Finance
ADMS 3530 - Winter 2012 – Professor Lois King
Lecture 5 – Valuing Stocks – Jan 31
5.1 Stocks & the Stock Market
 Stocks = equities.
 Equity:
o Common shares
o Preferred shares
 Common equity
o Represents a ‘share’ of ownership in a corporation.
o Entitled to a firm’s residual cash flow.
o Elects a board of directors.
o Entitled to any common dividends.
 Primary market
o Sales of ‘new’ shares by the firm.
 Secondary market
o Where shares are resold or ‘traded’, often on a stock exchange such as the
Toronto Stock Exchange.
 Preferred equity
o Characteristics of both common stock and debt.
o The shares often have no maturity date.
o Dividend tends to be fixed.
o Entitled to dividends declared by the board of directors (but at the board’s
discretion).
o Preferred shareholders cannot put the firm into receivership due to a missed
payment.
5.2 Stock Valuation – an Overview
 Valuing stocks
o Usually means determining the ‘market value’ of the shares.
 ‘Value’
o The terms market value, book value and liquidation value are different.
 Book value
o The accounting value of assets less the accounting value of liabilities.
 Liquidation value
o The amount of cash per share that a firm could raise if it sold off its assets
quickly and paid off all its debts.
 Market value
o Analyze the expected amount of future cash flows and the variability or risk
associated with those cash flows.
 Equity valuation models
o Expected return model
o Dividend yield model
o Dividend discount model (DDM)
 General DDM
 No growth DDM
 Constant growth DDM
5.3 The Dividend Discount Model (DDM)
 The dividend discount model (or DDM)
o Share value = PV of all expected future dividends.
 Since dividends are the cash flows which most truly belong to
common shareholders.
 Problem with general DDM
o It is unrealistic to know the amounts of all future dividends of a stock.
 Practical use of DDM: 2 special cases:
o No growth DDM – no growth in dividends.
o Constant growth DDM – growth rate in the dividends is constant.
 Instead of no growth in dividends, the dividends (and earnings) will
grow at a constant rate ‘g’.
5.4 Multi-Stage Growth Version of DDM
 The basic version of the constant growth DDM: assumes constant growth in
dividends from now until infinity.
 With multiple growth versions, growth may be variable for the first few years and
then becomes constant at some future point in time until infinity. – There are
multiple stages of ‘g’.
 Four steps to solving multi-stage DDM problems:
o Step 1 – identify all the variables.
o Step 2 – calculate the dividends up to the year where growth rate becomes
constant.
o Step 3 – calculate the price of the stock for the year prior to which the growth
becomes constant.
o Step 4 – enter the variables into your multi-stage DDM formula.
5.5 Notes on Market Efficiency
 Effective capital markets:
o What it means:
 Financial markets and hence security prices rapidly reflect all the
information currently available to investors.
o For example:
 All securities are fairly priced.
o And
 No one can outperform or ‘beat’ the market.
 Random walk theory [a predecessor to the efficient market hypothesis]
o What it means
 Security prices change randomly, without predictable trends or
patterns.
o For example
 The odds of a price increase or decrease do not depend at all on
previous price movements;
o And
 The history of stock prices cannot be used to predict future returns to
investors  technical analysis is pretty much useless.
 Technical analysts
o Investors who attempt to identify undervalued or overvalued securities,
based on patterns in historical prices and trading volumes.
 Fundamental analysts
o Investors who attempt to identify undervalued or overvalued securities by
analyzing fundamental information, such as earnings, asset values and new
business prospects.
 Efficient Market Theory (EMT)
o Weak from efficiency
 Random walk theory
 Market prices reflect all information contained in past market prices.
 Technical analysis is of no value.
o Semi-strong form efficiency
 Market prices reflect all publicly available information.
 Fundamental analysis is useless.
o Strong form efficiency
 Prices reflect all public and private information.
 Stock prices are always fair.
 No investor can consistently outperform the market (even insiders!)
 Efficient-Market Theory (EMT) – Supporting evidence:
o Evidence shows markets tend to be efficient at least in weak form and semistrong form.
 Stock prices react immediately to any change in information (for
example, takeover news).
 General inability of professionally managed portfolios to outperform
the market.
o If markets are efficient, what is the role of professional portfolio managers?
 First, professional portfolio managers help investors choose the
correct level of risk and diversification.
 And secondly, they help keep the market efficient.
5.6 Summary – Valuing Equities
 But we can use one model, the DDM, under special circumstances:
o If the dividends are fixed or not growing  no growth DDM.
o If they are growing at a constant rate ‘g’  constant growth DDM.
o If they begin growing at a constant rate at some future point in time  multistage DDM.
 If we can use the DDM:
o We use it to calculate what the market value of a common stock should be or
the ‘intrinsic’ market price.
 If intrinsic price  current market price  buy!
 If intrinsic price  current market price  do not buy, or sell!
 Question:
o How do we value equity securities when the dividend fluctuates or even
when there is no dividend paid?
 Answer:
o Other discounted cash flow models which uses a cash flow number (instead
of a dividend) in the numerator of a similar formula.
o Relative valuation techniques, such as Price/Earnings multiples, are also
used.