Presentation on theme: "Chapter 7 Learning Objectives"— Presentation transcript:
1Chapter 7 Learning Objectives Understand the stock trading reports on the internet or in the financial pages of the newspaper.Calculate the present value of a stock given forecasts of future dividends and future stock price.Use stock valuation formulas to infer the expected rate of return on a common stock.Interpret price-earnings ratios.Understand what professionals mean when they say that there are no free lunches on Wall Street.
2Valuing StocksThis chapters introduces valuations techniques for equity (stocks). The Dividend Discount Model provides an excellent measure of a stock’s intrinsic value.Chapter 07 OutlineThe Stock MarketPrimary vs. Secondary MarketsTypes of OfferingsCommon Stock TerminologyMeasures of ValueBook ValueLiquidation ValueMarket ValueGoing-Concern ValueValuing StocksStock Price & Intrinsic ValueMeasuring Expected ReturnThe Dividend Discount ModelCase 1: DDM with No Growth FirmsCase 2: DDM with Constant Growth FirmsCase 3: DDM with Nonconstant Growth FirmsEstimating Expected Rates of ReturnUnderstanding GrowthValuing Growth StocksMethods of AnalysisTechnical AnalysisRandom Walk TheoryFundamental AnalysisEfficient Market HypothesesWeak-form EfficiencySemistrong-form EfficiencyStrong-form EfficiencyMarket AnomaliesThe Earnings Announcement PuzzleThe New-Issue PuzzleBubblesBehavioral Finance
3The Stock Market Primary Market vs. Secondary Market The two principal stock exchanges in the US are the New York Stock Exchange & NASDAQPrimary Market vs. Secondary MarketInitial Public OfferingPrimary OfferingPrimary market – Market for the sale of new securities by corporations.Secondary Market – Market in which previously issued securities are traded among investors.Initial Public Offering (IPO) – First offering of stock to the general public.Primary Offering – Occurs when a corporation sells shares in the firm.
4Primary vs. Secondary Markets: Example Shannon sells 100 shares of Google stock from her portfolio for $500 per share to help pay for her son Domenic’s college education.How much does Google receive from the sale of its shares?Does this transaction occur on the primary or secondary market?
5Bid Price/Ask PriceBid Price: The prices at which investors are willing to buy shares.Ask Price: The prices at which current shareholders are willing to sell their shares.Example:If an investor wishes to purchase 100 shares of Apple with a bid price of $ and an ask price of $253.48, how much could the investor expect to pay for the shares?Bid price – The prices at which investors are willing to buy shares.Ask price – The prices at which current shareowners are willing to sell their shares.Bid-ask spread – The difference between the bid price and the ask price.Market order – An order to buy or sell shares at the best currently available market price.Limit order – An order to buy or sell shares at a predetermined price, to be executed when the market price reaches the requested price.Answer: $253.48
6Terminology Market Cap P/E Ratio Dividend Yield Investors use a number of methods to determine the quality of a company’s shares.Market CapP/E RatioDividend YieldMarket cap (market capitalization) – The total value of a company’s outstanding shares.P/E Ratio – Ratio of stock price to earnings per share.Dividend Yield – The ratio of dividends paid and share price. Tells the investor how much dividend income they can expect for every $1 invested in the stock.
7Basic Terminology: Example You are considering investing in a firm whose shares are currently selling for $50 per share with 1,000,000 shares outstanding. Expected dividends are $2/share and earnings are $6/share.What is the firm’s Market Cap? P/E Ratio? Dividend Yield?
8Measures of ValueThree ways to value a firm: Book Value – Net worth of the firm according to the balance sheet. Liquidation Value – Net proceeds that could be realized by selling the firm’s assets and paying off its creditors. Market Value – The value of the firm as determined by investors who would be willing to purchase the company.Book Value – Net worth of the firm according to the balance sheet.Liquidation Value – Net proceeds that could be realized by selling the firm’s assets and paying off its creditors.Market Value – The value of the firm as determined by investors who would be willing to purchase the company.Unlike book value and liquidation value, market value treats the firm as a going concern.To help identify sources of value, financial managers sometimes construct market-value balance sheets.Market Value Balance Sheet – Balance sheet showing market rather than book values of assets, liabilities, and shareholders’ equity.
