MBF2273 Fund Management
L2: The Equity Market
Google IPO
In August of 2004, Google went public, auctioning its
shares in an unusual IPO format.
The shares originally sold for $85 / share, and closed at
over $100 on the first day. In November of 2010, shares
are trading on Nasdaq at over $620 / share.
Facebook IPO
Facebook held its IPO on May 18, 2012.
The IPO was one of the biggest in technology, and the biggest in
Internet history, with a peak market capitalization of over $104 billion.
Offer price was $38/share. It closed at $38.23/share.
The IPO raised $16 billion, making it the third largest in U.S. history
(just ahead of AT&T Wireless and behind only General Motors and Visa
Inc.).
The stock price left the company with a higher market capitalization
than all but a few U.S. corporations – surpassing heavyweights such as
Amazon.com, McDonald's, Disney, and Kraft Foods – and made
Zuckerberg's stock worth $19 billion.
Trends in Global Equity and Bond Markets, 2001 - 2009
World Equity and Stock Markets (Trillions of USD)
100
90
80
70
60
Stock
Market
50
Debt
Market
40
30
20
10
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
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Investing in Stocks
1. Represents ownership
in a firm
2. Earn a return in
two ways
– Price of the stock rises
over time
– Dividends are paid to the
stockholder
3. Stockholders have claim
on all assets
4. Right to vote for
directors and on
certain issues
5. Two types
─ Common stock
• Right to vote
• Receive dividends
─ Preferred stock
• Receive a fixed dividend
• Do not usually vote
Investing in Stocks: How Stocks are Sold
• Organized exchanges
– NYSE is best known, with daily volume around 4
billion shares, with peaks at 7 billion.
– “Organized” used to imply a specific trading
location. But computer systems (ECNs) have
replaced this idea.
– Others include the ASE (US), and Nikkei, LSE, DAX
(international)
– Listing requirements exclude small firms
Investing in Stocks: How Stocks are Sold
• Over-the-counter markets
– Best example is NASDAQ
– Dealers stand ready to make a market
– Today, about 3,000 different securities are listed
on NASDAQ.
– Important market for thinly-traded securities—
securities that don’t trade very often. Without a
dealer ready to make a market, the equity would
be difficult to trade.
Investing in Stocks: Organized vs. OTC
• Organized exchanges (e.g., NYSE)
– Auction markets with floor specialists
– 25% of trades are filled directly by specialist
– Remaining trades are filled through SuperDOT
• Over-the-counter markets (e.g., NASDAQ)
– Multiple market makers set bid and ask prices
– Multiple dealers for any given security
Investing in Stocks: ETFs
Exchange Traded Funds are a recent innovation to help
keep transaction costs down while offering
diversification.
 Represent a basket of securities
 Traded on a major exchange
 Index to a specific portfolio (eg., the S&P 500), so
management fees are low (although commissions still apply)
 Exact content of basket is known, so valuation is certain
Computing the Price of Common Stock
• Valuing common stock is, in theory, no
different from valuing debt securities:
determine the future cash flows and discount
them to the present at an appropriate
discount rate.
• We will review four different methods for
valuing stock, each with its advantages
and drawbacks.
Computing the Price of Common Stock:
The One-Period Valuation Model
• Simplest model, just taking using the expected
dividend and price over the next year.
•
Computing the Price of Common Stock: The
One-Period Valuation Model
What is the price for a stock with an expected
dividend and price next year of $0.16 and $60,
respectively? Use a 12% discount rate
Answer:
Computing the Price of Common Stock:
The Generalized Dividend Valuation Model
• Most general model, but the infinite sum may
not converge.
•
• Rather than worry about computational
problems, we use a simpler version, known as
the Gordon growth model.
Computing the Price of Common Stock:
The Gordon Growth Model
• Same as the previous model, but it assumes
that dividend grow at a constant rate, g. That
is,
Computing the Price of Common Stock:
The Gordon Growth Model
The model is useful, with the following
assumptions:
 Dividends do, indeed, grow at a constant rate
forever
 The growth rate of dividends, g, is less than
the required return on the equity, ke.
Computing the Price of Common Stock:
The Generalized Dividend Valuation Model
• The price earnings ratio (PE) is a widely
watched measure of much the market is
willing to pay for $1.00 of earnings from
the firms.
•
Computing the Price of Common Stock:
The Price Earnings Valuation Method
If the industry PE ratio for a firm is 16,
what is the current stock price for a firm
with earnings for $1.13 / share?
Answer:
Price = 16  $1.13 = $18.08
How the Market Sets Security Prices
• Generally speaking, prices are set in
competitive markets as the price set by the
buyer willing to pay the most for an item.
• The buyer willing to pay the most for an asset
is usually the buyer who can make the best
use of the asset.
• Superior information can play an important
role.
How the Market Sets Security Prices
• Consider the following three valuations for a
stock with certain dividends but different
perceived risk:
• Bud, who perceives the lowest risk, is willing
to pay the most and will determine the
“market” price.
