8-1 CHAPTER 8 Stocks and Their Valuation  Features of common stock  Determining common stock values  Efficient markets  Preferred stock 8-2 Facts about common stock  Represents ownership  Ownership implies control  Stockholders elect directors  Directors elect management  Management’s goal: Maximize the stock price 8-3 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. 8-4 Types of stock market transactions  Secondary market  Primary market  Initial public offering market (“going public”) 8-5 Different approaches for valuing common stock  Dividend growth model  Corporate value model  Using the multiples of comparable firms 8-6 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 ^ 8-7 Constant growth stock  A stock whose dividends are expected to grow forever at a constant rate, g. D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D 0 (1+g) t  If g is constant, the dividend growth formula converges to: g -k D g -k g)(1D P s 1 s 0 0 ^ = + = 8-8 Future dividends and their present values t 0t ) g 1 ( DD += t t t ) k 1 ( D PVD + = t0 PVDP ∑ = $ 0.25 Years (t) 0 8-9 What happens if g > k s ?  If g > k s , the constant growth formula leads to a negative stock price, which does not make sense.  The constant growth model can only be used if:  k s > g  g is expected to be constant forever 8-10 If k RF = 7%, k M = 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 (k s ): k s = k RF + (k M –k RF )β = 7% + (12% - 7%)1.2 = 13% [...]... 2 2.12 2.247 3 2. 382 1 .87 61 1.7599 ks = 13% 1.6509 8- 1 1 What is the stock’s market value? Using the constant growth model: D1 $2.12 = P0 = k s - g 0.13 - 0.06 $2.12 = 0.07 = $30.29 8- 1 2 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 ^ $2.247 D2 = P1 = k s - g 0.13 - 0.06 = $32.10 Could... ^ $2.00 (0.94) $1 .88 = = = $9 .89 0.13 - (-0 .06) 0.19 8- 2 1 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 8- 2 2 Corporate value model Also... better information Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency 8- 3 3 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 8- 3 4 Semistrong-form efficiency All publicly available information... Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value 0 k = 10% 1 -5 -4 .545 8. 264 15.026 3 98. 197 416.942 2 10 3 4 20 g = 6% 21.20 21.20 530 = 0.10 - 0.06 = TV3 8- 2 6 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... 13.00% - 7. 78% = 5.22% After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6% 8- 2 0 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 D0 ( 1 + g ) D1 P0 = = ks - g ks - g ^ $2.00 (0.94) $1 .88 =... $2.00 P0 = = = $15. 38 k 0.13 ^ 8- 1 5 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 8- 1 6 Valuing common stock with nonconstant growth 0 k = 13% 1 s g = 30% D0 = 2.00 2 g = 30% 2.600 3 g = 30% 3. 380 4 g = 6% 4.394 4.6 58 2.301 2.647 3.045... 30% 2.600 3 g = 30% 3. 380 4 g = 6% 4.394 4.6 58 2.301 2.647 3.045 P3 = 46.114 54.107 ^ = P0 4.6 58 0.13 − 0.06 = $66.54 8- 1 7 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, and... capital gains yield = 6% 8- 1 8 Nonconstant growth: What if g = 0% for 3 years before longrun growth of 6%? 0 k = 13% 1 s g = 0% D0 = 2.00 2 g = 0% 2.00 3 g = 0% 2.00 4 g = 6% 2.00 2.12 1.77 1.57 1.39 P3 = 20.99 25.72 ^ = P0 2.12 0.13 − 0.06 = $30.29 8- 1 9 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... million Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69 8- 2 7 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 to back out an estimate of the stock price 8- 2 8 What is market equilibrium? In equilibrium, stock prices are stable and... also find expected P1 as: ^ P1 = P0 (1.06) = $32.10 8- 1 3 What is 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 (ks) = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0% 8- 1 4 What would the expected price today be, if g . converges to: g -k D g -k g)(1D P s 1 s 0 0 ^ = + = 8- 8 Future dividends and their present values t 0t ) g 1 ( DD += t t t ) k 1 ( D PVD + = t0 PVDP ∑ = $ 0.25 Years (t) 0 8- 9 What happens. = 6% 0 1 2.247 2 2. 382 3 2.12 8- 1 2 What is the stock’s market value?  Using the constant growth model: $30.29 0.07 $2.12 0.06 - 0.13 $2.12 g - k D P s 0 = = == 1 8- 1 3 What is the expected. 8- 1 CHAPTER 8 Stocks and Their Valuation  Features of common stock  Determining common stock values  Efficient markets  Preferred stock 8- 2 Facts about common stock 