Stock Valuation

When the stock market closed on January 16, 2009, common stock of McGraw -Hill, a publishing
house that publishes high-quality college books, was selling for $21.44 per share. That same day,
shares of Adobe Systems, maker of the popular Acrobat software , closed at $21.06 per unit, while
shares of Boardwalk Pipeline Partners, which transports and stores natural gas, closed at $20.72.
Since the stock prices of these three companies were so similar, we might expect them to offer similar
dividends to their shareholders, but we would be wrong. In fact, Boardwalk Pipeline Partners' annual
dividend was $1.90 per share, McGraw-Hill's was $0.88 per share , and Adobe Systems paid no
dividend.
As we will see in this chapter, the current dividend is one of the main factors in evaluating
common stocks . However, it logically follows from the analysis of Adobe Sys We fear that
current dividends are not the end of the story. This chapter explores dividends, stock values, and the
connection between the two.

In the previous chapter we discussed bonds and bond valuation. In this chapter we will analyze
the other main source of financing for corporations: common shares . First we will describe the
cash flows associated with a stock and then develop a famous result, the dividend growth model.
We will examine growth opportunities and the price-to-earnings ratio later. We will conclude the
chapter with an analysis of how stocks are traded and how stock prices and other important data
are formed in the financial press.

9.1 Present value of common shares

Dividends versus capital gains
In this section our goal is to value the common stock. In previous chapters you learned We said
that the value of an asset is determined by the present value of its future cash flows. Stocks
produce two types of cash flows. First, many actions pa They earn dividends regularly. Second,
the shareholder receives the sales price when he sells the stock. Therefore, to value common
shares it is necessary to answer an interesting question: what is the value of a share equal to:
1. At the present discounted value of the sum of the dividend of the following period plus the
pre price of the stock in the following period, or
2. At the present discounted value of all future dividends.
This is the type of question that students would like to see on a multiple choice exam, because
both 1) and 2) are correct answers.
 Chapter 9 Stock Valuation 269

To understand why 1) and 2) are the same, let's start with a person who buys a stock and
holds it for a year. In other words, it has a shelf life of one year. Furthermore, today it is willing
to pay F 0 for the shares. That is, calculate:
div, F'
(9.1)
1 + fi + 1 *R
Div is the dividend paid at the end of the year and P is the price at the end of the year. P 0 is the
total value of the investment in the common stock. The denominator term, A, is the stock's
appropriate discount rate.
This seems very simple; but where does P come from? P is not an expression that comes out
of nowhere. Rather, there must be a buyer at the end of year 1 who is willing to buy the stock at
P. This buyer determines the price as follows:
Div, + P,
(9.2)
1 + fi 1 * R
Substituting the value of P from equation 9.2 into equation 9.1, we obtain:

div, div, Pz
R (1 jt) 2 (I + a)'

We can ask a similar question about equation 9.3: where does T 2 come from? At the end of year 2,
an investor is willing to pay P 2 due to the dividend and the stock price tion in year 3. This process can be
repeated ad nauseani.' In the end this is left:
Div, Div div, div,
1 * R (1 + fi)" (1 fi)' 2(1+R) (9.4)

Therefore, the price of a common stock to the investor is equal to the present value of all expected future
dividends.
This is a very useful result. A common objection to applying present value analysis to stocks is that
investors are too short-sighted to worry about long-term dividend scric. These critics maintain that, in
general, investments nists do not look beyond their temporal horizon. Consequently, the prices of a
market dominated by short-term investors will reflect only short-term dividends. However, our analysis
shows that a long-term dividend discount model is valid even when investors have short-term time
horizons. Although an investor may need to sell his shares soon, he must find another investment. that you
are willing to buy. The price this second investor pays depends on the dividends after the purchase date.

Valuation of different types of shares

The above analysis shows that the price of a stock is the present value of its future dividends. How do we
apply this idea in practice? Equation 9.4 represents a ge model neral that is applicable regardless of
whether dividends are expected to increase, decrease

'This procedure is reminiscent of that physicist who gave a lecture about the origins of the universe. It was abor given by an elderly
gentleman in public who did not agree with the conference. It was said that the universe rested on the back of an enormous turtle. When the
physicist offered him a question about 9 where the tortoise was resting , this cafiallerc4 replied, "Yes, about another tortoise." Anticipating
physical objections, the old man then said: “Don't get tired, man! There are more and more turtles until the end.”
 270 f' ar te 11 Valuation and capital budget

Figure 9.1
Patterns of zero growth, constant growth and
differential growth

Dividend growth models:

Constant growth: Pg =

= T Div(1 + g1)4 Divr+1 . 1____

Differential growth: P = Z
t=1 (1 +R) It — g2 (1 + R} T

or remain at the same level. The general model can be simplified if dividends are expected to follow some
basic guidelines: 1) zero growth, 2) constant interest , and 3) differential growth. These cases are
illustrated in Figure 9.1.

Gaso 4 (Zero Growth) The price of a stock with a constant dividend is given by:
Div div, Div
651+R*(1+R)2*m5R
Here it is assumed that Div a - Diva - = Div. This is just one application of the perpetuities formula from
chapter 4.

Gasoline 2 ( Constant Growth) Dividends grow at rate g, as described below:

End of the year

Note that Div is the dividend at the end of the first period.

Dividend Di Div(l +g) Div(l +g)2 Div(I + g)'

v
 Chapter 9 Valuation of rectories 271

Projected Dividends Hampshire Products will pay a dividend of $4 per share within a year. Financial analysts believe
EXAMPLE 9.1
that dividends will increase at 6% annually for the foreseeable future. What will be the dividend per share at the end
of each of the first five years?

1 2 3 4 5
2
$4.00 $4 > (I.06) $4 x (I .06) $4 x (I .06)' $4 (I .06)'
= $4.24 = $4.4944 = $4,764 I = $5.0499

The value of a common stock with dividends growing at a constant rate is:

Div Div (1 + g) Div (1 * ç)' Div (1 “ 8) Div

“ 1+R' (1 +R) (1 * R)' (1 * R)' R—z

where ę is the growth rate. Div is the dividend on the shares at the end of the first period. This is
the formula for the present value of an increasing perpetuity that was presented in Chapter 4.

Stock Valuation Suppose an investor is considering purchasing a share of Utah P1ining Company stock. The stock will
pay a $3 dividend within a year. It is expected that this divi expected to grow I 0% annually (g - I 0%) in the
EXAMPLE 9.2 foreseeable future. The investor thinks that the required return (A) on this stock is I 5%, given Ucah Mining's risk
assessment. (A is also the discount house for the stock.) What will be the price of a share of Utah Mining!
Using the constant growth formula from case 2 we determine that the value will be 60 dollars:
Pg depends largely on the value of g. If g had been estimated to be I 2.5%, the value of the share would have
been:
$120 $3

$3
$60 =
.1-5 .10
15 — . 125

E| The stock price doubles (from $60 to $120) when g increases by only 25% (from 10% to I 2.5%). Because of
You will find details for Ph's dependence on g, one must maintain a healthy sense of skepticism when using this dividend-consistent
applying the dividend growth model.
discount model at Also, note that P# is equal to infinity when the growth rate g is equal to the discount house A. Because stock
http://dividend- prices do not grow to infinity, an estimate of g equal to or greater than R implies an error in the estimate. We will
discounłmodeI.com
elaborate on this aspect later.

The assumption of constant dividend growth may seem peculiar to

you. Why would a dividend grow at a constant rate? The reason is that in
many companies the growth Consistent dividend growth is an explicit
goal. For example, in 2008, Procter & Gamble, a maker of household and
personal care products headquartered in Cincinnati, increased its dividend
14.3"/›, to $1.60 per share; this increase was
272 Part II Valuation and budgeting ‹Je capital

notable because it was the 52nd in a row. The issue of dividend

growth enters the ru general discussion of dividend policy, so we will
postpone its analysis until a later chapter. 2

Case 3 ( Differential growth) In this case it would be very difficult to handle an

alge formula
braica. Instead we present some examples.

