Ch 5. Basic Stock Valuation

1. Legal rights and privileges of common stock holders. Shareholders → Directors → Managers. One stock generally represents one vote. Directors usually have three year terms. Proxy: transferring a voting right to others. Preemptive right: right to purchase any additional shares sold by the firms. 2. Types of common stocks -Common stocks: voting right and dividend. -Classified stocks: various voting right and dividend payment. They do not have standards. (e.g) GM developed class H stock called tracking (target) stock. It has a limited voting right and its dividend payment is linked to the performance of a subsidiary.

3. Market for common stocks - Initial Public Offering (IPO) market: Closely held corporations or private firms place the stocks for the first time. Then they turn into public corporations. - Primary market: Additional stocks are placed by public corporations. - Secondary market: already outstanding shares are traded.

4. Stock Valuation Cash flow patterns from holding a stock: Dividend payment & Capital gains Basic starting formula:

As shown before, stock prices mainly rely on the dividend payments. And depending on the patterns of dividend payments, we can come up with three types of stock pricing models. 1) Constant growth model (Gordon Model) It assumes that dividend payments grow by g% every time.

Growth in dividends occurs as a result of growth in EPS. More than 80% of the stock price is due to cash flows expected more than 5 years in the future. Earnings report implies the chance of cash flow growth. It is appropriate for mature companies with stable growth. Expected rate of return = expected dividend yield + expected growth rate or capital gains yield.

2) zero growth model It assumes that dividend payment is constant. P= D/k It is used to evaluate the price of a preferred stock 3) non-constant growth (supernormal) model. It assumes no consistent patterns of dividend payments. using horizontal (HV) or terminal value (TV) that comes from constant growth or zero growth formula, converting unlimited cash flows to limited cash flows.

4) Free cash flows approach Free cash flow (FCF): cash flow available for distribution to all of the firm’s investors, not just the shareholders. Using FCF, estimate total value and then stock price.

5) Market multiple analysis Estimating stock price, using financial or accounting ratios of industry or benchmarking companies. E.g) P/E*EPS = price Total value /EBITDA *EBTDA = total value.

6) Stock market equilibrium. Required rate of return from CAPM Expected rate of return If Required rate of return > (<) expected return, investor would sell (buy) stocks, lowering (increasing) the price. It would happen up to equilibrium (=). Two conditions are held In equilibrium: (1) the market price would be set in order to make the required rate of return equal to the expected rate of return. (2) market price = intrinsic value.

7. Volatility Stock price tends to fluctuate due to new information. Volatility indicates that as more new piece of information about the situation becomes available, the market adjusts to them.

8. Market Efficiency The hypothesis that securities are typically in equilibrium - that they are fairly priced in the sense that the price reflects all publicly available information on each security (1) weak-form efficiency All information contained in past price movements is fully reflected in current market prices. Chartist and technician can’t make money (2) Semi-strong form efficiency The current market prices reflect all publicly available information. Trades based on the annual reports and other published information can’t generate any profit. Investors are expected to earn the returns predicted by the SML

(3) Strong-form efficiency The current market prices reflect all pertinent information, where publicly available or privately held. Even insiders can’t generate profits (4) Stock price reporting: page 159