Practical financial manaegment lasher 7th ed chapter 08

The Return on an Investment in Common StockThe return on a stock investment is the interest rate that equates the present value of the investment’s expected future cash flows to the amo

Common Stock

Corporations are owned by common

stockholders

Most large companies are “widely held’

– Ownership spread among many investors.

The Return on an Investment in Common Stock

Income in a stock investment comes from:

– dividends

– gain or loss on the difference between the purchase and sale

price

If you buy a stock for price P0, hold it for one year, receive a dividend

of D1, then sell it for price P1, you return, k, would be :

A capital gain (loss) occurs

if you sell the stock for a price greater (lower) than

you paid for it

P -P D

P 14 2 43 P

The Return on an Investment in Common Stock

Solve the previous equation for P0, the stock’s price today:

The Return on an Investment in Common Stock

The return on a stock investment is the interest rate that equates the present value of the

investment’s expected future cash flows to the amount invested today, the price, P0

Figure 8-1 Cash Flow Time Line for

Stock Valuation

The Nature of Cash Flows from Stock Ownership

– For stockholders:

Expected dividends and future

selling price are not known

with any precision

Similarity to bond cash flows is

superficial – both involve a

stream of small payments

followed by a larger payment

When selling, investor receives

money from another investor

– For bondholders:

Interest payments are guaranteed, constant Maturity value is fixed

At maturity, the investor receives face value from the issuing company

Comparison of Cash Flows from Stocks and Bonds

The Basis of Value

The basis for stock value is the present value

of expected cash inflows even though

dividends and stock prices are difficult to

forecast

P = D PVF   + D PVF   + + K D PVF   + P PVF  

Concept Connection Example 8-1 Valuation of Stock

Based on Projected Cash Flows

Joe Simmons is interested in the stock of Teltex Corp

He feels it is going to have two very good years because

of a government contract, but may not do well after that

Joe thinks the stock will pay a dividend of $2 next year and $3.50 the year after By then he believes it will be selling for $75 a share, at which price he'll sell anything

he buys now

People who have invested in stocks like Teltex are

currently earning returns of 12% What is the most Joe should be willing to pay for a share of Teltex?

Concept Connection Example 8-1 Valuation

of Stock Based on Projected Cash Flows

Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and

$3.50 plus $75 at the end of two years

The Intrinsic (Calculated) Value and Market Price

A stock’s intrinsic value is based on

assumptions about future cash flows made from fundamental analysis of the firm and its industry

Different investors with different cash flow estimates will have different intrinsic values

Growth Models of Common

Stock Valuation

Based on predicted growth rates since

forecasting exact future prices and dividends is difficult

More likely to forecast a growth rate of

earnings rather than cash flows

Developing Growth-Based Models

A stock’s value today is the sum of the present values

of the dividends received while the investor holds it and the price for which it is eventually sold

An Infinite Stream of Dividends

Many investors buy a stock, hold for awhile, then sell, as represented in the above equation

Developing Growth-Based Models

A person who buys stock at time n will hold it until period m and then sell it

– Their valuation will look like this:

Repeating this process until infinity results in:

The Constant Growth Model

If dividends are assumed to be growing at a constant rate forever and the last dividend paid is, D0, then the model is:

This represents a series of fractions as follows

If k>g, the fractions get smaller (approach zero) as exponents get larger

0

)k1(

)g1(

DP

Constant Normal Growth

The Gordon Model

Constant growth model can be simplified to

k must be greater than

g

The Gordon Model is a simple expression for forecasting the price of a stock that’s expected to grow at a constant, normal rate

1 0

D P

g k

=

−

Concept Connection Example 8-3 Constant Normal

Growth - The Gordon Model

Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future It recently paid a dividends of $2.25 a share The rate of return on

stocks similar to Atlas is about 11% What should a share of Atlas Motors sell for today?

