 2. 3820 4

7 - 14 What’s the stock’s market value? D 0 = 2. 00, rs = 13%, g = 6%. Constant growth model: $2. 12 = = $30. 29. 0. 13 - 0. 06 0. 07

7 - 15 What is the stock’s market value one ^ year from now, P 1? n D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. Thus,

7 - 16 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%.

7 - 17 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% = rs. n For constant growth stock: Capital gains yield = 6% = g.

7 - 18 Rearrange model to rate of return form: ^ Then, rs = $2. 12/$30. 29 + 0. 06 = 0. 07 + 0. 06 = 13%.

7 - 19 What would P 0 be if g = 0? The dividend stream would be a perpetuity. 0 r =13% s 1 2 3 2. 00 PMT $2. 00 P 0 = = = $15. 38. r 0. 13 ^

7 - 20 If we have supernormal growth of 30% for 3 years, then a long-run ^ constant g = 6%, what is P 0? r is still 13%. n Can no longer use constant growth model. n However, growth becomes constant after 3 years.

7 - 21 Nonconstant growth followed by constant growth: 0 r =13% s 1 g = 30% D 0 = 2. 00 g = 30% 2. 60 2. 3009 2. 6470 3. 0453 46. 1135 54. 1067 2 ^ = P 0 3 g = 30% 3. 38 4 g = 6% 4. 394 4. 6576

7 - 22 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…)

7 - 23 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 rs = 13%, the t = 4 dividend yield = 13% - 6% = 7%.

7 - 24 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%.

7 - 25 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.

7 - 26 Suppose g = 0 for t = 1 to 3, and then g ^ is a constant 6%. What is P 0? 0 rs=13% g = 0% 1 2 g = 0% 2. 00 1. 7699 1. 5663 1. 3861 20. 9895 25. 7118 3 g = 0% 2. 00 4 g = 6% 2. 00 . . . 2. 12 30. 2857 P 3 0. 07

7 - 27 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%.

7 - 28 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

7 - 29 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.

7 - 30 Using the Stock Price Multiples to Estimate Stock Price n Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. n Example: l Estimate the average P/E ratio of comparable firms. This is the P/E multiple. l Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.

7 - 31 Using Entity Multiples n The entity value (V) is: l the market value of equity (# shares of stock multiplied by the price per share) l plus the value of debt. n Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. n Calculate the average entity ratio for a sample of comparable firms. For example, l V/EBITDA l V/Customers

7 - 32 Using Entity Multiples (Continued) n Find the entity value of the firm in question. For example, l Multiply the firm’s sales by the V/Sales multiple. l Multiply the firm’s # of customers by the V/Customers ratio n The result is the total value of the firm. n Subtract the firm’s debt to get the total value of equity. n Divide by the number of shares to get the price per share.

7 - 33 Problems with Market Multiple Methods n It is often hard to find comparable firms. n The average ratio for the sample of comparable firms often has a wide range. l 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?

7 - 34 Why are stock prices volatile? ^ n rs = r. RF + (RPM)bi could change. l Inflation expectations l Risk aversion l Company risk n g could change.

7 - 35 Stock value vs. changes in rs and g D 1 = $2, rs = 10%, and g = 5%: P 0 = D 1 / (rs-g) = $2 / (0. 10 - 0. 05) = $40. rs 9% 10% 11% What if rs or g change? g g g 4% 5% 6% 40. 00 50. 00 66. 67 33. 33 40. 00 50. 00 28. 57 33. 33 40. 00

7 - 36 Are volatile stock prices consistent with rational pricing? n Small changes in expected g and rs cause large changes in stock prices. n As new information arrives, investors continually update their estimates of g and rs. n If stock prices aren’t volatile, then this means there isn’t a good flow of information.

7 - 37 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…)

7 - 38 In equilibrium, expected returns must equal required returns: ^ rs = D 1/P 0 + g = rs = r. RF + (r. M - r. RF)b.

7 - 39 How is equilibrium established? ^ If rs = D 1 + g > rs, 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 = rs.

7 - 40 Why do stock prices change? ^ n ri = r. RF + (r. M - r. RF )bi could change. l Inflation expectations l Risk aversion l Company risk n g could change.

7 - 41 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…)

7 - 42 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.

7 - 43 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.

7 - 44 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.

7 - 45 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.

7 - 46 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.

7 - 47 What’s the expected return on preferred stock with Vps = $50 and annual dividend = $5?