EXAMPLE 9.3
Differential Growth Consider shares of Elixir Drug Company, which has posted rapid growth

since the introduction of a new ointment for back pain . The dividend of one share of Elixir in
one year will be I. 15 dollars. In the following four years the dividend will grow by I 5% annually
(g¡ = IS%). After that, growth (gt) will be I 0% per year. Calculate the present value of the stock
if the required return (R) is IS percent.

Figure 9.2 Elixir Drug Company Dividend Growth

1 2 3 4 5 6 7 8 9
10
End of the year

Figure 9.2 shows dividend growth. We need to apply a two-step process to discount these
dividends. First we calculate the present value of the dividends that grow I 5% annually. That is,
we first calculate the present value of the dividends as of the end of year 6.

Until now we have assumed that dividends are just the cash payments the company makes to its
shareholders. Actually . in recent times. Companies often pay cash to shareholders through record
purchases of outstanding shares. Share repurchase payments are substitutes for current customer
payments. We will say much more about the advantages and disadvantages of ‹1vidcn‹1os
payments compared to the purchase of airplanes.
To understand how share buyback payments might work in the growth version of the dividend
discount model. Suppose Red Industries has 100 million shares outstanding and expects year-end
earnings of $400 million. Trojan plans to pay 60"?› of its net income as follows: 3t)'fi' in
‹lividcn‹los and 3I)'fi' in repurchasable shares. 'I'ro jan espci:aq nc the subsidiary ad net a
umcntc .5'fi› annually in perpetuity. If Trojan's required return is 10', what price does the stock
have?
Solution:

yp wow $ 5.24 billion

‹ ›‹ff J million
.10— .05
$4.8 billion
Price per share = 545 per share
Chapter 9 Stock Valuation 273

100 million shares

274 Part II Valuation and budgeting ‹Je capital

Present value of the first five dividends The present value of the dividend payments
in years T to 5 is as follows:

Expected Present
Future year Growth rate (g,) dividend value

1 .15 $l. es $1
2 .15 I .3225 1
3 .15 I .5209 1
4 .15 1.7490 1
5 .15 2.0114 1
Years I - 5 Present value of diyidends - $5

The increasing annuity formula from the previous chapter could be used regularly in this
step. However, notice that dividends grow I 5% annually, which is also the discount rate.
Because g = R, the increasing annuity formula cannot be used in this example.
Present value of dividends as of year 6. We use this procedure to calculate the
deferred perpetuities and deferred annuities that were explained in Chapter 4. They divide
them two as of the end of year 6 are:

End of the year

Div Divs
Diva God (!” g2)'
2.0 I S I4 x 2.01 14 X (1.10) 2.HEAR I4 x
$2.OÍ I4 x I . I0
(1.10)s =G2.6772 (I .10)'
Dividend = $2.2125
= $2.4338 $2 9449
As mentioned in Chapter 4, the crescent perpetuities formula calculates the present value
with
date one year prior to the first payment. Because payment begins at the end of year 6, the
present value formula calculates the present value at the end of year 5.
The price at the end of year 5 is given by:
Diva $2.2125
goes .
= = $44.25
— gt . IS—.10

Today, the present value of Pt is:

Q $44.25
. e — /. qe = $22
(R& R) 5
(1.15)5
Today, the present value of all dividends is $27 ($22 + $5).

.2 Parameter estimates in the model

dividend discount
The value of the company is a function of its growth rate g and its
discount rate fi. How are these variables estimated?

Does rfoncfe pro•'íene g?'

Chapter 9 Stock Valuation 275

In the previous analysis we assumed that dividends grow at the rate g.

Now we need to estimate this growth rate. Consider a company that
expects its profits for the year
276 Part II Valuation and budgeting ‹Je capital

next year will be the same as this year, unless you make a net investment. This situation is likely
to arise because net investment is equal to gross investment. or total, less depreciation. A net
investment of zero occurs when the total investment equals the depreciation. If total investment
equals depreciation, the company simply maintains It has the physical plant. which is consistent
with the absence of profit growth.
Net investment will only be positive if no profits are paid as
dividends, that is, only if some profits are retained.' This leads to the

Utilities Utilities
of the year = deeste
next year
following equation:
Utilities Performance
retained x overutili- (9.5)
this year retained data
Increase in profits
The increase in profits is a function of both the retained profits and the
performance on the retained profits.
Now we divide both sides of equation 9.5 by this year's profits to
obtain:
Next year's profits This year's profits This year's retained earnings
This year's profits This year's profits This year's profits (9.6)
Return on retained earnings
The left side of equation 9.6 is just one plus the growth rate of profits.
des, which is written like this: 1 + g. The ratio of retained earnings to
profits is called the earnings retention ratio. Therefore, we can write:
1 * g = I * Earnings retention ratio Return on retained earnings (9.7)
It is difficult for a financial analyst to determine the expected return
on currently retained earnings because, in general, details about upcoming
projects are not made public knowledge. However, it is often assumed
that the projects Projects selected in the current year have an expected
return equal to the returns of projects from other years. Here we can
estimate the expected return on current retained earnings with the
historical return on equity , or ROE. After all, ROE is simply the return
on all the company's capital, which is equivalent to the return
accumulated ment of all the company's past projects.
Thanks to equation 9.7 we have a simple way to estimate profit
growth:
Company growth rate formula:
g = Earnings retention ratio X Return on retained earnings (ROE) (9.8)
The estimate of the earnings growth rate, g, is also the estimate of the
dividend growth rate consistent with the common assumption that the
ratio of dividends to earnings remains constant.

EXAMPLE 9.4
Earnings Growth Pagemasrer Enterprises just announced earnings of $2 million.
Chapter 9 Stock Valuation 277

The company plans to retain 40% of its profits for years from now. In other words,
the utility collection rate is 40%. We can also say that 60% of the profits will be paid

3 We ignore issuing stocks and bonds to raise capital. These possibilities are considered in later
chapters.
278 Part II Valuation and budgeting ‹Je capital

as dividend. The dividend-to-earnings ratio is often known as the dividend payout ratio, so Pagemasrer's dividend
payout ratio is 60%. The historical return on equity (ROE) has been . 16, a figure that is expected to continue in the future.

How much will profits grow next year?

We first perform the calculations without referring to equation 9.8. Then we will use equation (9.8) as a check.

CATCUT without reference to Equation 9.8 The company will retain $800,000 (40% and 2 million). Assuming that the
historical ROE is an appropriate estimate of future returns, the expected increase in earnings is:

$800 000 . 16 - $128 000

The percentage growth of utilities is:

Change in u!Iities $128,000
064
Local utilities $2 million

This implies that within one year the profits will be $2,128,000 ($2,000,000 x I .064).

Check with Equation 9.8 We use g = Earnings retention ratio AND ROE. Thus, we have:
g - .4 x .16 - .064
Since Pagemascer's dividend-to-earnings ratio, that is, its dividend payout ratio, is constant thereafter, .064 is the
growth rate for both earnings and dividends.

Where does R* come from?