1 0

DP

k - g

$2.25 (1.06).11 - 06

$47.70

=

=

=

The Zero Growth Rate Case —

A Constant Dividend

If a stock is expected to pay a constant, non-growing dividend, each dollar dividend is the same

Gordon model simplifies to:

A zero growth stock is a perpetuity to the investor

0

D P

k

=

The Expected Return

Recast Gordon model to focus on the return (k)

implied by the constant growth assumption

The expected return reflects investors’ knowledge of a

company

If we know D0 (most recent dividend paid) and P0

(current actual stock price), investors’ expectations are input via the growth rate assumption

1 0

D P

k = + g

Two Stage Growth

At times, a firm’s future growth may not be expected to be constant

– A new product may lead to temporary high growth

The two-stage growth model values a stock that is expected

to grow at an unusual rate for a limited time

– Use the Gordon model to value the constant portion

– Find the present value of the non-constant growth periods

Figure 8-2 Two Stage Growth Model

Concept Connection Example 8-5

Valuation Based on Two Stage Growth

Zylon Corporation’s stock is selling for $48 a share

We’ve heard a rumor that the firm will make an

exciting new product announcement next week

We’ve concluded that this new product will support an overall company growth rate of 20% for about two years

Concept Connection Example 8-5

Valuation Based on Two Stage Growth

We feel growth will slow rapidly and level off at about 6% The firm currently pays an annual dividend of $2.00, which can be expected to grow with the

Concept Connection Example 8-5 Valuation

Based on Two Stage Growth

D1 = D0 (1+g1) = $2.00(1.20) = $2.40

D2 = D1 (1+g1) = $2.40(1.20) = $2.88

D3 = D2(1+g2) = $2.88(1.06) = $3.05

Concept Connection Example 8-5

Valuation Based on Two Stage Growth

We’ll develop a schedule of expected dividend

20%

$2.88 2

20%

$2.40 1

Growth

Expected Dividend Year

3 2

Concept Connection Example 8-5 Valuation Based on Two Stage Growth

Then we take the present value of D1, D2 and P2:

Compare $67.57 to the listed price of $48.00 If we

=

=

Practical Limitations of

Pricing Models

Stock valuation models give estimated results since the inputs are approximations of reality Actual growth rate can be VERY different from predicted growth rates

precise because the

inputs are precise

Future cash flows are

guaranteed in amount

and time, unless firm

Stocks That Don’t Pay Dividends

Have value because of expectation that they will someday pay them

Some firms don’t pay dividends even if they are profitable

– Firms are growing and

Valuing New Stocks Investment Banking and

The Initial Public Offering (IPO)

IPOs are the first public sales of a new

company stocks

Promoting and Pricing the IPO

Quiet Period

Book Building and the Road Show

Ends before the IPO date

Prices After the IPO

The Investment Bank in the Middle Underpricing and IPO Pops

A little Big Pop History

POP Strategies

Market Stabilization

Insights – Practical Finance

Some Institutional Characteristics of

Common Stock

Corporate Organization and Control

– Controlled by Board of Directors

Some Institutional Characteristics of

Common Stock

Preemptive Rights

– Allows stockholders to maintain a

proportionate share of ownership

– If firm issues new shares, existing

shareholders can purchase pro rata share of new issue

Voting Rights and Issues

Each share of common stock has one vote

– Vote for directors and other issues at the annual stockholders’ meeting

– Vote usually cast by proxy

Majority and Cumulative Voting

Majority Voting

gives the larger group

control of the company

Cumulative Voting

gives minority interest a chance at some

representation on the board

Shares With Different Voting Rights

Different classes of stock can be issued different rights

Some stock may be issued with limited or no

Stockholders’ Claim on

Income And Assets

Stockholders have a residual claim on income and assets

What is not paid out as dividends is retained for reinvestment in the business (retained

earnings)

Common stockholders are last in line, they

bear more risk than other investors

Preferred Stock

A hybrid security with characteristics of common stock and bonds

– Pays a constant dividend forever

– Specifies the initial selling price and the dividend

– No provision for the return of capital to the investor

Valuation of Preferred Stock

Since securities are worth the present value of their future cash flows, preferred stock is worth the present value of the indefinite stream of

Concept Connection Example 8-6

Pricing Preferred Stock

Roman Industries’ $6 preferred originally sold for $50 Interest rates on similar issues are now 9% What should Roman’s preferred sell for

today?

