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Chapter 6B: Stocks and Their Valuation

This document discusses various methods for valuing common stock, including the dividend growth model and corporate value model. It provides examples of how to apply these models to value stocks and calculate expected returns. The dividend growth model values a stock based on the present value of expected future dividend payments, assuming constant or non-constant dividend growth rates. The corporate value model values a firm based on the present value of its expected future free cash flows.
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100% found this document useful (1 vote)
259 views39 pages

Chapter 6B: Stocks and Their Valuation

This document discusses various methods for valuing common stock, including the dividend growth model and corporate value model. It provides examples of how to apply these models to value stocks and calculate expected returns. The dividend growth model values a stock based on the present value of expected future dividend payments, assuming constant or non-constant dividend growth rates. The corporate value model values a firm based on the present value of its expected future free cash flows.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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CHAPTER 6b

Stocks and Their Valuation

 Features of common stock


 Determining common stock values
 Efficient markets
 Preferred stock

8-1
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the st
ock price

8-2
Social/Ethical Question
 Should management be equally concerned
about employees, customers, suppliers, an
d “the public,” or just the stockholders?
 In an enterprise economy, management sh
ould work for stockholders subject to const
raints (environmental, fair hiring, etc.) and
competition.

8-3
Types of stock market transacti
ons
 Secondary market
 Primary market
 Initial public offering market (“goi
ng public”)

8-4
Different approaches for valuin
g common stock
 Dividend growth model
 Corporate value model
 Using the multiples of comparable firm
s

8-5
Dividend growth model
 Value of a stock is the present value of the future
dividends expected to be generated by the stock.

^ D D D D
1
P
0
1
2
2
3
3
 
...



(1
k
s 
)(1
k 
)(1
s k
) (1
s 
k
)
s

8-6
Constant growth stock
 A stock whose dividends are expected to grow for
ever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

 If g is constant, the dividend growth formula conv


erges to:
^ D 
(1g)D
0
P  1
0
k
s-g k
s-g
8-7
Future dividends and their presen
t values
t
$ D
tD
0(
1g
)

D
0.25 PVD
t  t
t
(1k)

0
P 
PVD
t

0 Years (t)
8-8
What happens if g > ks?
 If g > ks, the constant growth formula l
eads to a negative stock price, which do
es not make sense.
 The constant growth model can only be
used if:
 ks > g
 g is expected to be constant forever

8-9
If kRF = 7%, kM = 12%, and β = 1.2, wh
at is the required rate of return on the fi
rm’s stock?
 Use the SML to calculate the required ra
te of return (ks):

ks = kRF + (kM – kRF)β


= 7% + (12% - 7%)1.2
= 13%

8-10
If D0 = $2 and g is a constant 6%, fin
d the expected dividend stream for th
e next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382


1.8761
ks = 13%
1.7599
1.6509

8-11
What is the stock’s market valu
e?
 Using the constant growth model:

D1 $2.12
P0  
ks - g 0.13- 0.06
$2.12

0.07
 $30.29

8-12
What is the expected market price
of the stock, one year from now?
 D1 will have been paid out already. So, P1 is t
he present value (as of year 1) of D2, D3, D4, e
tc.
^
D $2.247
P  2

k -g 0.13 -0.06
1
s

$32.10
 Could also find expected P1 as:
^
P
1P
0 
(1.06)
$32.10
8-13
What is the expected dividend yield, cap
ital gains yield, and total return during t
he first year?
 Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
 Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
 Total return (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%

8-14
What would the expected price to
day be, if g = 0?
 The dividend stream would be a perpetuity.

0 1 2 3
ks = 13%
...
2.00 2.00 2.00
^PMT
$2.00
P
0  $15.38
k 0.13

8-15
Supernormal growth:
What if g = 30% for 3 years before ach
ieving long-run growth of 6%?
 Can no longer use just the constant growth
model to find stock value.
 However, the growth does become consta
nt after 3 years.

8-16
Valuing common stock with non
constant growth

0 k = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P$ 3   $66.54
^ 0.13 - 0.06
54.107 = P0
8-17
Find expected dividend and capital gains
yields during the first and fourth years.
 Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% - 4.81% = 8.19%
 During nonconstant growth, dividend yield
and capital gains yield are not constant, an
d capital gains yield ≠ g.
 After t = 3, the stock has constant growth a
nd dividend yield = 7%, while capital gains
yield = 6%.
8-18
Nonconstant growth:
What if g = 0% for 3 years before long-r
un growth of 6%?

0 k = 13% 1 2 3 4
s
...
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P$ 3   $30.29
^ 0.13 - 0.06
25.72 = P0
8-19
Find expected dividend and capital gains
yields during the first and fourth years.

 Dividend yield (first year)


= $2.00 / $25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
 After t = 3, the stock has constant gr
owth and dividend yield = 7%, while
capital gains yield = 6%.

8-20
If the stock was expected to have negativ
e growth (g = -6%), would anyone buy th
e stock, and what is its value?

 The firm still has earnings and pays dividends, eve


n though they may be declining, they still have val
ue.