Up to this point we have considered the required return, or the discount rate fi, as given. We will
have many important things to say about estimating R in later chapters. For now, we will
examine the implications of the dividend growth model for this required return. Previously we
calculated f 0 as follows:
Po = Div/(R - 8)
We rearrange this expression to solve for the value of fi and we obtain:
fi g = Div/Pp (9.9)
R Dix'f Pz g
Equation 9.9 tells us that the performance totn1, fi, has two components. The prime One of
them, Diy f Pz, is called the dividend yield. Because this is calculated as the expected dividend
on elective divided by the current price, it is conceptually similar to the current yield on a bond.
The second part of total return is the growth rate, g. As we will see shortly, the growth rate
of the dividend is also the growth rate of the stock price. Therefore, this growth rate can be
interpreted in terms of the capital gains yield, that is, the rate at which the value of the
investment grows.
To illustrate the components of required return, suppose that we observe that a stock is
selling at a unit price of $20. The next dividend will be $1 per share. Do you think the dividend
will grow 10"?› annually more or less for an indefinite period? do. What return does this stock
offer you?
The dividend growth model calculates the total return as:
fi = Dividend Yield + Capital Gains Yield R Dwl P„ * g
 Chapter 9 Value of shares 279

In this case, the total performance is:

fi = $1/20 + 10"/›
= 5"/› + 10'/
= 15a›
Consequently, this stock is expected to have a return of 15 ›.
To check this answer, we calculate the price within of one year, Q ,
using 15"?›
as required rate of return. Since the dividend that HEwill receive inside a unit
is 1 dollar and the dividend growth rate is 10a, he dividendthat will be received
In two years, Div„ is $1.10. Based on the growth model of di videndos, the price of the share within
a year will be:
P = Div,/(fi — ç) = $1.10/(. 15 — . 10) = $1 . 10/.05 = $22
Notice that this $22 is $20 X 1.1, which indicates that the stock price has grown 10"?› as anticipated.
That is, the capital gains yield is 10›, which is equal to the dividend growth rate.
What total return does the investor get? If you pay 20 dollars for the ac today tion, you will earn
a dividend of 1 dollar at the end of the year and will have a profit of $22 - 20 2 dollars. Therefore,
the dividend yield is $1/20 = 5"/›. The capital gains yield is $2/20 10"?i, so the total return would be
5 , * 10"/› = 15a›, as we calculated earlier.
To get an idea of the real numbers in this context, consider that, according to the Value Line
investment survey, Procter & Gamble's dividend was expected to grow They will grow 8.8"/› over the
next five years or so, compared with a historical growth rate of 10.5"/› over the preceding five years
and 11"ú› over the past 10 years. In 2008, the projected dividend for the following year was $1.45.
The share price at that time was approximately $63. What return do investors require on P&G stock?
In this case, the performance of the divi dendo is 2.3"/› (1.45/63) and that of capital gains is 8.8"/i,
resulting in a total required return of 11.1'? on P&G shares.

CATACUTE OF REQUIRED PERFORMANCE Pagemaster Enterprises, the company we examined in the example
Previously, it has 1 million shares in circulation. Each of them sells for 10 dollars. What is the required return on
EXAMPLE 9.5 the shares!
Because the profit retention ratio is 40%, the dividend payout ratio is 60% (I- retention reason). The dividend
payout ratio is the dividend/profit ratio. In reason
that the profits within one year will be 2,128,000 dollars ($2,000,000 YI .064), the dividends will be 1,276,800
dollars (.60 X $2,128,000). Dividends per share will be I .28 dollars ($1,276,800/1,000,000). Given the previous
result of g = .064, we calculate A from (9.9) in this way:

.192 $1.28
.064
$I 0.00

A sa/tzcfaó/e feeling of skepticism

It is important to emphasize that this method only estimates the value of ,ç; The method does not determine the value of g
in a precise manner. We already mentioned that the estimate of ,p is based ba in various assumptions. For example, we
assume that the return on reinvestment of future retained earnings is equal to the company's historical ROE.
Furthermore, we assume that tl€• l £ future retention ratio is equal to the historical retention ratio. The estimate of e will
be incorrect if these assumptions are wrong.
Unfortunately, the determination of fi depends largely on g. For example, if y is estimated to be 0 in the
Pagemaster example, fi is equal to 12.8fi ($1.28/$10.00). If it is assume that p is 12"/›, fi is equal to 24.8"/›
($1.28/$10.00 * 12"/›). Therefore, we must take
fi estimates with a healthy sense of skepticism.
Because of this, some financial economists argue that the estimation error of fi for a single security is
generally too large to be practical. For this reason his They allow the calculation of the average fi for the entire
industry. This value of fi would then be used to discount the dividends of a specific stock within that same
industry.
It is advisable to be especially skeptical of the two polar cases when estimating the R value on individual
280 Part II Valuation and budgeting ‹Je capital

securities. First consider a company that today does not pay a dividend. two. If it begins to pay a dividend at
some point, the growth rate of the dividend corresponding to the interval will be infinite. Consequently, we
must use equation 9.9 with great caution here, if at all; We will emphasize this topic later in this chapter.
Second, we mentioned that the value of the stock is infinite when g is equal to fi. Because stock prices
never grow to infinity in the real world, an analyst whose estimate of g for a particular company is equal to or
greater than fi must have made some error. It is very likely that the high estimate of g will be correct for the
next few years. However, companies cannot maintain an abnormally high growth rate Rior .sic•iiipre.The
analyst's mistake was using a short-term estimate of g in a model that requires a perpetual growth rate.

/Vote on the relationship between corporate cash flows and cash flows
In Chapter 6 we value corporate projects by discounting cash flows. These were determined using a top-down
method starting with estimates of income and expenses. Although we did not value entire companies in that
chapter, we might well have done so if we had discounted the cash flows of the entire company. In this chapter
we discount dividends to establish the price of a single share. However, so far we have assumed specific
dividend values, rather than determining them using a similar top-down method. What is the relationship
between the company's cash flows, as presented in Chapter 6, and dividends?
The dividends of a simplified company that is financed entirely by equity capital can be written like this:

Income
— Cash expenses
— Depreciation
Profits before taxes
— Taxes
Profits after taxes

+ Depreciation
— Investment in plant and equipment
— Investment in crab capital
Dividends

To estimate the dividends we forecast each of the items mentioned above. We divide by the number of shares
in circulation and obtain the dividends per share, that is, the figure used in the dividend growth model.'

This explanation raises a logical question: why do companies invest excessively in working capital and other assets? The section on capital
structure means that this book answers this question one step at a time. For example, the li fire cash flow hypothesis, presented in Chapter 17.
explains why some managers prefer to retain assets rather than pay dividends. Besides. In Chapter 19 we examine the dividend decision in detail.
 Chapter 9 Value of shares 281

However, to understand the previous relationship it is necessary to distinguish between real investment
dear and real investment, in particular investment in cash and short-term securities. All companies need to have
a certain degree of liquidity, which they can obtain from their holdings. cies of cash and securities that are
almost like cash. However, many companies have amounts of cash far greater than what they need. For
example, Microsoft held tens of billions of dollars in cash and short-term investments throughout the past
decade, far more than many analysts considered optimal. Since cash is part of working capital, these analysts
argued that the actual investment in working capital was greater than the required investment in working
capital. A reduction in this cash hoard would have allowed more dividends to be paid.' An analyst must
forecast the actual cash values when a stock is worth. Using the lower required cash levels produces an
optimistic forecast of dividend payments. dends and, consequently, an optimistic valuation of the shares.

9.3 Growth opportunities

Earlier we talked about the dividend growth rate. We now address the related concept of growth opportunities.
Imagine a company that has a uniform set of earnings per share per share. This company pays all of these
profits to shareholders as dividends. Therefore:
UPA = Div
where EPS are earnings per share and Div are dividends per share. Such a company is often known as a cash
rod.
The perpetuities formula from the previous chapter allows you to calculate the value of a share as follows:
Value of a share when the company acts as a cash cow:
UPA Div

where fi is the discount rate on the company's shares.

