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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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) Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 % Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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) Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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% Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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% Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 ^ Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-26 Dividend Growth Rates CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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? Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. $50 8-36 Expected return: given Vps = $50 and annual dividend = $5 CH8 $5 Vps = $50 = $5 ^ rps = $50 ^ rps = 0.10 = 10.0% Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-39 In equilibrium, expected returns must equal required returns: CH8 ^ rs = D1/P0 + g = rs = rRF + (rM - rRF)b Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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! Copyright © 2011 by Nelson Education Ltd. All rights reserved. 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-46