Practical financial manaegment lasher 7th ed chapter 08

Chapter - The Valuation and Characteristics of Stock 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: k= D1+ ( P1 -P0 ) P0 or k= D1 P {0 dividend yield + ( P1-P0 ) P 14 2043 A capital gain (loss) occurs if you sell the stock for a price greater (lower) than you paid for it capital gains yield The Return on an Investment in Common Stock Solve the previous equation for P0, the stock’s price today: kP0 = D1 + ( P1 − P0 ) P0 + kP0 = D1 + P1 ( + k ) P0 = D1 + P1 D1 + P1 P0 = ( 1+ k ) 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 Comparison of Cash Flows from Stocks and Bonds – 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 – For bondholders: Interest payments are guaranteed, constant Maturity value is fixed At maturity, the investor receives face value from the issuing company When selling, investor receives money from another investor 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 P0 = D1 PVFk,1  + D2 PVFk,2  + K + Dn PVFk,n  + Pn PVFk,n  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 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 P0 = $2 PVF12%,1  + $3.50 PVF12%,2  + $75 PVF12%,2  = $2[0.8929] + $3.50[0.7972] + $75.00[0.7972] = $64.37 10 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 54 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 55 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 56 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 58 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, resulting in a loss of $5, but the loss is offset by the $8 premium received for writing the option The overall gain is $3 60 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 61 Figure 8-5 Basic Put Option Concepts 62 Figure 8-6 The Value of a Put Option 63 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 Volatility of underlying stock’s market price Risk-free interest rate 64 Warrants Options Warrants – Trade between investors, not between the companies that issue the underlying stocks – Issued by underlying company – Secondary market instruments – Primary market instruments while options are secondary market instruments – When exercised – new stock is issued and company receives the exercise price 65 Warrants Similar to calls with a longer expiration period (several years vs months) Issued as a “sweetener” (especially for risky bonds) Can generally be detached from another issue and sold separately 66 Employee Stock Options More like warrants than traded options – Expire after several years – Strike price set far out of the money – May receive options instead of salary increases Wanted if future expectations are good Companies offering options may pay lower salaries 67 Employee Stock Options Executive Stock Option Problem Senior executives may receive most of the stock options Provide an incentive for executives to misstate financial statements and inflate stock prices 68 [...]...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 11 Growth Models of Common Stock Valuation Based on predicted growth rates since forecasting exact future... Constant Dividend If a stock is expected to pay a constant, non-growing dividend, each dollar dividend is the same Gordon model simplifies to: D P0 = k A zero growth stock is a perpetuity to the investor 18 The Expected Return Recast Gordon model to focus on the return (k) implied by the constant growth assumption D1 k= +g P0 The expected return reflects investors’ knowledge of a company If we know D0 (most... Zylon a good buy at $48? 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: Expected Year Dividend Growth 1 $2.40 20% 2 $2.88 20% 3 $3.05 6% Next, we’ll... should be worth about $20 more than it is selling for in the market, so we should buy Zylon’s stock 26 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 27 Practical Limitations of Pricing Models Comparison to Bond Valuation Stocks That Don’t Pay Dividends... 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 P0 = D1 D2 Dn Pn + + K + + n n ( 1+ k ) ( 1+ k ) 2 1 + k 1 + k ( ) ( ) An Infinite Stream of Dividends Many investors buy a stock, hold for awhile, then sell, as represented in the above equation 13 Developing Growth-Based Models... 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 20 Figure 8-2 Two Stage Growth Model 21 Concept Connection Example 8-5 Valuation Based on Two Stage... IPO Pops A little Big Pop History POP Strategies Market Stabilization Insights – Practical Finance Facebook’s IPO Most anticipated IPO in history NASDAQ trading issues Fourth largest IPO in history 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... 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 22 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 company The rate of return on stocks... Normal Growth The Gordon Model Constant growth model can be simplified to D1 P0 = k −g 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 16 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... Pricing Models Comparison to Bond Valuation Stocks That Don’t Pay Dividends Bond valuation is precise because the inputs are precise Have value because of expectation that they will someday pay them Future cash flows are guaranteed in amount and time, unless firm defaults Some firms don’t pay dividends even if they are profitable – Firms are growing and using profits to finance the growth 28 Valuing New Stocks