by Donglin Li 9-1

CHAPTER 9Stocks and Their Valuation

Features of common stock Determining common stock

values Efficient markets Preferred stock

by Donglin Li 9-2

Facts about common stock Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the

stock price

by Donglin Li 9-3

Types of stock market transactions Initial public offering

market (“going public”) (Company sells shares to the public for the 1st times.)

Secondary market (stockholders sell shares to each other)

by Donglin Li 9-4

Stock Market Transactions Apple Computer decides to issue additional

stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction?

Since new shares of stock are being issued, this is a primary market transaction.

What if instead an investor buys existing shares of Apple stock in the open market – is this a primary or secondary market transaction?

Since no new shares are created, this is a secondary market transaction.

by Donglin Li 9-5

Different approaches for valuing common stock Dividend growth model Corporate value model Using the multiples of

comparable firms

by Donglin Li 9-6

Dividend growth model Value of a stock is the present value of

the future dividends expected to be generated by the stock.

)r(1

D ... )r(1D )r(1

D )r(1D P

s3

s

32

s

21

s

10^

by Donglin Li 9-7

Constant growth stock A stock whose dividends are expected

to grow forever 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 converges to:

g -rD g -r

g)(1D Ps

1

s

00^

by Donglin Li 9-8

Future dividends and their present values

t0t ) g 1 ( DD

tt

t )r 1 (DPVD

t0 PVDP

$

0.25

Years (t)0

by Donglin Li 9-9

What happens if g > rs? If g > rs, the constant growth

formula leads to a negative stock price, which does not make sense.

The constant growth model can only be used if: rs > g g is expected to be constant forever

by Donglin Li 9-10

If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firm’s stock? Use the SML to calculate the

required rate of return (rs):

rs = rRF + (rM – rRF)b= 7% + (12% - 7%)1.2= 13%

by Donglin Li 9-11

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

1.87611.7599

D0 = 2.00

1.6509

rs = 13%

g = 6%0 1

2.247

2

2.382

3

2.12

by Donglin Li 9-12

What is the stock’s intrinsic value? Using the constant growth model:

$30.29 0.07

$2.12

0.06 - 0.13$2.12 g - r

D Ps

0

1ˆ

by Donglin Li 9-13

What is the expected market price of the stock, one year from now? D1 will have been paid out already.

So, P1 is the present value (as of year 1) of D2, D3, D4, etc.

Could also find expected P1 as:

$32.10 0.06 - 0.13

$2.247 g - rD Ps

2^1

$32.10 (1.06) P P 0^1

by Donglin Li 9-14

What are the expected dividend yield, capital gains yield, and total return during the 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 (rs)= Dividend Yield + Capital Gains Yield= 7.0% + 6.0% = 13.0%

by Donglin Li 9-15

What would the expected price today be, if g = 0? The dividend stream would be a

perpetuity.

2.00 2.002.00

0 1 2 3rs = 13% ...

$15.38 0.13$2.00 r

PMT P^0

by Donglin Li 9-16

Supernormal growth:What if g = 30% for 3 years before achieving long-run growth of 6%? Can no longer use just the constant

growth model to find stock value. However, the growth does become

constant after 3 years.

by Donglin Li 9-17

Valuing common stock with nonconstant growth

rs = 13%

g = 30% g = 30% g = 30% g = 6%

P 0.06

$66.5434.658

0.13

2.3012.6473.045

46.11454.107 = P0

^

0 1 2 3 4

D0 = 2.00 2.600 3.380 4.394

...

4.658

by Donglin Li 9-18

If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? The firm still has earnings and pays

dividends, even though they may be declining, they still have value.

$9.89 0.19$1.88 (-0.06) - 0.13

(0.94) $2.00

g - r) g 1 (D g - r

D Ps

0

s

1^0

by Donglin Li 9-19

Find expected annual dividend and capital gains yields.

Capital gains yield= g = -6.00%

Dividend yield= 13.00% - (-6.00%) = 19.00%

Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.

by Donglin Li 9-20

Corporate value model Also called the free cash flow

method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows.

Remember, free cash flow is the firm’s after-tax operating income less the net capital investment FCF = NOPAT – Net capital investment

by Donglin Li 9-21

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 get 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 shares outstanding to get intrinsic stock price (value). P0 = MV of common stock / # of shares

by Donglin Li 9-22

Issues regarding the corporate value model Often preferred to the dividend growth

model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast.

Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate.

Terminal value (TVn) represents value of firm at the point that growth becomes constant.

by Donglin Li 9-23

Given the long-run gFCF = 6%, and WACC (weighted average cost of capital) of 10%, use the corporate value model to find the firm’s intrinsic value.

g = 6%

r = 10%

21.20

0 1 2 3 4

-5 10 20

...

416.942

-4.5458.264

15.026398.197

21.20530 = = TV30.10 0.06-

by Donglin Li 9-24

If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’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 shares

= $376.94m / 10m= $37.69

by Donglin Li 9-25

Firm multiples method Analysts often use the following

multiples to value stocks. P / E P / CF P / Sales

EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings per share to back out an estimate of the stock price.

by Donglin Li 9-26

What is market equilibrium? In equilibrium, stock prices are stable and

there is no general tendency for people to buy versus to sell.

In equilibrium, two conditions hold: The current market stock price equals its

intrinsic value (P0 = P0). Expected returns must equal required returns.