Errors in Valuation
Although the pricing models are useful, market
participants frequently encounter problems in using
them. Any of these can have a significant impact on
price in the Gordon model.
 Problems with Estimating Growth
 Problems with Estimating Risk
 Problems with Forecasting Dividends
Errors in Valuation
To illustrate this point, the next two slides show
how dramatically a stock’s price can change by
simple changes in the expected dividend growth
rate (Table 13.1) and required return (Table
13.2).
Errors in Valuation: Dividend growth rates
Errors in Valuation: Required returns
Errors in Valuation
These two slides also point out that security
valuation is not an exact science. Considering
different growth rates, required rates, etc., is
important in determining if a stock is a good
value as an investment.
Case: The 2007–2009 Financial Crisis and the Stock
Market
• The financial crisis, which started in August 2007,
was the start of one of the worst bear markets.
• The crisis lowered “g” in the Gordon Growth
model—driving down prices.
• Also impacts ke—higher uncertainty increases this
value, again lowering prices.
• The expectations were still optimistic at the start of
the crisis. But, as the reality of the severity of the
crisis was understood, prices plummeted.
Buying Foreign Stocks
• Buying foreign stocks is useful from a diversification
perspective. However, the purchase may be
complicated if the shares are not traded in the U.S.
• American depository receipts (ADRs) allow foreign
firms to trade on U.S. exchanges, facilitating their
purchase. U.S. banks buy foreign shares and issue
receipts against the shares in U.S. markets.
Regulation of the Stock Market
• The primary mission of the SEC is “…to protect
investors and maintain the integrity of the
securities markets.”
• The SEC brings around 500 actions against
individuals and firms each year toward this
effort. This is accomplished through the joint
efforts of four divisions.
Regulation of the Stock Market: Divisions of the SEC
• Division of Corporate Finance: responsible for
collecting, reviewing, and making available all
of the documents corporations and individuals
are required to file
• Division of Market Regulation: establishes and
maintains rules for orderly and
efficient markets.
Regulation of the Stock Market: Divisions of the SEC
• Division of Investment Management: oversees
and regulates the investment management
industry
• Division of Enforcement: investigates
violations of the rules and regulations
established by the other divisions.
Global Equity Market: Recent Trends
(1) Stock exchanges becoming public traded organizations
 Historically stock markets were private organizations.
 However, in February of 2001 Germany’s stock exchange, the
Deutsche Stock Exchange went public;
 In July of 2001, both the London Stock Exchange and Euronext
went public;
 In 2006, the NYSE went public.
•
Implications of publically traded exchanges:
 Inclusion in investor portfolios.
 Possibility of take-overs
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Global Equity Market: Recent Trends
(2) Consolidations (mergers and acquisitions) among independent stock
exchanges.
 On September 22, 2000, Euronext Stock Exchange was formed through
the merger of the national stock exchanges of France, Belgium, and
the Netherlands. In December 2001, Euronext acquired the shares of
the London International Financial Futures and Options Exchange
(LIFFE), in 2002 it acquired the Portuguese Stock Exchange.
 On April 4, 2007, the New York Stock Exchange and Euronext merged
to form NYSE Euronext.
 In February 2011, NYSE Euronext and Deutsche Börse announce that
they were engaged in "advanced merger talks.”

On April 1st, NASDAQ countered with a higher bid for NYSE
Euronext (19% over Deutsche’s offer); however, the offer is
rejected by NYSE Euronext as not “strategically attractive.”
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Global Equity Market: Recent Trends
•
In 2006 and 2007 NASDAQ twice attempted a hostile takeover of the London
Stock Exchange.
 Both takeover attempts were rejected by LSE shareholders.
•
In late 2010, Singapore offered to buy out the Australian Securities Exchange
for $7.8 billion
 The offer was recently rejected by the Australian Government.
•
In February 2011, the London Stock Exchange announced a merger with the
Toronto Stock Exchange.
•
Why are exchanges merging?
(1)
cost reductions (to the exchanges themselves through economies of
scale).
(2)
to expand global capital raising benefits (IPOs) to corporations and
(3)
to provide liquidity (turnover) and global outreach benefits to investors.
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Global Equity Market: Recent Trends
(3) Increasing number of national stock markets around the world.



John Thain, 2006, CEO, NYSE: “Most countries have an army, a
flag, an airline, and a [stock] exchange.”
Today there are approximately 300 stock exchanges.
Many emerging countries have their own stock markets.
•
Part of their privatization process.
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Gordon Growth Model
• The Gordon Growth Model, also known as the dividend
discount model (DDM), is a method for calculating the intrinsic
value of a stock, exclusive of current market conditions.
• The model equates this value to the present value of a stock's
future dividends.
• There are two basic forms of the model:
 the stable model and
 the multistage growth model.
