Presentation on theme: "Chapter 8 - The Valuation and Characteristics of Stock"— Presentation transcript:
1 Chapter 8 - The Valuation and Characteristics of Stock
2 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
3 The Return on an Investment in Common Stock Income in a stock investment comes from:dividendsgain or loss on the difference between the purchase and sale priceIf 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.
4 The Return on an Investment in Common Stock Solve the previous equation for P0, the stock’s price today:
5 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
6 Figure 8-1 Cash Flow Time Line for Stock Valuation
7 The Nature of Cash Flows from Stock Ownership Comparison of Cash Flows from Stocks and BondsFor stockholders:Expected dividends and future selling price are not known with any precisionSimilarity to bond cash flows is superficial – both involve a stream of small payments followed by a larger paymentWhen selling, investor receives money from another investorFor bondholders:Interest payments are guaranteed, constantMaturity value is fixedAt maturity, the investor receives face value from the issuing company.
8 The Basis of ValueThe basis for stock value is the present value of expected cash inflows even though dividends and stock prices are difficult to forecast
9 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?
10 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.
11 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 industryDifferent investors with different cash flow estimates will have different intrinsic values
12 Growth Models of Common Stock Valuation Based on predicted growth rates since forecasting exact future prices and dividends is difficultMore likely to forecast a growth rate of earnings rather than cash flows
13 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 soldAn Infinite Stream of DividendsMany investors buy a stock, hold for awhile, then sell, asrepresented in the above equation
14 Developing Growth-Based Models A person who buys stock at time n will hold it until period m and then sell itTheir valuation will look like this:Repeating this process until infinity results in:
15 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 followsIf k>g, the fractions get smaller (approach zero) as exponents get larger
16 Constant Normal Growth The Gordon Model Constant growth model can be simplified tok 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
17 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?
18 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 sameGordon model simplifies to:A zero growth stock is a perpetuity to the investor
19 The Expected ReturnRecast Gordon model to focus on the return (k) implied by the constant growth assumptionThe expected return reflects investors’ knowledge of a companyIf we know D0 (most recent dividend paid) and P (current actual stock price), investors’ expectations are input via the growth rate assumption
20 Two Stage GrowthAt times, a firm’s future growth may not be expected to be constantA new product may lead to temporary high growthThe two-stage growth model values a stock that is expected to grow at an unusual rate for a limited timeUse the Gordon model to value the constant portionFind the present value of the non-constant growth periods
22 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.
23 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 like Zylon is approximately 10%.Is Zylon a good buy at $48?
24 Concept Connection Example 8-5 Valuation Based on Two Stage Growth D1 = D0 (1+g1) = $2.00(1.20) = $2.40D2 = D1 (1+g1) = $2.40(1.20) = $2.88D3 = D2(1+g2) = $2.88(1.06) = $3.05
25 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:YearExpected DividendGrowth1$2.4020%2$2.8820%3$3.056%
26 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 $ If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy Zylon’s stock.
27 Practical Limitations of Pricing Models Stock valuation models give estimated results since the inputs are approximations of realityActual growth rate can be VERY different from predicted growth rates
28 Practical Limitations of Pricing Models Comparison to Bond ValuationBond 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 profitableFirms are growing and using profits to finance the growth
29 Valuing New Stocks Investment Banking and The Initial Public Offering (IPO) IPOs are the first public sales of a new company stocks
30 IPO Process Investment Banking Syndication Registration Underwriting Best Efforts
31 Promoting and Pricing the IPO Quiet PeriodBook Building and the Road ShowEnds before the IPO date
32 Prices After the IPO The Investment Bank in the Middle Underpricing and IPO PopsA little Big Pop HistoryPOP StrategiesMarket Stabilization
33 Insights – Practical Finance Facebook’s IPOMost anticipated IPO in historyNASDAQ trading issuesFourth largest IPO in history
34 Some Institutional Characteristics of Common Stock Corporate Organization and ControlControlled by Board of Directorselected by stockholdersBoard appoints top management who appoint middle/lower managementBoard consists of top managers and outside directors (may include major stockholders)In widely held corporations, top management in “control”
35 Some Institutional Characteristics of Common Stock Preemptive RightsAllows stockholders to maintain a proportionate share of ownershipIf firm issues new shares, existing shareholders can purchase pro rata share of new issue
36 Voting Rights and Issues Each share of common stock has one voteVote for directors and other issues at the annual stockholders’ meetingVote usually cast by proxy
37 Majority and Cumulative Voting Majority Votinggives the larger group control of the companyCumulative Votinggives minority interest a chance at some representation on the boardShares With Different Voting RightsDifferent classes of stock can be issued different rightsSome stock may be issued with limited or no voting rights
38 Stockholders’ Claim on Income And Assets Stockholders have a residual claim on income and assetsWhat 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
39 A hybrid security with characteristics of common stock and bonds Preferred StockA hybrid security with characteristics of common stock and bondsPays a constant dividend foreverSpecifies the initial selling price and the dividendNo provision for the return of capital to the investor
40 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.
