Chapter 08 McGraw-Hill/Irwin Valuing Stocks Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 1 Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved Common Stock • Represents ownership in corporation • Value of common stock based on – Company’s profitability and growth potential – Current market interest rates – Overall stock market conditions 8-2 Stock Markets • Provide liquidity through stock exchanges • Provide means for buyers and sellers to transact 8-3 Stock Markets • • • • • New York Stock Exchange (NYSE) American Stock Exchange (AMEX) NASDAQ FTSE Nikkei 8-4 Stock Markets • Stock market indexes – Dow Jones Industrial Average tracks 30 large industry-leading stocks – Standard & Poor’s 500 tracks largest 500 U.S. firms – NASDAQ Composite Index primarily tracks technology firms 8-5 Stock Markets • Trading Stocks – Quoted bid is highest price at which market makers will buy – Quoted ask is lowest price at which market makers will sell 8-6 Stock Markets • Trading Stocks – Market order is filled at current ask price – Limit order only executed if ask price is below price target 8-7 Basic Stock Valuation • Present value calculations used • Unlike present value for bonds, stock cash flows are unknown – Dividends – Future selling price 8-8 Basic Stock Valuation • Find present value of future dividends and future selling price • One-year-holding-period timeline example 8-9 Basic Stock Valuation • Today’s value = present value of next year’s dividend and price 8-10 Basic Stock Valuation • Two-year-holding-period timeline example 8-11 Basic Stock Valuation • For a holding period of n years, the value of a stock is measured by the present value of dividends over n years plus the sale price 8-12 Dividend Discount Model • Stock’s value is the present value of an infinite stream of dividends and no future final sales price 8-13 Constant Growth Model • Assumes growth rate smaller than discount rate • Next year’s dividend ÷ (Discount rate – Growth rate) 8-14 Preferred Stock • Has priority over common stock in bankruptcy • Pays a constant dividend • Valued using constant-growth model 8-15 Expected Return • Investors demand higher returns from higherrisk investments • Dividend yield and expected stock price appreciation comprise Expected Return 8-16 Variable Growth-Rate Valuation • Combines present-value cash flow with constant-growth-rate model 8-17 Two-Stage Growth Valuation • Variable-growth-rate stock • Stock value = Present value of each dividend during first growth stage + Present value of second growth stage 8-18