)br(r r r g PD r RFMRFs

0

1^s

^

by Donglin Li 9-27

Market equilibrium Expected returns are obtained by

estimating dividends yield and expected capital gains yield.

Required returns are obtained by estimating risk and applying the CAPM.

by Donglin Li 9-28

How is market equilibrium established? If expected return exceeds

required return … The current price (P0) is “too low”

and offers a bargain. Buy orders will be greater than sell

orders. P0 will be bid up until expected

return equals required return

by Donglin Li 9-29

Factors that affect stock price

Required return (rs) could change Changing inflation could cause rRF to

change Market risk premium or exposure to

market risk (β) could change Growth rate (g) could change

Due to economic (market) conditions Due to firm conditions

0 10

s s

D (1 g) D r - g r - g

P

by Donglin Li 9-30

Stock Market Reporting52WEEKS YLD VOL NET

HI LO STOCKSYMDIV % PE 100s HI LOCLOSE CHG52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

Gap has been as high as $52.75 in the last year.

Gap has been as low as $19.06 in the last year.

Gap pays a dividend of 9 cents/share

Given the current price, the dividend yield is ½ %

Given the current price, the PE ratio is 15 times earnings

6,517,200 shares traded hands in the last day’s trading

Gap ended trading at $19.25, down $1.75 from yesterday’s close

by Donglin Li 9-31

Where can you find a stock quote, and what does one look like? Stock quotes can be found in a variety of print sources

(Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

by Donglin Li 9-32

Efficient Capital Markets Stock prices are in equilibrium or are “fairly”

priced If this is true, then you should not be able to earn

“abnormal” or “excess” returns, in expectation. Efficient markets DO NOT imply that investors

cannot earn a positive return in the stock market. They do mean that, on average, you will earn a

return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns.

by Donglin Li 9-33

What is the Efficient Market Hypothesis (EMH)? Securities are normally in

equilibrium and are “fairly priced.” Investors cannot “beat the

market” except through good luck or better information.

Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

by Donglin Li 9-34

Weak-form efficiency Can’t profit by looking at past price

trends. A recent decline is no reason to think stocks will go up (or down) in the future. There is no predictable price pattern based on price path.

Real world evidence supports weak-form EMH, but “technical analysis” is still used by some people.

by Donglin Li 9-35

Efficient Market Theory Technical Analysts

Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watcherswiggle watchers”)

by Donglin Li 9-36

Semistrong-form efficiency All publicly available information

is reflected in stock prices, so it doesn’t pay to over-analyze annual reports looking for undervalued stocks.

Largely true in real world, but superior analysts can still profit by finding and using new information

by Donglin Li 9-37

Efficient Market Theory

-40

-30

-20

-10

0

10

20

30

40

Ret

urn

(%)

FundsMarket

Average Annual Return on 1493 Mutual Funds and the Market Index

by Donglin Li 9-38

Implications of market efficiency You hear in the news that a medical

research company received FDA approval for one of its products. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing the stock? No – if the market is semi-strong efficient,

this information will already have been incorporated into the company’s stock price. So, it’s probably too late …

by Donglin Li 9-39

One-year-ahead hedge returns based on capital investment levels. ©Donglin Li 2004

Go long the lowest investment

stocks.

Go short the highest investment stocks.

12 month size adjusted buy and hold hedge returns after May each year.

Positive in 36 out of 39 years, average 12.6%

Pattern is consistent with market mispricing.

1 year ahead hedge returns between lowest and highest deciles of investment (d_PPE) firms

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Year

Hed

ge P

ortfo

lio R

etur

n

by Donglin Li 9-40

Strong-form efficiency All information, even inside

information, is embedded in stock prices. That is, one cannot profit even on private information.

Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

by Donglin Li 9-41

Is the stock market efficient?

Empirical studies have tried to test the three forms of efficiency. 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.

by Donglin Li 9-42

What Makes Markets Efficient? There are many investors out there

doing research As new information comes to market,

this information is analyzed and trades are made based on this information

Therefore, prices should reflect all available public information, and almost instantly.

by Donglin Li 9-43

Preferred stock Hybrid security. Like bonds, preferred stockholders

receive a fixed dividend that must be paid before dividends are paid to common stockholders.

However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

No voting right.

by Donglin Li 9-44

If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return?

Vp = D / rp

$50 = $5 / rp

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

^

by Donglin Li 9-45

Exercises1. You purchase a stock expecting the price to rise 10% in

the coming year. After one year, the stock has actually increased in value by 30%, due primarily to new information released during the year concerning unexpectedly higher sales. Which of the following describes this result?

A) This is a violation of weak form efficiency.

B) This is a violation of semi-strong form efficiency.

C) This is a violation of strong form efficiency.

D) This is not a violation of market efficiency.

by Donglin Li 9-46

2. You track the liquidity of companies and find that you can consistently earn unusually high returns by purchasing the shares of firms whose stock price falls below the cash value per share as indicated on the balance sheet. Which of the following describes this strategy?

A) This would not be a violation of market efficiency.

B) This would be a violation of weak form efficiency.

C) This would be a violation of semi-strong form efficiency.

by Donglin Li 9-47

3. You have discovered from looking at charts of past stock prices that if you buy just after a stock price has declined for three consecutive days, you make money every time! This is clearly a violation of _________ market efficiency.

A) weak form

B) semi-weak form

C) semi-strong form

D) strong form