This policy of paying all profits as dividends may not be optimal. Many companies have growth
opportunities, that is, opportunities to invest in profitable projects. Because these projects may represent a
significant fraction cative of the value of the company, it would be absurd not to take advantage of them to pay
all profits as dividends.
Although companies often think in terms of a set of opportunities growth rates, let's focus on a single
opportunity, that is, the opportunity to invest in a single project. Suppose that the company withholds the entire
dividend on date 1 to invest in a particular capital budgeting project. The current value of the project
corresponding to date 0 is NPV OC, which means current value. net sense ( per share 1 of the growth
opportunity.
What is the price of a share on date 0 if the company decides to undertake the project on date 1? Because
the per share value of the project is added to the original share price, the share price must now be:
Share price after the company commits to a new project:
EPS
VPNOC (9.10)

"We can expand the concept of dividends on page 4 to include other payments that are made for repurchasing shares (refer to
footnote 2).
282 Partthis
In II Valuation and capital9.10
way, equation budgeting
indicates that the price of a share can be understood as the sum of
two different items. The first term (UPA/r.) is the value of the company if it sleeps on its heels,
that is, if it simply distributes all profits among shareholders. The second term is the added value
if the company retains profits to finance new projects.

EXAMPLE 9.6
Opportunities for growth Sarro Shipping, Inc., expects to earn $1 million per year per year tuity if you do not
take advantage of any new investment opportunities. There are 100,000 shares outstanding, so earnings per share
are equal to $10 ($1,000,000/100,000). The company will have an opportunity on date I to spend I million dollars on a
new marketing campaign. This new campaign contri It will result in utilities increasing by $2,10,000 (or $2. 10 per
share) in each subsequent period. This figure implies a return of 2 I% per year on the project. The company's
discount rate is I OK. t What is the value of each action before and after deciding to accept the marketing
campaign?
The value of a Sarro Shipping share before the campaign is:

Value of a clay share when the company acts as a cash cow:

EPS $10
$i oo

The value of the marketing campaign on date I is:

Value of the marketing campaign on date I •

$2 10 000
—$1 000 000 • $1 100 000 (9.1 1
)
Because the investment is made on date I and the first cash inflow is received on date 2, equation 9. II represents the
value of the marketing campaign on date I. The value at date 0 will stop mine by discounting one period backwards
as follows:

Value of the marketing campaign on Ta date 0:

$1 100 000
$ 1 000 000
Therefore, the NPVOC per share is $10 ($ 1,000,000 /100,000).
The price per share is:

UPA/R +VPNOC = $100 + $10 = $1 10

The calculation can also be done directly based on the net present value. Because all profits on date I are
spent on the marketing campaign, no dividends are paid to shareholders. ists on that date. The dividends of all
subsequent periods are $1,210,000 ($1,000,000). $2I 0 000). In this case, I million dollars is the annual
dividend when Sarro is a cash cow.
The additional contribution to the dividend from the marketing campaign is $210,000. Dividends per share are
$12. 10 ($ 1 210 000/ 100 000). Because these dividends begin on date 2. The price per share on date I is $12 I ($12.
10/. YO ). The price per share on date 0 is $I 10 ($I 2 I /1 . YO ).

Note that in Example 9.6, value is created because the project earned a higher rate of return.
ment of 21"/› when the discount rate is only 10a›. No value would have been created if the
project had earned a rate of return of 10a. In other words, the

1.2% + .95 x 7% = 7.85%

 Chapter 9 Stock Valuation 283

VPNOC would have been zero. The NPVOC would have been negative if the project had earned a
percentage return less than 10a.
Two conditions must be satisfied to increase the value:
1. Profits must be retained in order to finance the projects."
2. Projects must have positive net prcscntc value.
Surprisingly, many companies seem to invest in projects that they know have negative net
present values. For example, in the late 1970s, oil and tobacco companies had plenty of cash. Due to
the existence of mer Increasingly weaker in both industries, a rational measure would have been to
pay high dividends and make few investments. Unfortunately, several companies operating in both
industries reinvested heavily in what were perceived as negative NPVOC projects.
Since NPV analysis (such as that presented in Chapters 5 and 6) is cone common foundation in
companies, why did managers choose projects with negative NPV? One guess is that some managers
enjoy controlling a large company. Because paying dividends instead of reinvesting profits reduces
the size of the company, some managers find it emotionally difficult to do so.

VPNOC from real companies

Sarro Shipping Company in Example 9.6 had a new project. In reality, companies have a whole
series of projects, some that they can undertake in the short term and others that they will develop in
the long term. The stock price of any real company should reflect the market's perception of the net
present values of all these future projects. In other words, the stock price should reflect the market's
estimate of the company 's NPVOC.
Can the NPVOC of real companies be estimated? Yes, and although Equation 9.10 may seem
conceptual in nature, it can easily be used to estimate NPVOC in the real world. For example,
consider Home Depot (HD). A recent issue of Value Line forecast HD's earnings per share to be
$1.30 in 2009. With a discount rate of .0785,' the price of one share of HD, assuming that the
projected nominal earnings are constant over time and are paid in full with dividends, would be:
51.30
= $16.56
.0785
In other words, one share of HD would be worth $16.56 if profits had not been retained. des for
investment.
HD stock was selling for $16.56 when the la/ue Line issue came out? No, HD was sold for
$22.95. Because the difference? The difference between HD's market price and its value per share as
a cash cow was $6.39 (= 22.95 16.56), which can be considered HD's NPVOC. That is, the market
expected that

Later we will talk to you about the issuance of shares or debt instruments to finance projects.
3. Discount rates are discussed in detail in Chapter 13. We use the methodology from that chapter to

of capital based on the assumption that the risk-free rate is 1.25a', the expected risk premium of the portfolio The market value
above the risk rate is 7"/› and the beta of HD is .95, which generates a discount rate based on the 1 l D rates of:

HD's investment strategy will increase value 6. $39 above the company's value as a cash cow.
HD's VPNOC. conto was calculated above, it represents 27.8 (= 6.39/22.95) of HD's share price.
We calculate the ratio of NPVOC to share price for each of the companies listed on the Dow
Jones 30-industry index. Below is a list of the seven companies in the index that have the highest
ratios.

Bank of America .182

Caterpillar .379
Chevron .077
284 Part II Valuation
Disney and capital budgeting
(Walt) .078
Home Depot .278
Intel .70l
JP Morgan Chase .232

The companies represent several industries, indicating that opportunities for creation
foundation arise from many different sectors of the market.

Growth in profits and dividends

facing growth opportunities
As already mentioned, a company's value increases when it invests in growth opportunities that
have positive NPVOC. The value of a company decreases when you select tions opportunities
that have negative NPVOC. However, profits and dividends grow regardless of whether projects
with positive or negative NPV are selected. This surprising result can be explained with the
following example.

EXAMPLE 9.7
YPPg faces dividends Lane Supermarkets, a new company, will earn $100,000 a year per petuity if you pay all your profits as
dividends. However, it plans to invest 20% of its profits in projects that earn I 0% annually. The house discount is I 8%.
Does the company's investment policy lead to an increase or decrease in the value of the company? sas The policy
reduces the value because the return house of I 0% on future projects is lower than the discount house of I 8%. That is, the
company will invest in projects that have negative NPV, which implies that it would have a higher value on date 0 if it only
paid out all its profits as dividends.
Does the company record growth? Yes, the company will grow over time, whether in terms of profits or dividends.
Equation 9.8 tells us that the annual growth rate of profits is:

g Earnings retention ratio X Return on retained earnings .2 Y . IO 2%

Since the profits in the first year will be $100,000, the profits in the second year will amount to $100,000Y I .02 $I 02,000;
Profits in the third year will be $100,000 Y (I .02) Z — $I 04 040, and so on.
(keep
going)

1.2% + .95 x 7% = 7.85%

285 Part II National value and capital budget

Because dividends are a fixed proportion of profits, dividends must grow at 2% annually as well. Since Lane's
retention ratio is 20%, dividends are (I - 20%) 80% of profits. In the first year of the new policy, the dividends will be
$80,000 [' (I- .2) x $100,000].
Next year's dividends will amount to $8 1,600 (- $80,000 XI .02). The next year's dividends will be $83,232 [= $80,000 Y
(I .02)°] and so on.
In conclusion, Lane's policy of investing in projects with negative NPV produces two results. First, the policy reduces
the value of the company. Second, politics creates growth in both profits as well as dividends. In other words, Lane
Supermarkecs' growth policy actually destroys the company's value.
; Under what conditions do Lane's earnings and dividends actually decrease over time? Profits and dividends would
decrease over time only if the company invested with negative rates of return.

