Practical financial managment 7e LASHER chapter 8

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 amou

Common Stock

Corporations are owned by common stockholders

Most large companies are “widely held’

– Ownership spread among many investors.

Investors don’t think of their role as owners

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

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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

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

) k 1 (

) g 1 (

D P

( ) ( ) ( ( ) ) ( ( ) )

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

D P

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

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 payments:

Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins That’s year 2, so:

6%

$3.05 3

20%

$2.88 2

20%

$2.40 1

Growth Expected Dividend

Year

32

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 are correct in our assumptions, Zylon

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=

=

Practical Limitations of

Pricing Models

Comparison to Bond Valuation

Bond valuation is precise because the

inputs are precise

Future cash flows are guaranteed in

amount and time, unless firm defaults

Stocks That Don’t Pay DividendsHave 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 using profits to finance the growth

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

elected by stockholders

– Board appoints top management who appoint middle/lower management – Board consists of top managers and outside directors (may include major stockholders)

– In widely held corporations, top management in “control”

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

voting rights

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 dividends

p

D

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

Dividend payments not tax deductible to the firm

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 changes without

holding the asset

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 movements

Trade 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

Call Options

The more volatile the stock’s price, the more attractive the option

– Stock’s price more likely to exceed the strike price before the option expires

The longer the time until expiration the more attractive the option

– The stock’s price is more likely to exceed the strike price before the option expires

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

– Time premium - difference between option’s intrinsic value and price

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 of the underlying stock

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

– If the price of a call option is not expected to increase, the option is sold, not exercised

Writing Options

People write options for the premium income, hoping that the option will never be exercised

Option writers give up what option buyers make

Covered option — writer owns underlying stock

Naked option — writer does not own the underlying stock

Concept Connection Example 8-7

Stock Options

The following information refers to a three-month call option on the stock of Oxbow, Inc

Price of the underlying stock: $30

Strike price of the three-month call: $25

Market price of the option: $8

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 in-the-money by $5, which is the intrinsic value.

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 purchasing the stock once it started to rise in value

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.