Just substitute the new market interest rate into the preferred stock valuation model to determine today’s price:

67

66 09

Characteristics of Preferred Stock

Cumulative Feature - can’t pay common dividends

unless cumulative preferred dividends are current

Never returns principal

Stockholders cannot force bankruptcy

Receives preferential treatment over common stock in bankruptcy

No voting rights

Securities Analysis

The art and science of selecting investments

Fundamental analysis looks at a company’s

business to forecast value

Technical analysis bases value on the pattern of past prices and volume

The Efficient Market Hypothesis (EMH) -

financial markets are efficient since new

information is instantly disseminated

Options and Warrants

Options

Gives the holder the

temporary right to buy

or sell an asset at a

fixed price

Speculate on price

WarrantsSimilar but less common

Options and warrants make it possible to

invest in stocks without holding shares

Stock Options

Stock options speculate on stock price movementsTrade in financial markets

Call option — option to buy

Put option — option to sell

Options are Derivative Securities

– Derive value from prices of underlying securities– Provide leverage – amplifying returns

Call Option

Basic Call Option

– Gives owner (the holder) the right to buy stock at a fixed price (the exercise or strike price) for a specified time period

– Once expired, it can’t be exercised

– Option price < price of the underlying stock

Figure 8-3 Basic Call Option

Concepts

The Call Option Writer

The option writer originates the contract

The original writer must stand ready to deliver on the contract regardless of how many times the option is sold

Call writer hopes stock price will remain stable or not rise

Intrinsic Value

Intrinsic value of a call is the difference between the underlying stock’s current price and the

option’s strike price

If out-of-the-money, intrinsic value is zero

Option always sells for intrinsic value or above

Figure 8-4 The Value of a Call Option

Options and Leverage

Financial leverage – magnifies return on investment

Options offer leverage due to the lower price at which the option can be

purchased when compared to the price

Options that Expire

Options are worthless at expiration

– Risky because they expire after a short time

If the price of an out-of-the-money option does not exceed the strike price prior to expiration, the option expires and is worthless

– Results in a 100% loss

The time premium approaches zero as the

expiration date approaches

Trading in Options

Options can be bought and sold at any time prior to

expiration

– Chicago Board Options Exchange (CBOE)

Price volatility in the options market

– As the underlying stock’s price changes, the option’s price changes by a greater relative movement due to the option’s lower price

Options are rarely exercised before expiration

Writing Options

People write options for the premium income, hoping that the option will never be exercised Option writers give up what option buyers

Concept Connection Example 8-7

a What is the intrinsic value of the option?

The intrinsic value represents by how much the option is in-the-money Since the stock price is $30 and the call option’s strike price is $25, the option is

Concept Connection Example 8-7

Stock Options

b What is the option’s time premium at this price?

The time premium represents the difference between the market price

of the option and the intrinsic value, or $8 - $5 = $3.

c Is the call in or out of the money?

The call option is in the money because it has a positive intrinsic value

d If an investor writes and sells a covered call option, acquiring the

covering stock now, how much has he invested?

The premium ($8) that the writer receives for the option will offset some

of the purchase price of the stock ($30), therefore the investor has

invested $30 - $8 = $22.

Concept Connection Example 8-7

Stock Options

e What is the most the buyer of the call can lose?

The buyer can lose, at most, 100% of his

investment which is the purchase price of the option

of $8.

f What is the most the writer of a naked call option

on this stock can lose?

In theory since the stock price can rise to any

price the writer can lose an infinite amount

However, a prudent writer would limit his losses by

Concept Connection Example 8-7

Stock Options

Just before the option’s expiration Oxbow is

selling for $32.

g What is the profit or loss from buying the call?

The buyer would exercise the option paying $25 for the stock and simultaneously selling the stock for

$32, resulting in a gain of $7 However, this gain would be offset by the $8 premium paid for the

option, resulting in an overall loss of $1.

Concept Connection Example 8-7

Stock Options

h What is the profit or loss from writing the call naked?

A naked writer would have to buy the stock for $32 and sell it

to the option owner for $25, resulting in a loss of $7 However, this loss would be offset by the premium received on the writing

of the option of $8, resulting in an overall gain of $1.

i What is the profit or loss from writing the call covered if the covering stock was acquired at the time the call was

written?

The call writer bought the stock for $30 and sold it for $25,

Put Options

Option to sell stock at a specified price by a

specified date

Put buyer profits if underlying stock declines

Intrinsic value – “in-the-money”

– difference between the option’s strike price and the current stock price (when positive), Option is out-of-the-money if the strike price is above the current stock price

Figure 8-5 Basic Put Option Concepts

Figure 8-6 The Value of a Put Option

Option Pricing Models

Option pricing model is more difficult than pricing models for stocks and bonds

Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model

– Determines option’s price based on

Price of underlying stock

Strike price of option

Time remaining until expiration of option