The previous example leads us to two conclusions:

1. Projects that have negative NPV reduce the value of the company. In other pa works, projects
that have rates of return lower than the discount rate reduce the value of the company.
2. Both the company's profits and dividends will grow as long as the profits projects have positive
rates of return.
Therefore, as in the Lane Supermarkets example above, any company that selects projects with rates
of return below the discount rate will grow in terms of profits and dividends, but will destroy the
value of the company.

Does a high retention CFE ratio benefit shareholders?

In the previous section we talked about the impact of the investment both on the value of the
company and on the growth rate of its dividends and profits. The dividend discount model (MDD)
expands on the ideas in that section. According to the MDD, the price of a share is:

Q DIY
(9.12)

where Div is the dividend per share at the end of the first year, fi is the discount rate, and g is the
annual dividend growth rate. Previously we defined that:

g = RR x ROE (9.13)

where RR is the company's profit retention ratio and ROE is the company's return on equity.
Additionally, the dividend per share at the end of the first year can be written like this:
Div = Dividend payout ratio X EPS = (1— RR) x EPS (9.14)
where EPS is equal to the company's earnings per share.
Substituting equations 9.13 and 9.14 into (9.12), we have:

Div (1 — RR) x EPS

.
" R — g R — (RR x ROE)

What is the effect of retention in equation 9.15? Although to establish the result of retention in
this equation we can take the derivative of the equation with respect to RR, it is easier to examine the
effect through an example.
 Chapter 9 Value of shares 286

EXAMPLE 9.8
Effect of Earnings Retention Ratio and ROE on Firm Value Scottton Company's earnings per share at the end of the year

are projected to be $50 without any further investment. sion, the company forecasts flat earnings per share (EPS) of
$5 in perpetuity. The discount rate is I 0á. Based on the assumption that the company pays all its profits as dividends,
The price of a share will be:
$5 50

. 10

In other words, the price is $50 if Scock Company acts as a cash cow.
On the other hand, the company considers a utility collection rate of either 30% or 60%. What will be the price of a share
if the company's ROE is I 5% f What will the price be if the ROE is S%!
From equation 9.15 we know that the price per share depends on the earnings retention ratio and ROE as follows:

Price per share for different values of the retention ratio (RR) and ROE

ROE
I5%
(I — .3) 5 (.7)s (I — .6) S (.4) S (.
(.10 — .3x .OS) " . I0 — .04S IO — .6x .15) " . I0 — .09
.
= 2 = $200
.055
5% (I - .3)5 (.7) 5 (I — .6) S (.4) Yes
(. 10 — .3x .05) . 10 — .0I 5 (. 10 — .6x .05)" .10
— .03 3.50 2
$4I . 18 — - $28.57
.085 .07

As already mentioned, the price per share is $50 if the company's retention ratio is 0.
Since the discount rate, R, is l0%, an ROE of I 5% implies that ROE A. In this case, the price per share increases with the
holding ratio, as indicated by the first row of the table. This result makes sense because the
investments have higher returns than the cost of capital In other words, investments have positive NPV tive. An increase
in the retention ratio implies an increase in the number of projects with positive NPV.
Apparently, the ROE of 5% implies that ROE r. In this case, the price per share decreases with the share price, as
indicated in the second row of the table. This result also makes sense because the investments
They have lower returns than the cost of capital. In other words, investments have negative NPV. An increase in the retention
ratio implies an increase in the number of projects with negative NPV.
;What is eIVPNOC per share for each value of ROE and RRA? We know, from equation 9.10, that the price
per action can be written like this:
EPS
VPNOC

In other words, the share price is the sum of the price of a share, if the company is a cash cow, plus the net present value of
growth opportunities. Since the stock price is $50 with no investment (Stockzon Company is a cash cow), the NPVOC for each
ROE and RR value is calculated by subtracting $50 from each of the prices given in the table above. Thus, the VPNOC table
is:

NPVOC per share for different values of the retention ratio and eT ROE

RO
E
15% $l 3.64 ($63.64 — 50) $i
5% 5o 8.82
—$ —$2I .43

We thank Professor H. Thank you for allowing us to use the example he presents in his classes.
 Chapter 9 Value of shares 287

If ROE A, the NPVOC is positive. Furthermore, the NPVOC increases with the retention ratio, since an increase in the ratio implies an
increase in the number of projects with positive NPV undertaken. Ocu rre the opposite if ROE R. The NPVOC is negative and becomes
increasingly negative as the earnings retention ratio increases.
In what cases do dividends and profits grow? Since growth is equal to RR X ROE, the growth houses are:

Growth rates of profits and dividends

ROE
15% .30 x .15' .045 .60 x .15' .09
5% .30 x .05 = .0l 5 .60 x .05 = .03

Since ROE is always positive, growth houses are also always positive. That is, positive growth in profits and dividends occurs even if ROE is
5%. However, the table above shows that NPVOC is negative when ROE is 5a. Consequently, with ROE of 5%, Stockton Company's
policy of accepting new projects produces growth, but destroys the value of the company. The investment destroys value in this case because
the ROE of 5% is lower than the discount house 's 10%.

Dividends or profits: what should be deducted?

As already mentioned, this chapter applied the growing perpetuities formula to stock valuation. In our application
we discount dividends, not profits. This is the most accurate because investors select a stock based on what they
can get from it. You can only get two things from a stock: dividends and the final selling price, which is
determined by what future investors expect to receive in dividends.
The calculated share price would be too high if profits were discounted instead of dividends. As we saw in
estimating the growth rate of a company, only a portion of the profits reaches shareholders as dividends. The
remainder is retained to generate future dividends. In our model the retained earnings are equal the investment in
the company. Discounting profits instead of dividends would be to overlook the investment a company must make
today to generate future returns.

The company without dividends

Specifically, students ask the following: If the dividend discount model two is correct, why don't stocks that don't
pay dividends sell for 0'! This is a good question and refers to the companies' goals. Those with many opportunities
for growth face a dilemma. They can pay dividends now or abandon paying dividends for the moment to make
investments that will generate even higher dividends in the future." This is often a painful choice because a strategy
of applause Dividend distribution may be optimal but unpopular with certain shareholders.
Many companies choose not to pay dividends, despite which their shares sell at positive prices. For example,
most Internet companies, such as Amazon.com, Google, and Bay, do not pay dividends. International shareholders
believe that they will receive dividends at some point, or they will receive something equally good. That is to say,

1 The third alternative consists of taking shares so that the company has enough cash both to pay dividends and to invest. This possibility is explored in a
later chapter.
 Chapter 9 Stock Valuation 28fi

The company will be acquired in a merger and, at that time, shareholders will receive either cash or equity shares.
Of course, the actual application of the dividend discount model is difficult for companies of this type. It is
evident that the constant dividend growth model does not apply. Although the differential growth model may
work in theory, difficulties in estimating the date of the first dividend, the rate of growth of dividends after that
date, and the final price of the merger make the application of the model very difficult.
Empirical evidence indicates that companies with high growth rates are likely to pay lower dividends, a
result consistent with this analysis. For example, consider the case of Microsoft Corporation. The company
started in 1975 and grew rapidly for many years. It paid its first dividend in 2003, even though it built a
multibillion-dollar company (both in sales and market value of shareholders' equity) before then. Why did it
wait so long to pay a dividend? espe ró because it had many positive growth opportunities to finance, for
example, new software products. (In addition, as we explained in this chapter, you may have deliberately held
excessive levels of cash and short-term securities.)