34
Gordon Growth Model
• Stable Model
•
Value of stock = D1/ (k - g)
where:
D1 = next year's expected annual dividend per share
k = the investor's discount rate or required rate of return, which
can be estimated using the Capital AssetPricing Model or the
Dividend Growth Model (see Cost of Equity)
g = the expected dividend growth rate (note that this is assumed
to be constant)
35
Gordon Growth Model
• Multistage Growth Model
• When dividends are not expected to grow at a constant rate,
the investor must evaluate each year's dividends separately,
incorporating each year's expected dividend growth rate.
• However, the multistage growth model does assume that
dividend growth eventually becomes constant.
• See the example in the next slides.
36
Gordon Growth Model
• Stable Model
Let's assume XYZ Company intends to pay a $1 dividend per share
next year and you expect this to increase by 5% per year thereafter.
• Let's further assume your required rate of return on XYZ Company
stock is 10%. Currently, XYZ shares are trading at $10 per share.
• Using the formula e, we can calculate that the intrinsic value of one
share of XYZ Company stock is:
• $1.00/(.10-.05) = $20
• According to the model, XYZ Company stock is worth $20 per share
but is trading at $10; the Gordon Growth Model suggests the stock is
undervalued.
• The stable model assumes that dividends grow at a constant rate. This
is not always a realistic assumption for growing (or declining)
companies, which gives way to the multistage growth model.
37
Gordon Growth Model
• Multistage Growth Model
Let's assume that during the next few years XYZ Company's
dividends will increase rapidly and then grow at a stable rate.
• Next year's dividend is still expected to be $1 per share, but
dividends will increase annually by 7%, then 10%, then 12%, and then
steadily increase by 5% after that.
• By using elements of the stable model, but analyzing each year of
unusual dividend growth separately, we can calculate the current fair
value of XYZ Company stock.
• Here are the inputs:
D1 = $1.00
k = 10%
g1 (dividend growth rate, year 1) = 7%
g2 (dividend growth rate, year 2) = 10%
g3 (dividend growth rate, year 3) = 12%
gn (dividend growth rate thereafter) = 5%
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Gordon Growth Model
• Since we have estimated the dividend growth rate, we can
calculate the actual dividends for those years:
D1 = $1.00
D2 = $1.00 * 1.07 = $1.07
D3 = $1.07 * 1.10 = $1.18
D4 = $1.18 * 1.12 = $1.32
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Gordon Growth Model
• We then calculate the present value of each dividend
during the unusual growth period:
$1.00 / (1.10) = $0.91
$1.07 / (1.10)2 = $0.88
$1.18 / (1.10)3 = $0.89
$1.32 / (1.10)4 = $0.90
40
Gordon Growth Model
• Then, we value the dividends occurring in the stable growth
period, starting by calculating the fifth year's dividend:
D5 = $1.32*(1.05) = $1.39
• We then apply the stable-growth GGM formula to these
dividends to determine their value in the fifth year:
$1.39 / (0.10-0.05) = $27.80
• The present value of these stable growth period dividends are
then calculated:
$27.80 / (1.10)5 = $17.26
41
Gordon Growth Model
• Finally, we can add the present values of XYZ's future dividends
to arrive at the current intrinsic of XYZ stock:
$0.91+$0.88+$0.89+$0.90+$17.26 = $20.84
• The multistage growth model also indicates that XYZ stock is
undervalued (a $20.84 intrinsic value, compared with a $10
trading price).
• Analysts frequently incorporate an assumed sale price and sale
date into these calculations if they know the stock is not going
to be held indefinitely. Also, coupon payments can be used in
place of dividends when analyzing bonds.
42
Gordon Growth Model
• The GGM allows investors to calculate the value of a share
of stock exclusive of current market conditions.
• This exclusion allows investors to make apples-to-apples
comparisons among companies in different industries, and for
this reason GGM is one of the most widely used equity analysis
and valuation tools.
• However, there is some sentiment that Gordon Growth Model’s
exclusion of nondividend factors tends to undervalue stocks in
companies with exceptional brand names, customer loyalty,
unique intellectual property, or other nondividend, valueenhancing characteristics.
43
Gordon Growth Model
• Mathematically, two circumstances are required to make the
GGM effective.
• First, a company must distribute dividends however,
analysts frequently apply the GGM to stocks that do not pay
dividends by making assumptions about what
the dividend would be if the company did pay dividends).
• Second, the dividend growth rate (g) cannot exceed the
investor's required rate of return (k).
– If g is greater than k, the result would be negative, and
stocks cannot have negative values.
44
Gordon Growth Model
• The GGM, especially the multistage growth model, often
requires users to make somewhat unrealistic and difficult
estimates of dividend growth rates (g).
• It is important to understand that the GGM is highly sensitive to
changes in g and k, and many analysts perform sensitivity
analyses to evaluate how different assumptions change the
valuation.
• Under the GGM, a stock becomes more valuable when its
dividend increases, the investor's required rate of return
decreases, or the expected dividend growth rate increases. The
GGM also implies that a stock price grows at the same rate as
dividends.
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