CHAPTER 8 Stocks, Stock Valuation, and Stock Market Equilibrium 1

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CHAPTER 8
Stocks, Stock Valuation, and
Stock Market Equilibrium
1
Topics in Chapter




Features of common stock
Determining common stock values
Efficient markets
Preferred stock
2
Common Stock: Owners,
Directors, and Managers





Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.
3
Classified Stock



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.
4
Initial Public Offering (IPO)


A firm “goes public” through an IPO
when the stock is first offered to the
public.
Prior to an IPO, shares are typically
owned by the firm’s managers, key
employees, and, in many situations,
venture capital providers.
5
Seasoned Equity Offering
(SEO)


A seasoned equity offering occurs when
a company with public stock issues
additional shares.
After an IPO or SEO, the stock trades in
the secondary market, such as the
NYSE or Nasdaq.
6
Different Approaches for
Valuing Common Stock



Dividend growth model
Using the multiples of comparable firms
Free cash flow method (covered in
Chapter 15)
7
Stock Value = PV of Dividends
^
P0 =
D1
(1+rs)1
+
D2
(1+rs)2
+
D3
+…+
(1+rs)3
D∞
(1+rs)∞
What is a constant growth stock?
One whose dividends are expected to
grow forever at a constant rate, g.
8
For a constant growth stock:
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
9
Expected Dividends and PVs
(rs = 13%, D0 = $2, g = 6%)
0
g=6%
1
2.12
1.8761
1.7599
1.6508
2
2.2472
3
4
2.3820
13
%
10
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
11
Expected value one year from
now:

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
12
Expected Dividend Yield and
Capital Gains Yield (Year 1)
D1
$2.12
Dividend yield =
=
= 7.0%.
P0
$30.29
^
P1 - P0
$32.10 - $30.29
CG Yield =
=
P0
$30.29
= 6.0%.
13
Total Year-1 Return




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.
14
Rearrange model to rate of
return form:
D1
^
P0 =
to
rs - g
^
D1
rs =
P0
+ g.
^
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.
15
If g = 0, the dividend stream
is a perpetuity.
0 r =13%
s
1
2
3
2.00
2.00
2.00
PMT $2.00
P0 =
=
= $15.38.
r
0.13
^
16
Supernormal Growth Stock



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.
17
Nonconstant growth followed
by constant growth (D0 = $2):
0
rs=13%
g = 30%
1
2
g = 30%
2.60
3
g = 30%
3.38
4
g = 6%
4.394
4.6576
2.3009
2.6470
3.0453
46.1135
54.1067
^
= P0
^
$4.6576
P3 =
= $66.5371
0.13 – 0.06
18
Intrinsic Stock Value vs. 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.
19
Suppose g = 0 for t = 1 to 3, and
then g is a constant 6%.
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
P  2.12  30.2857
3
0.07
20
Preferred Stock



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.
21
Why are stock prices volatile?
D1
^
P0 =
rs - g

rs = rRF + (RPM)bi could change.




Inflation expectations
Risk aversion
Company risk
g could change.
22
Consider the following
situation.
D1 = $2, rs = 10%, and g = 5%:
P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40.
What happens if rs or g change?
23
Stock Prices vs. Changes in rs
and g
4%
g
5%
6%
9%
40.00
50.00
66.67
10%
33.33
40.00
50.00
11%
28.57
33.33
40.00
rs
24
Are volatile stock prices
consistent with rational 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 aren’t volatile, then this
means there isn’t a good flow of
information.
25
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…)
26
In equilibrium, expected returns
must equal required returns:
^
rs = D1/P0 + g = rRF + (rM - rRF)b.
27
How is equilibrium
established?
^
^
If rs = D1 + g > rs, then P0 is “too low.”
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.
28
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…)
29
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.
30
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.
31
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.
32
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