9.4 Price-earnings ratio

The price-earnings ratio (P/E) of a stock, as its name implies, is the ratio of the stock's price to its earnings per
share (EPS). For example, on a given day in August 2008, Google's stock price was $467.88 and its EPS was
$15.22, implying a P/E ratio (also called P/E multiple) of 30.74. " The community Financial institution pays
close attention to P/E ratios.
On the same day in 2008, Hewlett-Packard's P/E ratio was 14.24, IBM's was
15.61, Microsoft's 13.63 and Yahoo's 26.83. Why the actions of it
industry trade at different P/E ratios? Do the differences mean that Google
was priced too high and Microsoft was priced too low, or are there rational reasons why
explain the differences?
In our previous analysis we said that:
Price per share EPS
* VPNOC

Dividing by EPS we obtain:

Price per share 1 + VPNOC fi
EPS EPS (9.16)
The left side is the price-earnings ratio formula. The
equation shows that the P/E ratio is related to the net present value of growth opportunities. As an example,
consider two companies, each of which has just announced earnings per share. tion of 1 dollar. However, a
company has many valuable growth opportunities. sas, while the other company has no growth opportunity.
The former's shares should sell at a higher price because investors buy both the current profit of $1 and the
growth opportunities. Suppose the company with growth opportunities sells for $16 and the other company
sells for $8. Earnings of $1 per share appear in the denominator of the P/E ratio of both companies. dams.
Thus, the P/E ratio is 16 for the company with growth opportunities, but only eight for the company without
such opportunities.
This explanation seems to have relative validity in the real world. Stocks of electronics and other high-tech
companies typically sell at very high P/E ratios because they are generally perceived to have high growth rates.
In reality, some technology company stocks sell at high prices even when companies girls have never made a
profit. The P/KJ ratios of these companies are endless. By

'Value ulam c4s PU J as the reason for the preci‹4 c‹4rinen te to 11 PA of the year to spend it. On the other hand, P/l J can also be calculated as the ratio of
the current price to projected UPA for the next year.
 286 Part II National value and capital budget

Table 9.1
Selected P/E Ratios ,
2008 Anadarko Petroleum Oil production I I.76
Pfizer Pharmaceutical 13.98
Ryder Truck rental 14.99
S&P 500 Average girl 23.78
Abercrombie & Finch Clothing retailer 10.52
starbucks Expensive coffee 22.9
Adobe Systems Software applications 6
27.5
2

Conversely, railroads, utilities and steel companies sell at lower multiples due to their lower growth prospects.
Table 9.1 contains 2008 P/E ratios for some well-known companies and the S&P 550 Stock Index. Observe the
variations between industries.
Of course, the market only values perceptions of the future, but not the future itself. We will argue later in the
text that the stock market generally has realistic perceptions of a company's prospects. However it is not always so.
In the late 1960s, shares of many electronics companies sold at multiples of 200 times earnings. Perceived high
growth rates did not materialize, leading to sharp declines in stock prices during the pri mere part of the 1970s. In
previous decades, fortunes were made in stocks such as IBM and Xerox because investors did not foresee the high
growth rates. More recently, many Internet stocks were selling at multiples of thousands of times annual earnings
in the late 1990s, presumably because investors believed these companies would experience a high level of future
earnings growth. des and dividends. Internet stocks collapsed in 2000 and 2001 as new information emerged
indicating that projected growth would not materialize.
There are two additional factors that explain the P/E ratio. The first is the rate of story, R. Since R appears in
the denominator of formula 9.16, this formula implies that the P/E ratio is related neyr/rivrimen/e to the company's
discount rate. We have already indicated that the discount rate is positively related to the risk or variability of the
stock. Therefore, the P/E ratio is negatively related to the risk of the stock. To understand that this is an accurate
result, consider two companies, A and B, that behave like cash cows. The stock market expects both to earn annual
profits of $1 per share forever. However, the profits of company A are known with certainty, while those of
company B are highly variable. A rational shareholder is likely to pay more for a share of Company A due to the
absence of risk. If a share of this company is selling at a higher price and both companies have the same EPS,
Company A 's P/E ratio should be higher.
The second additional factor is related to the choice of accounting method applied by the company. Under
current accounting standards, companies have a lot of freedom to choose. For example, consider inventory
accounting where the FIFO or UEPS method (FIFO or USO, acronym for /irs/ in-first out and last in-fii'st out,
respectively) can be used. In an inflationary environment, the FIFO ( first in, second out) accounting method
underestimates the true cost of inventory and, consequently, inflates reported profits. When the UEPS method is
applied (last entry, first entry, last entry), inventories are valued according to the most recent costs, which implies
that the recorded profits are lower according to this method than those that are recorded with the FIFO method.
Therefore, the UEPS inventory accounting system is a more conservative method dor than the FIFO. There are
some similar freedoms in accounting for construction costs (‹ Final rates versus mc•l‹›‹ r/e porcc•ni‹ijc• ble lenninot
ion) and depreciation* n (accelerated depreciation versus straight line depreciation).
 Chapter 9 Stock Valuation 287

As an example, consider two identical companies, C and D. The first applies the UEPS
method and records profits of $2 per share. Company D uses accounting assumptions minus
FIFO values and records profits of $3 per share. The market knows that both companies are
identical and values both at $18 per share. This price-earnings ratio is 9 ($18/52) in the case of
company C and 6 ($18/$3) in the case of company D. Therefore, the company that has the most
conservative principles has the highest P/E ratio.
This last example depends on the assumption that the market is aware of the differences that
exist in accounting treatments. A considerable part of the community Academics believe that the
market can see through virtually all differences. accounting returns. These scholars defend the
efficient capital markets hypothesis, a theory we examine in greater detail later in the text.
Although many financial experts may be more moderate in their convictions regarding this issue,
the consensus view is that, without a doubt, many of the accounting differences can be discerned.
Therefore, the proposition that companies following conservative accounting methods have high
P/E ratios is commonly accepted.
In conclusion, we have argued that the P/E ratio of a stock is a function of three factors:
1. Oj:'growth opportunities . Companies with lots of growth opportunities are likely to have
high P/E ratios.
2. Risk. Stocks that offer little risk may have high P/E ratios.
3. Accounting Practices Companies that follow accounting practices retain companies could
have high P/E ratios.
; Which of these factors is most important in the real world? The consensus among teachers
financial reasons is that growth opportunities typically have the greatest effect on P/E ratios. For
example, high-tech companies typically have higher P/E ratios than, say, utility companies,
because the latter have fewer growth opportunities, even though they also generally have less
risk. Furthermore, within industries, differences in growth opportunities also generate the largest
differences in P/E ratios. In our example at the beginning of this section, Google's high P/E ratio
is almost certainly due to its growth opportunities and not its low risk or accounting
conservatism. In fact, because of its youth, Google's risk is likely higher than the risk of many of
its competitors. Microsoft's P/E ratio is much lower than Google's because Microsoft's growth
opportunities represent a small fraction of its existing business lines. However, Microsoft had a
much higher P/E ratio a few decades ago, when it had plenty of growth opportunities but few
existing lines of business.

9.5 Stock markets

The stock market is made up of a primary market and a secondary market. In the primary, or
new issue market, shares are launched on the market for the first time and sold to investors. In
the secondary market, existing shares are traded between investors. In the primary market,
companies sell securities to raise money. We will discuss this process in more detail in a later
chapter. Therefore, we will focus primarily on secondary market activity in this section. We
conclude with an explanation of how prices are quoted in the financial press.