9Going-Concern Value Refers to three factors: The difference between a company’s actual value and its book or liquidation value is called its going-concern value.Refers to three factors:Extra earning powerIntangible assetsValue of future investmentsExtra earning power – A company may have the ability to earn a higher rate of return on assets; the value of these assets will be higher than their book value.Intangible assets – Many assets can’t be quantified on the balance sheet; for example a company’s brand and its managerial expertise.Value of future investments – If investors believe a company will potentially make very profitable investments in the future, they will pay more for the company’s stock today.
10Price and Intrinsic Value Intrinsic Value – Present value of future cash payoffs from a stock or other security.Note: the intrinsic value represents the “fair” price of the stock. If investors by the stock for 𝑽_𝟎, their expected rate of return will precisely equal the discount rate.
11Price and Intrinsic Value What is the intrinsic value of a share of stock if expected dividends are $2/share and the expected price in 1 year is $35/share? Assume a discount rate of 10%.
12Expected ReturnNote: this return is sometimes referred to as the “Holding Period Return”It represents the return an investor can expect over one time period.
13Expected Return: Example What should be the price of a stock in one year if it sells for $40 today, has an expected dividend per share of $3, and an expected return of 12%?
14The Dividend Discount Model Dividend Discount Model – Discounted cash-flow model which states that today’s stock price equals the present value of all expected future dividends.
15The Dividend Discount Model Consider three cases:No growthConstant GrowthNonconstant GrowthDividend Discount Model – Discounted cash-flow model which states that today’s stock price equals the present value of all expected future dividends.
16The Dividend Discount Model Case 1: No GrowthWhat should the price of a share of stock be if dividends are projected at $5/share, the discount rate is 10%, and growth is 0%?In the case where a company reinvests no earnings into the firm (thus achieving no growth), the dividend discount model says that the firm’s shares should sell for the present value of a constant, perpetual stream of dividends.
17The Dividend Discount Model Case 2: Constant GrowthExample: What should the price of a share of stock be if the firm will pay a $4 dividend in 1 year that is expected to grow at a constant rate of 5%? Assume a discount rate of 10%.Constant-growth Dividend Discount Model – Version of the dividend discount model in which dividends grow at a constant rate. Also known as the Gordon growth modelNote: The dividend used is the dividend in year 1. If you are given the current (year 0) dividend, you must extrapolate the 1 year dividend by multiplying by (1+g).
18The Dividend Discount Model Case 3: Nonconstant GrowthIf we set “H” to the year in which we expect growth rate to change, we can use the dividend discount model to estimate the present value of these dividends.PV of dividends from year 1 to horizonPV of stock price at horizon
19Nonconstant Growth Dividend Discount Model Example: A firm is expected to pay $2/share in dividends next year. Those dividends are expected to grow by 8% for the next three years and 6% thereafter. If the discount rate is 10%, what is the current price of this security?
20Required Rates of Return Estimating Expected Required Rates of Return:Example: What rate of return should an investor expect on a share of stock with a $2 expected dividend and 8% growth rate that sells today for $60?Even if immediate dividends or expected growth rates are different, stocks with the same risk should offer the same expected total rate of return.Another way of writing this relationship is this:𝑟=(dividend yield)+(growth rate)
21Sustainable Growth Rate If a firm earns a constant return on its equity and plows back a constant proportion of earnings, then the growth rate g is:Example: Suppose a firm that pays out 35% of earnings as dividends and expects its return on equity to be 10%. What is the expected growth rate?Payout Ratio – Fraction of earnings paid out as dividends.Plowback Ratio - Fraction of earnings retained by the firmNote: Plowback Ratio = 1 – Payout Ratiog (sustainable growth rate) – The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant.
