Business finance ch 8 stocks and their valuation

CHAPTER 8 Stocks and Their Valuation     Features of common stock Determining common stock values Efficient markets Preferred stock 8-1 Facts about common stock      Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock price 8-2 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 8-3 Types of stock market transactions    Secondary market Primary market Initial public offering market (“going public”) 8-4 Different approaches for valuing common stock    Dividend growth model Corporate value model Using the multiples of comparable firms 8-5 Dividend growth model  Value of a stock is the present value of the future dividends expected to be generated by the stock D3 D1 D2 D∞ P0 = + + + + 1 2 3 ∞ (1+ ks ) (1+ ks ) (1+ ks ) (1 + ks ) ^ 8-6 Constant growth stock  A stock whose dividends are expected to grow forever at a constant rate, g D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t  If g is constant, the dividend growth formula converges to: D0 (1 + g) D1 P0 = = ks - g ks - g ^ 8-7 Future dividends and their present values $ Dt = D0 ( 1 + g ) t Dt PVDt = t (1+ k ) 0.25 P0 = ∑ PVDt 0 Years (t) 8-8 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:  k > g s  g is expected to be constant forever 8-9 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 = 13% 8-10 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 at the point that growth becomes constant 8-25 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 15.026 398.197 416.942 2 10 3 4 20 g = 6% 21.20 21.20 530 = 0.10 - 0.06 = TV 3 8-26 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 million Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69 8-27 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 8-28 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 D1 ks = +g P0 ^ = ks = kRF + (kM − kRF )β 8-29 Market equilibrium   Expected returns are obtained by estimating dividends and expected capital gains Required returns are obtained by estimating risk and applying the CAPM 8-30 How is market equilibrium established?  If expected return exceeds required return …    The current price (P0) is “too low” and offers a bargain Buy orders will be greater than sell orders P0 will be bid up until expected return equals required return 8-31 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  Due to economic (market) conditions  Due to firm conditions   8-32 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  Strong-form efficiency 8-33 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 8-34 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 8-35 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 8-36 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 understand how individuals and markets respond to different situations 8-37 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 preferred dividend payments without fear of pushing the firm into bankruptcy 8-38 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% 8-39 ... 7%)1.2 = 13% 8- 10 If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next years, and their PVs g = 6% D0 = 2.00 1 .87 61 1.7599 2.12 2.247 2. 382 ks = 13% 1.6509 8- 11 What... 2.600 g = 30% 3. 380 g = 6% 4.394 4.6 58 2.301 2.647 3.045 46.114 54.107 ^ = P0 P = 4.6 58 0.13 − 0.06 = $66.54 8- 17 Find expected dividend and capital gains yields during the first and fourth years... form Insiders could and did make abnormal (and sometimes illegal) profits Behavioral finance – incorporates elements of cognitive psychology to better understand how individuals and markets respond