41 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:
42 Characteristics of Preferred Stock Cumulative Feature - can’t pay common dividends unless cumulative preferred dividends are currentNever returns principalStockholders cannot force bankruptcyReceives preferential treatment over common stock in bankruptcyNo voting rightsDividend payments not tax deductible to the firm
43 Securities Analysis The art and science of selecting investments Fundamental analysis looks at a company’s business to forecast valueTechnical analysis bases value on the pattern of past prices and volumeThe Efficient Market Hypothesis (EMH) - financial markets are efficient since new information is instantly disseminated
44 Options and WarrantsOptions and warrants make it possible to invest in stocks without holding sharesOptionsGives the holder the temporary right to buy or sell an asset at a fixed priceSpeculate on price changes without holding the assetWarrantsSimilar but less common
45 Stock Options Stock options speculate on stock price movements Trade in financial marketsCall option — option to buyPut option — option to sellOptions are Derivative SecuritiesDerive value from prices of underlying securitiesProvide leverage – amplifying returns
46 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 periodOnce expired, it can’t be exercisedOption price < price of the underlying stock
48 The more volatile the stock’s price, the more attractive the option Call OptionsThe more volatile the stock’s price, the more attractive the optionStock’s price more likely to exceed the strike price before the option expiresThe longer the time until expiration the more attractive the optionThe stock’s price is more likely to exceed the strike price before the option expires
49 The Call Option WriterThe option writer originates the contractThe original writer must stand ready to deliver on the contract regardless of how many times the option is soldCall writer hopes stock price will remain stable or not rise
50 Intrinsic ValueIntrinsic value of a call is the difference between the underlying stock’s current price and the option’s strike priceIf out-of-the-money, intrinsic value is zeroOption always sells for intrinsic value or aboveTime premium - difference between option’s intrinsic value and price
52 Options and LeverageFinancial leverage – magnifies return on investmentOptions offer leverage due to the lower price at which the option can be purchased when compared to the price of the underlying stock
53 Options that Expire Options are worthless at expiration Risky because they expire after a short timeIf the price of an out-of-the-money option does not exceed the strike price prior to expiration, the option expires and is worthlessResults in a 100% lossThe time premium approaches zero as the expiration date approaches
54 Trading in OptionsOptions can be bought and sold at any time prior to expirationChicago Board Options Exchange (CBOE)Price volatility in the options marketAs the underlying stock’s price changes, the option’s price changes by a greater relative movement due to the option’s lower priceOptions are rarely exercised before expirationIf the price of a call option is not expected to increase, the option is sold, not exercised
55 Writing OptionsPeople write options for the premium income, hoping that the option will never be exercisedOption writers give up what option buyers makeCovered option — writer owns underlying stockNaked option — writer does not own the underlying stock
56 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: $30Strike price of the three-month call: $25Market price of the option: $8a. 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.
57 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 valued. 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.
58 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.
59 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.
60 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.
61 Put OptionsOption to sell stock at a specified price by a specified datePut buyer profits if underlying stock declinesIntrinsic 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
64 Option Pricing ModelsOption pricing model is more difficult than pricing models for stocks and bondsFischer Black and Myron Scholes developed the Black-Scholes Option Pricing ModelDetermines option’s price based onPrice of underlying stockStrike price of optionTime remaining until expiration of optionVolatility of underlying stock’s market priceRisk-free interest rate
65 WarrantsOptionsTrade between investors, not between the companies that issue the underlying stocksSecondary market instrumentsWarrantsIssued by underlying companyWhen exercised – new stock is issued and company receives the exercise pricePrimary market instruments while options are secondary market instruments
66 WarrantsSimilar 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
67 Employee Stock Options More like warrants than traded optionsExpire after several yearsStrike price set far out of the moneyMay receive options instead of salary increasesWanted if future expectations are goodCompanies offering options may pay lower salaries
68 Employee Stock Options Executive Stock Option ProblemSenior executives may receive most of the stock optionsProvide an incentive for executives to misstate financial statements and inflate stock prices