PowerPoint Presentation
prepared by
Traven Reed
Canadore College
chapter 8
Stocks, Stock Valuation,
and Stock Equilibrium
Corporate Valuation and
Stock Risk
CH8
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
8-3
Topics in Chapter
CH8
•
•
•
•
Features of common stock
Determining common stock values
Efficient markets
Preferred stock
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8-4
Common Stock: Owners,
Directors, and Managers
CH8
•
•
•
•
•
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Managers are “agents” of
shareholders, they always solicit
shareholders’ proxies and usually
succeed.
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8-5
Control of the Firm
CH8
• Shareholders often have the right (i.e.
preemptive right) to purchase any
additional shares sold by the firm
• This preemptive right protects the control
of the present shareholders and also
prevents dilution of their value
• The preemptive right makes it more
difficult to raise equity capital from new
large shareholders
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8-6
Types of Common Stock
CH8
• Not all common shares are created
equally
• Most firms have only one type of
common stock
• A system of dual-class shares is
used to meet the special needs of
the company
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8-7
Classified Stock
CH8
• 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.
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8-8
Stock Market Reporting
CH8
• In the past, tracking stock is through the
business section of a daily newspaper.
• Today, we can get quotes all during the day
from a wide variety of Internet sources (e.g.
Globeinvestor.com).
• Comparing with once a day from the
newspaper prints, the 20-minute delay with
the Internet information is nothing.
• The quote provides the price a buyer would
have to pay (“Ask”) and the price someone
can sell the stock (“Bid”) for.
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8-9
Different Approaches for
Valuing Common Stock
CH8
• Most stock’s expected total return =
dividend yield + capital gains yield
• Intrinsic value of a stock is the
present value of its expected future
cash flow stream
– Dividend growth model
– Free cash flow approach
– Using the multiples of comparable firms
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8-10
Stock Value = PV of
expected future dividends
CH8
^
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.
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8-11
For a constant growth stock:
CH8
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
Use decimals, not % in the calculation
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8-12
CH8
Dividend and Earnings
Growth
• Growth in dividends occurs primarily as
a result of growth in EPS.
• Earnings growth results from a number
of factors: (1) inflation, (2) reinvested
profit, and (3) ROE.
• Firms cannot increase stock price by just
raising the current dividend.
• There is a tradeoff between current
dividends and future dividends.
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8-13
Intrinsic Stock Value vs.
Quarterly Earnings
CH8
• If most of a stock’s value is due to longterm cash flows, why do so many
managers focus on 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.
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8-14
Dividend Growth and PV of
Dividends: P0 = ∑(PVof Dt)
CH8
$
0.25
Dt = D0(1 + g)t
Dt
PV of Dt =
(1 + rS)t
If g > rs , P0 = ∞ !
Years (t)
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8-15
What happens if g > rs?
CH8
^
P0 =
D0(1+g)1
(1+rs)1
If g > rs, then
+
D0(1+g)2
+…+
D0(1+rs)∞
(1+rs)∞
(1+rs)2
(1+g)t
> 1, and
^
P0 = ∞
(1+rs)t
So g must be less than rs to use the
constant growth model.
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8-16
Projected Dividends
CH8
• D0 = $2 and constant g = 6% = 0.06
• D1 = D0(1+g) = 2(1.06) = $2.12
• D2 = D1(1+g) = 2.12(1.06) =
$2.2472
• D3 = D2(1+g) = 2.2472(1.06) =
$2.3820
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8-17
CH8
Expected Dividends and PVs
(rs = 13%, D0 = $2, g = 6%)
0
1
g=6%
2.12
1.8761
1.7599
1.6508
2
2.2472
3
4
2.3820
13 %
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8-18
CH8
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
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8-19
Expected value one year
from now:
CH8
• 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 = $30.29(1+0.06)
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8-20
Expected Dividend Yield and
Capital Gains Yield (Year 1)
CH8
D1
$2.12
Dividend yield =
=
= 7.0%
P0
$30.29
^
P1 - P0
$32.10 - $30.29
CG Yield =
=
P0
$30.29
= 6.0%
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8-21
Total Year-1 Return
CH8
• 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
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8-22
CH8
Expected Rate of Return on
a Constant Growth Stock
D1
^
P0 =
to
rs - g
^
D1
rs =
P0
+g
^
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%
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8-23
If g = 0, the dividend stream
is a perpetuity
CH8
0 r =13%
s
1
2
3
2.00
2.00
2.00
PMT $2.00
P0 =
=
= $15.38
r
0.13
^
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8-24
Supernormal (Non-constant)
Growth Stock
CH8
• 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.