Bofsa operators and brokers

Because most securities transactions involve traders and dores, it is important to understand
precisely what the terms op‹•raJoi' and ‹orreifor mean. A trader maintains an inventory and is
prepared to sell and buy at any time. In contrast, the broker matches buyers with sellers, but does
not maintain inventory. So when we talk about used car salesmen and brokers
288 Part II Valuation and budgeting ‹Je capital

of real estate we recognize that the former maintain an inventory, while the latter do not.
In the stock market, the trader is prepared to buy securities from investors. Zionists who
want to sell them and sell securities to investors who want to buy them. The price the trader is
willing to pay is called the purchase price. The price at which the trader is willing to sell is
called /›recir› selling t a.sk ) (sometimes also known as and recir› .s'olit ila‹lo, offeri‹lo or ble
ofc• rla). The difference between the purchase price and the sale price is called margin, and is
the fundamental source of profits for the operator.
How big is the difference
(margin) between the
buying price and the
selling price of your
favorite stock? Check the
latest quotes at
.bIoomberg.com Traders exist in all areas of the economy and not just in the stock markets. For example, the
local college bookstore is probably owned by a grocery store operator. primary and secondary
collection of textbooks. If you buy a new book, it is a primary market transaction. If you buy a
used book, it would be a market transaction. secondary market and you would pay the store's
selling price. If you sell the book back to them, you will receive the bookstore's purchase price,
which is often half the sales price. The bookstore margin is the difference between the two
prices.
In contrast, a securities broker coordinates transactions among investors and brings together
those who wish to buy securities with those who hope to sell them. The characteristic dis The
characteristic of stockbrokers is that they do not buy or sell securities for their own account.
Their business is to facilitate transactions that others make.

Organization cfe Ia 8o/sa cfe V'a/ores of New York (NYSE)

Shares are bought and sold on various stock exchanges. The two most important (in the United
States) are the New York Stock Exchange and NASDAQ. The New York Stock Exchange, or
NYSE, popularly known as the Big Board, celebrated its bicentennial a few years ago. It has
occupied its current address on Wall Street since the beginning of the 20th century. In terms of
dollar activity volume and total value of listed shares, it is the largest stock market in the world.
Members Historically, the NYSE has had 1,366 members. Before dc 2006 it was said that the so
cios had their own “cscanos” on the exchange and, collectively, the members of the exchange
were also the owners. For this and other reasons, seats were valuable and were bought and sold
with relative regularity. Seat prices reached a record high of $4 million in 2005.
In 2006 all this changed, when the New York Stock Exchange became a publicly traded
corporation called NYSE Group, Inc. Naturally, its actions tions are bought and sold on the New
York Stock Exchange. Now, instead of buying seats, exchange members must acquire licenses to
carry out transactions, the number of which is limited to 1,500. In 2008, a license cost a tidy sum
of $44,000 a year. Having a license grants the right to sell and buy securities on the auction floor
of the Stock Exchange.
Different types of partners have different functions in the stock market. The largest group of
NYSE partners is made up of commission brokers who execute commission orders. purchase of
client shares. The primary responsibility of a commission broker is to obtain the best possible
price for their clients' orders. The exact number varies, but generally about 500 NYSE partners
are commission brokers. New York Stock Exchange brokers are typically employees of
brokerage firms such as Merrill Lynch.
The second-largest NYSE partners are specialists, so called because each of them acts as an
assigned trader of a small group of securities. With few exceptions. Each security traded on the
New York Stock Exchange is assigned to a single specialist. Specialists are also called “market
makers” because they are required to maintain a fair and orderly market for the securities
assigned to them.
The specialists publish the purchase and sale prices (supply and demand) of the securities
assigned to them. Traders are prepared to buy at the bid price and sell at the ask price when the
flow of buy orders for one of their securities differs.
 Chapter 9 Valuation of rectories 289

temporarily from the flow of sales orders. In this capacity, specialists act as operators of their
own accounts.
The stock market members who occupy third place in number are the brokers on the
auction floor. Busy commission brokers delegate the execution of some orders to brokers on the
auction floor. Sometimes the runners on the auction floor get caught They are known as $2
brokers, a name they earned back in the days when the standard commission for their services
was only $2.
In recent years, trading floor brokers have lost importance on the stock market due to the
efficient SuperDOT system (the acronym DOT stands for Designated Order Turnover). which
allows orders to be transmitted by electronic means directly to the specialists ta. Transactions
carried out through the Super DOT system now represent a substantial percentage of all
transactions on the New York Stock Exchange, particularly small orders.
Finally, a small number of members of the New York Stock Exchange are trading floor
traders , who carry out independent transactions for their own accounts. Trading floor operators
try to make profits from temporary price fluctuations. In recent decades, the number of rowing
floor operators kes has decreased considerably, indicating that it has become increasingly
difficult to profit from short-term transactions on the auction floor.

Operations Now that we have a basic idea of how the Stock Market is organized
of New York and who the main players are, we will answer the question of how the transactions
are carried out. Bottom line, the business of the New York Stock Exchange is to attract and
process order flow. The term "order flow" refers to the flow of orders. purchase and sale of
client shares. Customers of the Nue Stock Exchange va York are the millions of individual
investors and tens of thousands of institutional investors who place their orders to buy and sell
shares of companies listed on the stock exchange. The NYSE has been very successful in
attracting order flow. In the present It is not unusual to see more than 1 billion shares change
hands in a single day.

Auction floor activity It is very likely that you have seen a video of the refloor
of the New York Stock Exchange on television, or perhaps you have visited the exchange and
witnessed the activity on the trading floor from the visitors' gallery. One way or another, you will
have seen a huge room, almost the size of a basketball court. This Large room is called,
technically, “the Rig Room” (“c1 sa1‹in grandc”). They usually visit You don't see other smaller
rooms, one of which is called “the Garage” because it was a covered parking lot before it was
adapted for transactions.
Hama a virtual tour of
the New York Stock
Exchange in
On the auction floor there are several stations, which have a shape similar to a number eight.
www.nyse.com These stations have multiple counters with various termi screens. nals above and on the sides.
Employees operate behind or in front of counters in relatively stationary positions.
Other people circulate around the auction floor and frequently return to the abundant
telephone booths placed on the walls of the exchange. In general, they look like hard-working
ants moving around an anthill. It's natural to ask, “What are all those people doing down there
(and why do so many people wear funny-looking jackets)?”
We will give you a quick explanation of what is happening. Each of the eight-number
station counters has a specialist position. Ordinarily, specialists are placed in front of their
positions to supervise and manage the transactions of the shares assigned to them. The
specialist's administrative employees operate behind the mos trador Swarms of commission
brokers move from the telephones lining the walls of the exchange to the trading floor and back
again: they receive telephone orders from clients, go to specialist stations where they can execute
the orders, and return to meet them. sign the execution of orders and receive new instructions
from clients.
To better understand the activity on the trading floor of the New York Stock Exchange,
imagine yourself in the role of a commission broker. The employee who answers the phone
290 Part II Valuation and budgeting ‹Je capital

You have just been given a sell order for 20,000 shares of Wai-Mart for a client of the
brokerage firm you work for. The client wants to sell the shares at the best possible price as soon
as possible. You immediately walk (stock exchange rules prohibit running) to the specialist's
booth where Wal-Mart shares are traded.
As you approach the specialist's booth, check the terminal screen for information on the
current market price. The screen reveals that the last transaction executed was at €0.25 dollars
and that the specialist is offering €0.25 per share. You could immediately sell the shares to the
specialist for $60, but that would be too easy.
Instead, as a customer representative, you are obligated to obtain the best price. possible.
Their job consists of “working” the order and their employment depends on offering satisfactory
service in the execution of the orders. Therefore, look around to find a broker who represents a
potential buyer of Wal-Mart stock. Fortunately, quickly He quickly finds another trader in the
specialist's position who has a purchase order for 20,000 shares. Taking into account that the
operator asks 60.10 per share, both agree They agree to execute their orders against each other at
the price of $60.05. Precisely, this price is the midpoint between the specialist's buying and
selling prices, and saves each of his clients 0.05 X 20,000 = 1,000 dollars compared to the
advertised prices.
In the case of an actively traded stock, there may be many buyers and sellers around the
specialist's position and most transactions occur between brokers. This is known as transacting in
the “crowd.” In such cases, the specialist's responsibility is to maintain order and ensure that all
components buyers and sellers receive a fair price. In other words, the specialist functions, in
essence, as an arbitrator.
However, more often than not there is no crowd around the specialist's stand. Returning to
the Wal-Mart example, suppose you cannot quickly find another broker with a purchase order for
20,000 shares. As you have the order to sell immediately diato, he has no choice but to sell to the
specialist at the purchase price of $60. In this case, the need to execute the order quickly takes
priority and the specialist offers the necessary liquidity to allow immediate execution of the
order.
Lastly, many of the people who work on the auction floor wear colored jackets. The color of
the jacket indicates the position or function of the person. Administrative employees, brokers,
visiting stock exchange officials, etc., dress in specific colors to identify themselves. Plus, things
can get crazy on a busy day, with the result that good clothes don't last long; cheap jackets offer
There is some protection.

