Chapter 8: Stocks and Their Valuation. 1

Stocks and Their Valuation.

Chapter Outline: Common Stock Valuation. Preferred Stock. Features of Common Stock. Common Stock Valuation. Preferred Stock.

Features of Common Stock: Facts about common stock. Legal Rights and Privileges of Common Stockholders. Types of Common Stock. The Market for Common Stock.

Facts about common stock: Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock price

Legal Rights and Privileges of Common Stockholders: Control of the Firm. Voting Rights Preemptive rights Right of access to meeting minutes and lists of existing shareholders Right to vote on issues that affect the firm’s property as a whole

Legal Rights and Privileges of Common Stockholders: Proxy. Proxy Fight. Takeover.

Types of Common Stock: Classified stock has special provisions. Could classify existing stock as founders’ shares, with voting rights but dividend restrictions. New shares might be called “Class A” shares, with voting restrictions but full dividend rights.

Types of Common Stock: Classified Stock. Founders Shares.

The Market for Common Stock: Closely Held Corporation. Publicly Owned Corporation. Secondary market. Primary market. going public. Initial public offering market (IPO).

Common Stock Valuation: Dividend Growth Model. Corporate Value Model. Using the Multiples of Comparable Firms.

Dividend Growth Model: Expected Dividends as the Basis for Stock Values. Stock Values with Zero Growth. Normal, or Constant, Growth (Gordon Model). Expected Rate of Return on a Constant Growth Stock. Valuing Stocks with Nonconstant Growth.

Expected Dividends as the Basis for Stock Values: If you hold a stock forever, all you receive is the dividend payments. The value of the stock today is the present value of the future dividend payments.

Expected Dividends as the Basis for Stock Values:

Stock Values with Zero Growth: A Zero Growth Stock is a common stock whose future dividends are not expected to grow at all.

Constant Growth Stock (Gordon Model): A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t If g is constant, the dividend growth formula converges to:

What is the stock’s market value? Using the constant growth model:

What is the expected market price of the stock, one year from now? D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc. Could also find expected P1 as:

What is the expected dividend yield, capital gains yield, and total return during the first year? = D1 / P0 = $2.12 / $30.29 = 7.0% Capital gains yield = (P1 – P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0% Total return (ks) = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

What happens if g > ks? If g > ks, the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if: ks > g g is expected to be constant forever

Expected Rate of Return on a Constant Growth Stock: Dividend yield Expected growth rate, or capital gains yield

Valuing Stocks with Nonconstant Growth: Nonconstant Growth: The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole.

Valuing Stocks with Nonconstant Growth: Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends, Find the price of the stock at the end of the nonconstant growth period, at which time it has become a constant growth stock, and discount this price back to the present, and Add these two components to find the intrinsic value of the stock P0.

Corporate Value Model: Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. Remember, free cash flow is the firm’s after-tax operating income less the net capital investment FCF = NOPAT – Net capital investment

Firm Multiples Method: Analysts often use the following multiples to value stocks. P / E P / CF P / Sales

Factors that affect stock price: Required return (ks) could change Changing inflation could cause kRF to change Market risk premium or exposure to market risk (β) could change Growth rate (g) could change Due to economic (market) conditions Due to firm conditions

What is the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are “fairly priced.” Investors cannot “beat the market” except through good luck or better information. Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

Preferred Stock: Hybrid security Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

Preferred Stock: If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? Vp = D / kp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%

The End of The Course.