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8-25
CH8
Nonconstant growth followed
by constant growth (D0 = $2):
0
1
rs=13%
g = 30%
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
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8-26
Dividend Growth Rates
CH8
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8-27
Suppose g = 0 for t = 1 to 3, and
then g is a constant 6%
CH8
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
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8-28
If g = -6%, would anyone buy
the stock? If so, at what price?
CH8
Firm still has earnings and still pays
^
dividends, so P0 > 0:
D0(1+g)
D1
^
P0 =
=
rs - g
rs - g
$2.00(0.94) $1.88
=
=
= $9.89
0.13 - (-0.06) 0.19
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8-29
CH8
Stock Valuation:
FCF Approach
• Firm value is the present value of
its future expected free cash flows
(FCF) discounted at the WACC.
• Since PV (FCF) is the present value
of a growing annuity, we have
FCF (1  g )
V
WACC  g
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8-30
Using Stock Price Multiples
to Estimate Stock Price
CH8
• Analysts often use the P/E multiple
(the price per share divided by the
earnings per share).
• Example:
– Estimate the average P/E ratio of
comparable firms. This is the P/E
multiple.
– Multiply this average P/E ratio by the
expected earnings of the company to
estimate its stock price.
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8-31
Using Entity Multiples
CH8
• The entity value (V) is:
– the market value of equity (# shares of stock
multiplied by the price per share)
– plus the value of debt.
• Pick a measure, such as EBITDA, Sales,
Customers, Eyeballs, etc.
• Calculate the average entity ratio for a
sample of comparable firms. For
example,
– V/EBITDA
– V/Customers
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8-32
Using Entity Multiples (cont’d)
CH8
• Find the entity value of the firm in
question. For example,
– Multiply the firm’s sales by the V/Sales
multiple.
– Multiply the firm’s # of customers by the
V/Customers ratio
• The result is the total value of the firm.
• Subtract the firm’s debt to get the total
value of equity.
• Divide by the number of shares to get
the price per share.
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8-33
Problems with Market
Multiple Methods
CH8
• It is often hard to find comparable firms.
• The average ratio for the sample of
comparable firms often has a wide
range.
– 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?
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8-34
Preferred Stock
CH8
• 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.
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8-35
Preferred Stock Valuation
CH8
• Similar to the valuation of perpetual
bonds
DPS
VPS 
rPS
• A preferred stock pays a quarterly
dividend of $1.25 ($5 per year) with
a required return of10%. Its value
DPS 4($1.25) $5
is
VPS 
rPS

0.1

0.1
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 $50
8-36
Expected return: given Vps = $50
and annual dividend = $5
CH8
$5
Vps = $50 =
$5
^
rps =
$50
^
rps
= 0.10 = 10.0%
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8-37
CH8
Stock Price Volatility for
changes in rS and g
• Are volatile stock prices consistent with
rationing 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 are not volatile, then this
means there is not a good flow of
information.
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8-38
Stock Market Equilibrium
CH8
• 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.
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8-39
In equilibrium, expected returns
must equal required returns:
CH8
^
rs = D1/P0 + g = rs = rRF + (rM - rRF)b
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8-40
How is equilibrium
established?
CH8
^
D
If rs = 1 + 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
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8-41
Efficient Market Hypothesis
CH8
• Securities are normally in equilibrium
and are “fairly priced.”
• Investors cannot “beat the market”
except through good luck or inside
information.
• The prices of securities fully reflect
available information. They will adjust
immediately to any new development.
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8-42
Weak-form EMH
CH8
• Investors buying bonds and stocks
cannot 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.
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8-43
Semistrong-form EMH
CH8
• All publicly available information is
reflected in stock prices, so it does
not pay to pore over annual reports
looking for undervalued stocks.
Largely true.
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8-44
Strong-form EMH
CH8
• 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 is illegal!
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8-45
Markets are generally
efficient because:
CH8
• 100,000 or so trained analysts-MBAs, CFAs, and PhDs--work for
firms like Fidelity, Merrill, Morgan,
and Prudential.
• These analysts have similar access
to data and megabucks to invest.
• Thus, news is reflected in P0 almost
instantaneously.
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8-46