NASDAQ Trading
In terms of total dollar volume of transactions, the second largest value market largest in the
United States is the NAS DAQ. This slightly strange name was originally an acronym for the
National Association of Securities Automatc Quotations System, but NASDAQ is now a name in
its own right.
Introduced in 1971. The NASDAQ market is a computerized network of securities dealers
and other agents that timely publishes price quotes for securities on computer screens around the
world. NASDAQ traders act as market makers for securities listed on NASDAQ. As market
makers, NASDAQ traders post bid prices at which they agree to sell and buy orders. With each
price quote, they also publish the number of shares that are obligated to trade at the quoted prices.
A1 just like the NYSE specialists, the NASDAQ market makers actually transactions based
on inventory. That is, market makers use their sales as a buffer to resolve imbalances in purchase
and sale orders. Unlike the NYSE specialist system, NA S DAQ has multiple market makers for
actively traded stocks. Therefore, there are two differences in trades between NYSE and
NASDAQ:
 Ca Smurf 9 Stock Valuation 291

1. NASDAQ is a computerized network and does not have a physical establishment where it
can be reached. transactions are carried out.
2. NASDAQ has a multiple market maker system rather than a specialist system.
Traditionally, a securities market characterized for the most part by traded Companies that
buy and sell securities from their own inventories is called an over- the-counter ( OTC) market .
Consequently, NASDAQ is often said to be an over-the-counter or OTC market. However, in
their efforts to promote a distinctive image, NASDAQ officials prefer not to use the term over-
the-counter when discussing the NA SDAQ market. However, old habits are hard to break and
many people continue to refer to NASDAQ as an over-the-counter market.
By 2008, NASDAQ had grown to the point that by some measures it was as big or bigger
than the NYSE. For example, on May 7, 2008, 2,300 million were negotiated nes of shares on
NASDAQ compared to 1.3 billion on the NYSE. In dollars, NASDAQ's trading volume that day
was $68.6 billion compared to ration with 48.8 billion from the NYSE.
NASDAQ is actually made up of three different markets: the NASDAQ Global Se lect
NASDAO
( .nasdaq.com)
Market, the NASDAQ Global Market and the NASDAQ Capital Market. As the largest market
you have a fantastic where NA SDAQ's most active stocks are traded, the Global Select Market had around 1,200
website i ^ or stop visiting companies listed (as of early 2008), including some of the world's most famous companies, such
it! as Microsoft and Intel. . NA SDAQ Glo signatures Bal Market are a little smaller, and NASDAQ
lists the shares of about 1,450 of them. Finally, smaller companies listed on NASDAQ do so on
the NASDAQ Capital Market; More or less 500 companies are listed on this market. Of course,
as Capital Market companies become more established, they can move up to the Global Market
or Global Select Market.
EGN (EGN) In a very important development in the late 1990s, the NASDAQ system was
opened to so-called electronic communications networks (ECNs). RC E are essentially websites
that allow investors to carry out transactions. direct relations between individuals. Purchase and
sale orders placed by investors The prices in the CERs are transmitted to NASDAQ and are
displayed along with the purchase and sale prices of the award makers. CERs open up the
NASDAQ because, in essence, they allow individual investors, and not just market makers, to
register orders. As a result, CERs act to increase liquidity and competition.
Reports cfe/ mercacfo cfe v'a/ores
You can check aCci0rleS In recent years, stock price quotes and related information have increasingly moved from
quotes in real time on the traditional print media, such as The Wall Street Journal, to various websites. Yahoo! Finance
internet. See details at (finance.yahoo.com) is a good example. We visited the site and requested a quote for the shares
finance.yahoo.com of the wholesale club Costco, whose shares are traded on NASDAQ. Below we present a part of
what we found:

+ Trade 64.68 Dn's Rank 63 65-66 83 Nev

¡npurawGhaminBrt
Trado Tuma 2:28P#4 ET 52w* Ringe 51 52 72 68 mt EB-jm 2 i22pm tOYanco'
Chaoge: r0.ijo.5m] Vohume 5,216,851

Most of this information is self-explanatory. The most recent transaction reported took place
at 2:28 pm, and was priced at $64.68. The announced change
292 Part II Valuation and capital budgeting

is with respect to the closing price of the previous day. The opening price is the first tran action
of the day. We see buy prices of 64.65 and sell prices of $64.69, along with the “depth” of the market,
which is the number of shares that were requested at the com price. pra and were offered at the asking
price. The heading “1y Target Est” is the estimated average price of the stock for one year from now
based on the estimates of the securities analysts who follow said stock.
By placing ourselves in the COLUMN , we have the price range for this breed, followed by the
range for the previous 52 weeks. Volume (ro/ame) is the number of shares traded today, followed by
the average daily volume for the past three months. capitalizes it Market cap is the number of shares
outstanding (taken from the most recent quarterly financial statements) multiplied by the price per
share. P/E is the P/E ratio that we studied earlier in this chapter. The earnings per share (EPS) used in
the calculation correspond to the last 12 months (“ttm”, trailing f+ve/ve months). Finally, we have the
dividend on the stock, which is actually the most recent quarterly dividend multiplied by 4, and the
dividend yield. The yield is simply the announced dividend divided by the stock price: $.58/$64.68
= .009 = .9%.

Summary This chapter explained the basic details of stocks and their valuation. Main points include:
1. A stock can be valued by discounting its dividends. We mention three types of situations:
and a) The case of zero growth dividends.
conclusions a) The case of constant growth dividends.
c) The case of differential growth.
2. An estimate of the dividend growth rate is needed for the discount model of dividends. A useful
estimate of the growth rate is:
g = Earnings retention ratio Return on retained earnings (ROE)
As long as the company keeps the dividend-to-earnings ratio constant, g represents the growth
rate of both dividends and earnings.
3. The price of a stock can be thought of as the sum of its price (assuming the company behaves as a
“cash cow”) and the per-share value of the company's growth opportunities. A company is said
to be a cash cow if it pays out all of its profits as dividends.
In this case, the value of a share is expressed as:

UPA + VPNOC

4. Projects that have negative NPV reduce the value of the company. That is, projects that have rates
of return lower than the discount rate reduce the value of the company. However, both a
company's profits and dividends will grow as long as the projects have positive rates of return.
5. From accounting theory we know that profits are divided into two parts: dividends and retained
profits. Most companies continually retain earnings to create future dividends. Profits should not
be discounted to obtain the price per share because a portion of them must be reinvested. Only
dividends reach shareholders and nothing else must be discounted to obtain the price of the
shares.
6. We propose that a company's price-earnings ratio is a function of three factors:
a) The amount per share of the company's valuable growth opportunities.
a) The risk of the action.
c) The type of accounting method used by the company.
7. The two largest stock markets in the United States are the NYSE and NASDAQ. Ex We applied
the organization and functioning of these two markets and saw how information on stock prices
is published.