Copyright © 2003 South-Western/Thomson Learning All rights reserved. Chapter 9 The Valuation of Common Stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Investing in Stock Acquiring ownership in a corporation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Corporations Formed by a state Certificate of incorporation Charter - specifies the relation with the state Bylaws - specifies the relationship with stockholders

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rights of Stockholders Voting authority to elect a board of directors Cumulative voting Preemptive rights

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Source of Return Dividends Capital gains

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Sources of Return Difference in short and long-term capital gains taxation favor capital gains Transaction costs (e.g., commissions) favor dividend income

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Valuation The determination of what a stock is worth; the stock's intrinsic value If the price exceeds the valuation, buy the stock If the price is less than the valuation, short the stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. If the Dividend Is Fixed Valuation is V=D/k

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. If the Dividend Grows at a Constant Rate Valuation is V=D 0 (1+g)/(k - g)

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Dividend Growth Model Value depends on the –the required return –the dividend –the growth in the dividend

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Required Return (k) Depends on –the risk-free rate (r f ) –the return on the market (r m ) –the stock's beta

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Risk and Required Rate of Return

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Alternative Valuation Techniques A price-earnings multiple times earnings P=(m)(EPS)

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Weakness in the Use of P/E Ratios Different definitions of earnings Differences in estimated earnings Question of the appropriate multiple

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price to Book Value and Price to Sales Conceptually the same as using P/E ratios Same weaknesses apply

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The PEG Ratio Standardizes the P/E ratio for growth P/E Earnings growth Low PEG ratios (below 1.0) suggest undervaluation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Substitution of Cash Flow for Earnings and Dividends Emphasis on firm’s ability to generate cash May be applied when firm does not pay a dividend

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Substitution of Cash Flow for Earnings and Dividends May be applied if firm operates at a loss Value investing employs all of the alternative methods

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Efficient Market Hypothesis Hard to beat the market on a risk- adjusted basis consistently Earning a higher return is not necessarily outperforming the market Considering risk is also important

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Assumptions Concerning Efficient Markets Large number of competing participants Information is readily available Transaction costs are small

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk Another term for efficient markets Does not imply security prices are randomly determined Implies day-to-day price changes are random

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk Successive prices changes are independent Today's price does not forecast tomorrow's price Current price embodies all known information

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk New information must be random IF NOT An opportunity to earn an excess return would exist

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Undervaluation and Overvaluation Undervaluation drives prices up returns decline Overvaluation drives prices down returns increase

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Undervaluation and Overvaluation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk Prices change quickly to new information By the time most investors know the information the price change has already occurred

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Adjustments to New Information

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Degree of Market Efficiency The forms of the efficient market hypothesis: –the weak form –the semi-strong form –the strong form

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Degree of Market Efficiency Even if financial markets are efficient, that does not answer the question "How efficient?”

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Weak Form Studying past price and volume data will not lead to superior investment results While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior returns

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Semi-Strong Form Studying economic and accounting data will not lead to superior investment returns Studying inside information may lend to superior returns

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Strong Form Using inside information will not lead to superior investment returns

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Anomalies Empirical results generally support –the weak form –the semi-strong form Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Examples of Anomalies Low P/E stocks The small firm effect The January effect The neglected firm effect

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Examples of Anomalies The day-of-the-week effect The Value Line effect The overreaction effect Drifts in security prices

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Anomalies and Returns Empirical evidence of the existence of an anomaly, however, does not mean the individual can take advantage of the anomaly The anomaly can still exist and the market be effectively efficient from the individual investor's perspective

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Implications of Efficient Markets Security prices embody known information The playing field is level Specifying financial goals may be more important than seeking undervalued stocks

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Implications of Efficient Markets Other markets may not be efficient Importance of reducing transactions costs: the argument for a buy-and-hold strategy