Chapter 7 Stocks, Stock Valuation, and Stock Market Equilibrium

Background on Stock A stock is a certificate representing partial ownership in a corporation Stock is issued by firms to obtain long-term funds Owners of stock: Can benefit from the growth in the value of the firm Are susceptible to large losses Individuals and financial institutions are common purchasers of stock The primary market enables corporations to issue new stock The secondary market creates liquidity for investors who invest in stock Some corporations distribute earnings to investors in the form of dividends

Background on Stock (cont’d) Ownership and voting rights The owners are permitted to vote on key matters concerning the firm: Election of the board of directors Authorization to issue new shares Approval of amendments to the corporate charter Adoption of bylaws Voting is often accomplished by proxy Management typically receives the majority of the votes and can elect its own candidates as directors

Background on Stock (cont’d) Preferred stock Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred dividends have been paid Preferred stock is less risky because dividends on preferred stock can be omitted Preferred stock is a less desirable source of funds than bonds because: Dividends are not tax deductible Investors must be enticed to purchase the preferred stock since dividends do not legally have to be paid

Background on Stock (cont’d) Issuers participating in stock markets The ownership feature attracts many investors who want to have an equity interest but do not necessarily want to manage their own firm A firm issuing stock for the first time engages in an IPO If a firm issues additional stock after the IPO, it engages in a secondary offering

Initial Public Offerings An IPO is a first-time offering of shares by a specific firm to the public Usually, a growing firm first obtains private equity funding from VC firms An IPO is used to obtain new funding and to offer VC firms a way to cash in their investment Many VC firms sell their shares in the secondary market between 6 and 24 months after the IPO

Initial Public Offerings (cont’d) Going public An investment banking firm normally serves as the lead underwriter for the IPO Developing a prospectus The issuing firm develops a prospectus and files it with the SEC The prospectus contains detailed information about the firm and includes financial statements and a discussion of risks The prospectus is intended to provide investors with the information they need to decide whether to invest in the firm Once approved by the SEC, the prospectus is sent to institutional investors Underwriters and managers meet with institutional investors in the form of a “road show”

Initial Public Offerings (cont’d) Going public (cont’d) Pricing The offer price is determined by the lead underwriter During the road show, the number of shares demanded at various prices is assessed Bookbuilding In some countries, an auction process is used for IPOs Transaction costs The issuing firm typically pays 7 percent of the funds raised The lead underwriter typically forms a syndicate with other firms who receive a portion of the transaction costs

Initial Public Offerings (cont’d) Underwriter efforts to ensure price stability The lead underwriter’s performance can be measured by the movement in the IPO shares following the IPO If stocks placed by a securities firm perform poorly, investors may no longer purchase shares underwritten by that firm The underwriter may require a lockup provision Prevents the original owners from selling shares for a specified period Prevents downward pressure When the lockup period expires, the share price commonly declines significantly

Initial Public Offerings (cont’d) IPO Timing IPOs tend to occur more frequently during bullish stock markets Prices are typically higher In the 2000–2001 period, many firms withdrew their IPO plans Initial returns of IPOs First-day return averaged about 20 percent over the last 30 years In 1998, the mean one-day return for Internet stocks was 84 percent Most IPO shares are offered to institutional investors About 2 percent of IPO shares are offered as allotments to brokerage firms

Initial Public Offerings (cont’d) Abuses in the IPO market In 2003, regulators attempted to impose new guidelines that would prevent abuses Spinning is the process in which an investment bank allocated IPO shares to executives requiring the help of an investment bank Laddering involves increasing the price above the offer price on the first day of issue in response to substantial demand Excessive commissions are sometimes charged by brokers when there is substantial demand for the IPO

Initial Public Offerings (cont’d) Long-term performance following IPOs IPOs perform poorly on average over a period of a year or longer Many IPOs are overpriced at the time of issue Investors may be overly optimistic about the firm Managers may spend excessively and be less efficient with the firm’s funds than they were before the IPO

Secondary Stock Offerings A secondary stock offering is: A new stock offering by a firm whose stock is already publicly traded Undertaken to raise more equity to expand operations Usually facilitated by a securities firm In the late 1990s, the volume of publicly placed stock increased substantially From 2000 to 2002, the volume of publicly placed stock declined as a result of the weak economy Existing shareholders often have the preemptive right to purchase newly-issued stock

Secondary Stock Offerings (cont’d) Shelf-registration A corporation can fulfill SEC requirements up to two years before issuing new securities Allows firms quick access to funds Potential purchasers must realize that information disclosed in the registration is not continually updated

Copyright © 2014 by Nelson Education Ltd.

