CHAPTER 8 Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock

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

Types of stock market transactions Secondary market Primary market Initial public offering market (“going public”)

Different approaches for valuing common stock Dividend growth model Corporate value model Using the multiples of comparable firms

Terms used in stock valuation Dt = Dividend expected to receive at the end of year t. Po = Actual market price of the stock today = Expected price of the stock at the end of year t =Intrinsic or theoretical value

Terms used in stock valuation g= Expected growth rate in dividends. = Required rate of return = Expected rate of return = Actual or realized rate of return D1/P0 =Dividend Yield during the coming year (P1-P0)/P0 = Capital Gain Yield.

Dividend growth model Value of a stock is the present value of the future dividends expected to be generated by the stock.

Constant growth stock 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 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

If kRF = 7%, kM = 12%, and β = 1.2, what is the required rate of return on the firm’s stock? Use the CAPM to calculate the required rate of return (ks): ks = kRF + (kM – kRF)β = 7% + (12% - 7%)1.2 = 13%

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs. 1 2.247 2 2.382 3 2.12 ks = 13% g = 6% 1.8761 1.7599 D0 = 2.00 1.6509

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 would the expected price today be, if g = 0? The dividend stream would be a perpetuity. 2.00 1 2 3 ks = 13% ...

Self testing:1 Cook company is expected to pay a $0.50 per share dividend at the end of the year. The dividend is expected to grow at a constant rate of 7% per year. The required rate of return on the stock,Ks, is 15%. What is the value per share of the company’s stock?

Self testing:2 Dozier Corporation’s share currently sell for $20 per share. The stock just paid a dividend of $1 per share. The dividend is expected to grow at a constant rate of 10% a year. What stock price is expected 1 year from now? What is the required rate of return on the company’s stock?

Supernormal/Nonconstant growth: What if D0 = $2 & g = 30% for 3 years before achieving long-run growth of 6%? Can no longer use just the constant growth model to find stock value. However, the growth does become constant after 3 years.

Valuing common stock with nonconstant growth 1 2 3 4 D0 = 2.00 2.600 3.380 4.394 ... 4.658 ks = 13% g = 30% g = 6% 2.301 2.647 3.045 46.114 54.107 = P0 = 0.06 $66.54 3 4.658 0.13 - $ P ^

Find expected dividend and capital gains yields during the first and fourth years. Dividend yield (first year) = $2.60 / $54.11 = 4.81% Capital gains yield (first year) = 13.00% - 4.81% = 8.19% During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ≠ g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

Nonconstant growth: What if g = 0% for 3 years before long-run growth of 6%? 1 2 3 4 D0 = 2.00 2.00 2.00 2.00 ... 2.12 ks = 13% g = 0% g = 6% 1.77 1.57 1.39 20.99 25.72 = P0 ^ 0.06 $ $30.29 P 3 2.12 0.13 = -

Dividend yield (first year) Capital gains yield (first year) Find expected dividend and capital gains yields during the first and fourth years. Dividend yield (first year) = $2.00 / $25.72 = 7.78% Capital gains yield (first year) = 13.00% - 7.78% = 5.22% After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.

If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value? The firm still has earnings and pays dividends, even though they may be declining, they still have value.

Find expected annual dividend and capital gains yields. Dividend yield D1 / P0 = $1.88/$9.89 = 19.00% Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.

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. Free cash flow is the firm’s after-tax operating income less the net capital investment FCF = NOPAT – Net capital investment

Issues regarding the corporate value model Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast. Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. Terminal value (TVn) represents value of firm at the point that growth becomes constant.

Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm’s intrinsic value. 21.20 1 2 3 4 -5 10 20 ... g = 6% k = 10% 416.942 -4.545 8.264 15.026 398.197 21.20 530 = = TV3 0.10 0.06 -

What is market equilibrium? In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. In equilibrium, expected returns must equal required returns.

Market equilibrium Expected returns are obtained by estimating dividends and expected capital gains. Required returns are obtained by estimating risk and applying the CAPM.

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

Weak-form efficiency The weak form of the EMH states that all information contained in past price movements is fully reflected in current market prices.

Semistrong-form efficiency The semistrong-form of the EMH states that current market prices reflect all publicly available information.

Strong-form efficiency The strong form of the EMH states that current market prices reflect all related information, whether publicly available or privately held.

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.

If a 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%