22Valuing Growth Stocks Present Value of Growth Opportunities (PVGO) – Present Value of Growth Opportunities (PVGO) – Net present value of a firm’s future investments.Note: EPS/r can be thought of as the value of the assets currently in place.Where:EPS = Earnings per sharePVGO = Present Value of Growth Opportunities
23Valuing Growth Stocks: Example Suppose a stock is selling today for $55/share and there are 10,000,000 shares outstanding. If earnings are projected to be $20,000,000, how much value are investors assigning to growth per share? Assume a discount rate of 10%.
24Methods of AnalysisInvestors have many strategies for trying to beat the market consistently.Technical AnalysisFundamental AnalysisTechnical Analysis – Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices.Fundamental Analysis – Investors who attempt to find mispriced securities by analyzing fundamental information, such as accounting performance and earnings prospects.
25Technical Analysis Problem with this approach: Technical analysts try to achieve superior returns by spotting and exploiting patterns in stock prices.Problem with this approach:Prices follow a “random walk”Technical Analysis – Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices.Random walk – Security prices change randomly, with no predictable trends or patterns.They are equally likely to offer a high or low return on any particular day, regardless of what has occurred on previous days.
26Returns on NYCI on two successive weeks, 1970-2010 Technical AnalysisReturns on NYCI on two successive weeks,Are successive security prices related?.
27Fundamental AnalysisFundamental analysts are paid to uncover stocks for which price does not equal intrinsic value.What happens in a market with many talented and competitive fundamental analysts?Fundamental Analysis – Investors who attempt to find mispriced securities by analyzing fundamental information, such as accounting performance and earnings prospects.Note: In a market with many talented and competitive analysts, any bargains will be quickly eliminated.
28Efficient Market Hypotheses Is the US stock market a highly efficient market?Degrees of efficiency:Weak-form EfficiencySemistrong-form EfficiencyStrong-form EfficiencyEfficient Market – Market in which prices reflect all available information.Weak-form Efficient – A market in which prices already reflect all the information contained in past prices.Semistrong-form Efficient – A market in which prices reflect not just the information contained in past prices but also all publicly available information.Strong-form Efficient – A market where prices impound all available information.In a strong-form efficient market, no investor, however hardworking, could expect to earn superior profits.
29Market Anomalies The Earnings Announcement Puzzle The New-Issue Puzzle There are a number of market anomalies that seem to puzzle efficient market theorists, including:The Earnings Announcement PuzzleThe New-Issue PuzzleBubblesThe Earnings Announcement Puzzle:In an efficient stock market, a company’s stock price should react instantly at the announcement of unexpectedly good or bad earnings.However, stocks with the best earnings news typically outperform the stocks with the worst earnings news during the following six months (See Figure 7.11 in the text).This suggests that investors underreact to the earnings announcement and become aware of the full significance only as further information arrives.The New-Issue Puzzle:When firms issue stock to the public, investors typically rush to buy and these investors usually realize immediate capital gains.However, these early gains often turn into losses for the investor.Bubbles:There are sometimes cases where market prices as a whole become difficult or impossible to justify.Historical examples:The Japanese Nikkei,Japanese real estate bubble, 2005US dot-com bubble,
30Behavioral FinanceSome believe that deviations in prices from intrinsic value can be explained by behavioral psychology, in two broad areas:Attitudes toward risk--People generally dislike incurring losses, yet they are more apt to take bigger risks if they are experiencing a period of substantial gains.2. Beliefs about probabilities--Individuals commonly look back to what has happened in recent periods and assume this is representative of future outcomes.Attitudes toward risk:People generally dislike incurring losses, yet they are more apt to take bigger risks if they are experiencing a period of substantial gains.In the dot-com boom, it is theorized that investors experienced such great consistent gains that they stopped worrying about the risk of loss; thus driving prices artificially higher than their fundamental values.Beliefs about probabilities:When judging the possible future outcomes of an event, individuals commonly look back to what has happened in recent periods and assume this is representative of future outcomes.Another common bias is overconfidence.Most investors believe they are better-than-average investors, but not every speculator can consistently profit at the other’s expense.