Slide Financial Management - Chapter 8 potx

Different approaches for valuing common stock „ Dividend growth model „ Corporate value model „ Using the multiples of comparable firms... Dividend growth model„ Value of a stock is the

CHAPTER 8

Stocks and Their Valuation

„ Features of common stock

„ Determining common stock values

„ Efficient markets

Preferred stock

Facts about common stock

„ Represents ownership

„ Ownership implies control

„ Stockholders elect directors

„ Directors elect management

„ Management’s goal: Maximize the

Social/Ethical Question

„ Should management be equally concerned about employees, customers, suppliers,

and “the public,” or just the stockholders?

„ In an enterprise economy, management

should work for stockholders subject to

constraints (environmental, fair hiring,

etc.) and competition

Types of stock market

Different approaches for

valuing common stock

„ Dividend growth model

„ Corporate value model

„ Using the multiples of comparable

firms

Dividend growth model

„ Value of a stock is the present value of the future dividends expected to be generated by the stock

+ +

+ +

=

) k (1

D

) k (1

D )

k (1

D )

k (1

D P

s

3 s

3 2

s

2 1

s

1 0

^

Constant growth stock

„ A stock whose dividends are expected to

grow forever at a constant rate, g

Future dividends and their

present values

t 0

t D ( 1 g )

t

t t

)k1

(

DPVD

+

=

$

0.25

What happens if g > ks?

„ If g > ks, the constant growth formula leads to a negative stock price, which does not make sense.

„ The constant growth model can only be used if:

„ ks > g

„ g is expected to be constant forever

If kRF = 7%, kM = 12%, and β = 1.2,

what is the required rate of return on

the firm’s stock?

„ Use the SML to calculate the required rate of return (ks):

ks = kRF + (kM – kRF)β

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

If D0 = $2 and g is a constant 6%,

find the expected dividend stream for

the next 3 years, and their PVs.

2.12

What is the stock’s market value?

„ Using the constant growth model:

$30.29

0.07

$2.12

0.06-

0.13

$2.12g

k

-DP

s 0

=

=

=

= 1

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

$2.247g

k

-DP

s

2

^ 1

=

=

=

What is the expected dividend yield,

capital gains yield, and total return

during the first year?

What would the expected price today be, if g = 0?

„ The dividend stream would be a

P^0 = = =

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

Valuing common stock with

Find expected dividend and capital gains yields during the first and fourth years.

„ Dividend yield (first year)

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

growth and dividend yield = 7%,

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 - k

) g 1

(

D g

k

-D P

s

0 s

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

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

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

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

Given the long-run gFCF = 6%, and

WACC of 10%, use the corporate value model to find the firm’s intrinsic value.

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

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

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, expected returns must equal required returns

β

− +

=

= +

Market equilibrium

„ Expected returns are obtained by

estimating dividends and expected

capital gains.

„ Required returns are obtained by

estimating risk and applying the CAPM.

How is market equilibrium

Factors that affect stock price

„ Required return (ks) could change

„ Changing inflation could cause kRF to

change

„ Market risk premium or exposure to

market risk (β) could change

„ Growth rate (g) could change

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

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

future

„ Evidence supports weak-form EMH,

but “technical analysis” is still used.

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, but superior analysts

can still profit by finding and using

new information

Strong-form efficiency

„ All information, even inside

information, is embedded in stock

prices

„ Not true insiders can gain by

trading on the basis of insider

information, but that’s illegal.

Is the stock market efficient?

„ Empirical studies have been conducted to test 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

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

If preferred stock with an annual

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

Vp = D / kp

$50 = $5 / kp

kp = $5 / $50

= 0.10 = 10%