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Chapter 8 - The Valuation and Characteristics of Stock

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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 2

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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 P 0, hold it for one year, receive a dividend of D 1, then sell it for price P 1, you return, k, would be : 3 A capital gain (loss) occurs if you sell the stock for a price greater (lower) than you paid for it.

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The Return on an Investment in Common Stock Solve the previous equation for P0, the stock’s price today: 4

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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, P 0

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Figure 8-1 Cash Flow Time Line for Stock Valuation 6

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The Nature of Cash Flows from Stock Ownership –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 When selling, investor receives money from another investor –For bondholders: Interest payments are guaranteed, constant Maturity value is fixed At maturity, the investor receives face value from the issuing company. 7 Comparison of Cash Flows from Stocks and Bonds

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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 8

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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?

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Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows 10 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.

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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

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Growth Models of Common Stock Valuation Based on predicted growth rates since forecasting exact future prices and dividends is difficult More likely to forecast a growth rate of earnings rather than cash flows 12

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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 sold 13 An Infinite Stream of Dividends Many investors buy a stock, hold for awhile, then sell, as represented in the above equation

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Developing Growth-Based Models A person who buys stock at time n will hold it until period m and then sell it –Their valuation will look like this: 14 Repeating this process until infinity results in:

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The Constant Growth Model If dividends are assumed to be growing at a constant rate forever and the last dividend paid is, D 0, then the model is: 15 This represents a series of fractions as follows If k>g, the fractions get smaller (approach zero) as exponents get larger

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Constant Normal Growth The Gordon Model Constant growth model can be simplified to 16 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

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Concept Connection Example 8-3 Constant Normal Growth - The Gordon Model 17 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?

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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 same Gordon model simplifies to: 18 A zero growth stock is a perpetuity to the investor

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The Expected Return Recast Gordon model to focus on the return (k) implied by the constant growth assumption 19 The expected return reflects investors’ knowledge of a company If we know D 0 (most recent dividend paid) and P 0 (current actual stock price), investors’ expectations are input via the growth rate assumption

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Two Stage Growth At times, a firm’s future growth 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

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Figure 8-2 Two Stage Growth Model 21

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Concept Connection Example 8-5 Valuation Based on Two Stage Growth 22 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.

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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?

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Concept Connection Example 8-5 Valuation Based on Two Stage Growth D 1 = D 0 (1+g 1 ) = $2.00(1.20) = $2.40 D 2 = D 1 (1+g 1 ) = $2.40(1.20) = $2.88 D 3 = D 2 (1+g 2 ) = $2.88(1.06) = $3.05

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Concept Connection Example 8-5 Valuation Based on Two Stage Growth 25 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 : 6%$ %$ %$2.401 Growth Expected DividendYear

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Concept Connection Example 8-5 Valuation Based on Two Stage Growth 26 Then we take the present value of D 1, D 2 and P 2 : 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.

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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

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Practical Limitations of Pricing Models Comparison to Bond Valuation Bond 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 Dividends Have value because of expectation that they will someday pay them. Some firms don’t pay dividends even if they are profitable –Firms are growing and using profits to finance the growth 28

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Valuing New Stocks Investment Banking and The Initial Public Offering (IPO) IPOs are the first public sales of a new company stocks

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IPO Process Investment Banking Syndication Registration Underwriting Best Efforts

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Promoting and Pricing the IPO Quiet Period Book Building and the Road Show Ends before the IPO date

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Prices After the IPO The Investment Bank in the Middle Underpricing and IPO Pops A little Big Pop History POP Strategies Market Stabilization

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Insights – Practical Finance Facebook’s IPO Most anticipated IPO in history NASDAQ trading issues Fourth largest IPO in history

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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 –Board consists of top managers and outside directors (may include major stockholders) –In widely held corporations, top management in “control” 34

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Some Institutional Characteristics of Common Stock Preemptive Rights –Allows stockholders to maintain a proportionate share of ownership –If firm issues new shares, existing shareholders can purchase pro rata share of new issue 35

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Voting Rights and Issues Each share of common stock has one vote –Vote for directors and other issues at the annual stockholders’ meeting –Vote usually cast by proxy 36

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Majority and Cumulative Voting Majority Voting gives the larger group control of the company Cumulative Voting gives minority interest a chance at some representation on the board 37 Shares With Different Voting Rights Different classes of stock can be issued different rights Some stock may be issued with limited or no voting rights

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Stockholders’ Claim on Income And Assets Stockholders have a residual claim on income and assets What 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 38

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Preferred Stock A hybrid security with characteristics of common stock and bonds –Pays a constant dividend forever –Specifies the initial selling price and the dividend –No provision for the return of capital to the investor 39

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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. 40

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Concept Connection Example 8-6 Pricing Preferred Stock 41 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:

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Characteristics of Preferred Stock Cumulative Feature - can’t pay common dividends unless cumulative preferred dividends are current Never returns principal Stockholders cannot force bankruptcy Receives preferential treatment over common stock in bankruptcy No voting rights Dividend payments not tax deductible to the firm 42

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Securities Analysis The art and science of selecting investments Fundamental analysis looks at a company’s business to forecast value Technical analysis bases value on the pattern of past prices and volume The Efficient Market Hypothesis (EMH) - financial markets are efficient since new information is instantly disseminated 43

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Options and Warrants Options Gives the holder the temporary right to buy or sell an asset at a fixed price Speculate on price changes without holding the asset Warrants Similar but less common 44 Options and warrants make it possible to invest in stocks without holding shares

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Stock Options Stock options speculate on stock price movements Trade in financial markets Call option — option to buy Put option — option to sell Options are Derivative Securities –Derive value from prices of underlying securities –Provide leverage – amplifying returns 45

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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 period –Once expired, it can’t be exercised –Option price < price of the underlying stock 46

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Figure 8-3 Basic Call Option Concepts 47

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Call Options The more volatile the stock’s price, the more attractive the option –Stock’s price more likely to exceed the strike price before the option expires The longer the time until expiration the more attractive the option –The stock’s price is more likely to exceed the strike price before the option expires 48

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The Call Option Writer The option writer originates the contract The original writer must stand ready to deliver on the contract regardless of how many times the option is sold Call writer hopes stock price will remain stable or not rise 49

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Intrinsic Value Intrinsic value of a call is the difference between the underlying stock’s current price and the option’s strike price If out-of-the-money, intrinsic value is zero Option always sells for intrinsic value or above –Time premium - difference between option’s intrinsic value and price 50

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Figure 8-4 The Value of a Call Option 51

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Options and Leverage Financial leverage – magnifies return on investment Options offer leverage due to the lower price at which the option can be purchased when compared to the price of the underlying stock 52

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Options that Expire Options are worthless at expiration –Risky because they expire after a short time If the price of an out-of-the-money option does not exceed the strike price prior to expiration, the option expires and is worthless –Results in a 100% loss The time premium approaches zero as the expiration date approaches 53

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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

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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

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Concept Connection Example 8-7 Stock Options 56 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.

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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.

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Concept Connection Example 8-7 Stock Options 58 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.

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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.

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Concept Connection Example 8-7 Stock Options 60 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.

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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

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Figure 8-5 Basic Put Option Concepts 62

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Figure 8-6 The Value of a Put Option 63

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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

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Warrants Options –Trade between investors, not between the companies that issue the underlying stocks –Secondary market instruments Warrants –Issued by underlying company –When exercised – new stock is issued and company receives the exercise price –Primary market instruments while options are secondary market instruments 65

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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

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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

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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

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