^ D D (1g )
0
P 
1 0
ks -g k s -g

$2.00
(0.94)
$1.88
  $9.89
0.13
-(-0.06)
0.19

8-21
Find expected annual dividend and c
apital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% - (-6.00%) = 19.00%

 Since the stock is experiencing constant gro


wth, dividend yield and capital gains yield a
re constant. Dividend yield is sufficiently lar
ge (19%) to offset a negative capital gains.

8-22
Corporate value model
 Also called the free cash flow method.
Suggests the value of the entire firm eq
uals the present value of the firm’s fre
e cash flows.
 Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
 FCF = NOPAT – Net capital investment
8-23
Applying the corporate value model
 Find the market value (MV) of the firm.
 Find PV of firm’s future FCFs
 Subtract MV of firm’s debt and preferred stock to g
et MV of common stock.
 MV of = MV of – MV of debt and
common stock firm preferred
 Divide MV of common stock by the number of shar
es outstanding to get intrinsic stock price (value).
 P0 = MV of common stock / # of shares

8-24
Issues regarding the corporat
e value model
 Often preferred to the dividend growth model,
especially when considering number of firms t
hat don’t pay dividends or when dividends a
re hard to forecast.
 Similar to dividend growth model, assumes at
some point free cash flow will grow at a const
ant rate.
 Terminal value (TVn) represents value of firm
at the point that growth becomes constant.
8-25
Given the long-run gFCF = 6%, and WAC
C of 10%, use the corporate value mode
l to find the firm’s intrinsic value.

0 k = 10% 1 2 3 4
...
g = 6%
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = = TV3
0.10 - 0.06
416.942

8-26
If the firm has $40 million in debt and ha
s 10 million shares of stock, what is the f
irm’s intrinsic value per share?

 MV of equity = MV of firm – MV of debt


= $416.94m - $40m
= $376.94 million
 Value per share = MV of equity / # of sh
ares
= $376.94m / 10m
= $37.69

8-27
Firm multiples method
 Analysts often use the following multiples t
o value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms, esti
mate the appropriate P/E. Multiply this by
expected earnings to back out an estimate
of the stock price.
8-28
What is market equilibrium?
 In equilibrium, stock prices are stable and there is
no general tendency for people to buy versus to s
ell.
 In equilibrium, expected returns must equal requi
red returns.
^
D
k1
gkk
(k-
k
)
P
s s RFMRF
0

8-29
Market equilibrium
 Expected returns are obtained by estim
ating dividends and expected capital gai
ns.
 Required returns are obtained by estim
ating risk and applying the CAPM.

8-30
How is market equilibrium establi
shed?
 If expected return exceeds required ret
urn …
 The current price (P0) is “too low” and o
ffers a bargain.
 Buy orders will be greater than sell orde
rs.
 P0 will be bid up until expected return e
quals required return

8-31
Factors that affect stock price
 Required return (ks) could change
 Changing inflation could cause kRF to cha
nge
 Market risk premium or exposure to mark
et risk (β) could change
 Growth rate (g) could change
 Due to economic (market) conditions
 Due to firm conditions
8-32
What is the Efficient Market Hypo
thesis (EMH)?
 Securities are normally in equilibrium an
d are “fairly priced.”
 Investors cannot “beat the market” e
xcept through good luck or better infor
mation.
 Levels of market efficiency
 Weak-form efficiency
 Semistrong-form efficiency
 Strong-form efficiency
8-33
Weak-form efficiency
 Can’t profit by looking at past trends.
A recent decline is no reason to think
stocks will go up (or down) in the futu
re.
 Evidence supports weak-form EMH, b
ut “technical analysis” is still used.

8-34
Semistrong-form efficiency
 All publicly available information is ref
lected in stock prices, so it doesn’t
pay to over analyze annual reports lo
oking for undervalued stocks.
 Largely true, but superior analysts ca
n still profit by finding and using new
information

8-35
Strong-form efficiency
 All information, even inside informati
on, is embedded in stock prices.
 Not true--insiders can gain by tradin
g on the basis of insider information,
but that’s illegal.

8-36
Is the stock market efficient?
 Empirical studies have been conducted to t
est the three forms of efficiency. Most of
which suggest the stock market was:
 Highly efficient in the weak form.
 Reasonably efficient in the semistrong form.
 Not efficient in the strong form. Insiders could
and did make abnormal (and sometimes illegal
) profits.
 Behavioral finance – incorporates elements
of cognitive psychology to better understan
d how individuals and markets respond to
different situations.
8-37
Preferred stock
 Hybrid security
 Like bonds, preferred stockholders rec
eive a fixed dividend that must be pai
d before dividends are paid to commo
n stockholders.
 However, companies can omit preferr
ed dividend payments without fear of
pushing the firm into bankruptcy.

8-38
If preferred stock with an annual dividen
d of $5 sells for $50, what is the preferre
d stock’s expected return?

Vp = D / kp
$50 = $5 / kp

kp = $5 / $50
= 0.10 = 10%

8-39

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