Basic Valuation The (market) value of any investment asset is simply the present value of expected cash flows. The interest rate that these cash flows are discounted at is called the asset’s required return. The higher expected cash flows, the greater the asset’s value. It makes sense that an investor is willing to pay (invest) some amount today to receive future benefits (cash flows).

Basic Valuation Model V0 = CF1 + CF2 + … + CFn (1 + k)1 (1 + k)2 (1 + k)n Where: V0 = value of the asset at time zero CFt = cash flow expected at the end of year t k = appropriate required return (discount rate) n = relevant time period

Common Stock Valuation If an investor buys a share of stock, it is expected to receive cash in two ways The company pays dividends The investor sell shares, either to another investor in the market or back to the company As with bonds, the price of the stock is the present value of these expected cash flows

Common Stock Valuation - Example Suppose an investor is thinking of purchasing the stock of Moore Oil, Inc. and he expects it to pay a €2 dividend in one year, and he believes that he can sell the stock for €14 at that time. If he requires a return of 20% on investments of this risk, what is the maximum he would be willing to pay? Solution: Compute the PV of the expected cash flows Price = (14 + 2) / (1.2) = €13.33 Now what if he decides to hold the stock for two years? In addition to the dividend in one year, he expects a dividend of €2.10 in and a stock price of €14.70 at the end of year 2. Now how much would he be willing to pay? Solution: PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

Developing the valuation model The price of the stock is just the present value of all expected future dividends = dividends future expected of PV P ˆ V stock Value s ¥ + = ) k (1 D ˆ s 2 1 L

Stock Valuation Models The Zero Growth Model The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

The Zero Growth Model

Stock Valuation Models The Constant Growth Model The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year -- year after year.

The Constant Growth Model

If g = -6%, Would Anyone Buy the Stock? If So, at What Price? Firm still has earnings and still pays dividends, so P0 > 0: ^ = = = $9.89 $2.00(0.94) 0.13 – (-0.06) $1.88 0.19 P0 = ^ D0(1+g) rs – g = D1

Dividend and Earnings Growth Growth in dividends occurs primarily as a result of growth in EPS. Earnings growth results from a number of factors: (1) inflation, (2) reinvested profit, and (3) ROE. Firms cannot increase stock price by just raising the current dividend. There is a tradeoff between current dividends and future dividends.

Long-Term or Short-Term If most of a stock’s value is due to long-term cash flows, why do so many managers focus on quarterly earnings? Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes managers have bonuses tied to quarterly earnings.

Maturity Companies The constant growth model is often appropriate for mature companies. The growth rate is generally expected to be at about the rate of GDP growth. A zero growth stock can be valued by setting g = 0, that is, P0 = ^ D0(1+0) rs - 0 = D0 rs

What Happens if g > RS? ^ D0(1+g)1 D0(1+g)2 D0(1+rs)∞ P0 = +…+ + (1+rs)1 (1+rs)2 (1+rs)∞ (1+g)t ^ If g > rs, then > 1, and P0 = ∞ (1+rs)t So g must be less than rs to use the constant growth model.

Stock Price Volatility Are volatile stock prices consistent with rational pricing? Small changes in expected g and rs cause large changes in stock prices. As new information arrives, investors continually update their estimates of g and rs. If stock prices are not volatile, then this means there is not a good flow of information. Copyright © 2014 by Nelson Education Ltd.

Stock Market Equilibrium Copyright © 2014 by Nelson Education Ltd. Stock Market Equilibrium In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. 25

In Equilibrium, Expected Returns Must Equal Required Returns: Copyright © 2014 by Nelson Education Ltd. In Equilibrium, Expected Returns Must Equal Required Returns: rs = D1/P0 + g = rs = rRF + (rM – rRF)b ^ 25

How is Equilibrium Established? Copyright © 2014 by Nelson Education Ltd. How is Equilibrium Established? If rs = + g > rs, then P0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders; the price will be bid up until: D1/P0 + g = rs = rs ^ D1 P0 26

The Efficient Markets Hypothesis Weak form efficiency—past price information is contained in current prices Semistrong form efficiency—publicly available information is contained in current prices Strong form efficiency—all information, public and private, is contained in current prices

Markets are Generally Efficient Because: Copyright © 2014 by Nelson Education Ltd. Markets are Generally Efficient Because: 100,000 or so trained analysts––MBAs, CFAs, and PhDs––work for firms like Fidelity, Merrill, Morgan, and Prudential. These analysts have similar access to data and megabucks to invest. Thus, news is reflected in P0 almost instantaneously. 32