1. Stocks, Stock Valuation, and Stock Market Equilibrium
CHAPTER 8
Stocks, Stock Valuation, and
Stock Market Equilibrium

2. Topics in Chapter Features of common stock
Determining common stock values
Efficient markets
Preferred stock 1

3. Common Stock: Owners, Directors, and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

4. Initial Public Offering (IPO)
A firm “goes public” through an IPO when the stock is first offered to the public.
Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.

5. Seasoned Equity Offering (SEO)
A seasoned equity offering occurs when a company with public stock issues additional shares.
After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.

6. Different Approaches for Valuing Common Stock
Dividend growth model
Using the multiples of comparable firms
Free cash flow method (covered in Chapter 15)

7. Stock Value = PV of Dividends^
(1+rs) (1+rs) (1+rs) (1+rs)∞
D D D D∞ +
+…+
What is a constant growth stock?
One whose dividends are expected to
grow forever at a constant rate, g.

8. For a constant growth stock:
D1 = D0(1+g)1
D2 = D0(1+g)2
Dt = D0(1+g)t
If g is constant and less than rs, then:
P0 = ^
D0(1+g)
rs - g = D1

9. What happens if g > rs?^
D0(1+g) D0(1+g) D0(1+rs)∞
P0 =
+…+ +
(1+rs) (1+rs) (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.

10. Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%.
Use the SML to calculate rs:
rs = rRF + (RPM)bFirm
= 7% + (5%) (1.2)
= 13%.

11. Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)1
2.2472 2
2.3820 3
g=6% 4
1.8761
1.7599
1.6508
13%
2.12 11

12. Intrinsic Stock Value: D0 = 2.00, rs = 13%, g = 6%.
Constant growth model:
P0 = ^
D0(1+g)
rs - g = D1
= = $30.29.
$2.12
0.07

13. Expected value one year from now:
D1 will have been paid, so expected dividends are D2, D3, D4 and so on.
P1 = ^ D2
rs - g =
$2.2427
0.07
= $32.10

14. Expected Dividend Yield and Capital Gains Yield (Year 1)
$2.12
$30.29 D1 P0
CG Yield = =
P1 - P0 ^
$ $30.29
= 6.0%. 14

15. Total Year-1 Return
Total return = Dividend yield + Capital gains yield.
Total return = 7% + 6% = 13%.
Total return = 13% = rs.
For constant growth stock:
Capital gains yield = 6% = g.

16. Rearrange model to rate of return form:
P0 = ^ D1
rs - g to P0 rs =
+ g.
Then, rs = $2.12/$
= = 13%. ^

17. If g = 0, the dividend stream is a perpetuity.
2.00 1 2 3
rs=13%
P0 = = = $15.38.
PMT r
$2.00
0.13 ^ 16

18. Supernormal Growth Stock
Supernormal growth of 30% for 3 years, and then long-run constant g = 6%.
Can no longer use constant growth model.
However, growth becomes constant after 3 years. 17

19. Nonconstant growth followed by constant growth (D0 = $2):
rs=13% 1 2 3 4
g = 30%
g = 30%
g = 30%
g = 6%
2.3009
2.6470
3.0453 ^
$4.6576
P3 =
= $
0.13 – 0.06 ^
= P0 18

20. Preferred Stock Hybrid security.
Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock.
However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy. 33

21. Expected return, given Vps = $50 and annual dividend = $5
= $50 = $5
rps ^
rps $5
$50 ^ =
= 0.10 = 10.0%

22. Why are stock prices volatile?^ D1
rs - g
rs = rRF + (RPM)bi could change.
Inflation expectations
Risk aversion
Company risk
g could change.

23. Consider the following situation.
D1 = $2, rs = 10%, and g = 5%:
P0 = D1 / (rs-g) = $2 / ( ) = $40.
What happens if rs or g change?

24. Stock Prices vs. Changes in rs and g4% 5% 6% 9%
40.00
50.00
66.67
10%
33.33
11%
28.57

25. 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 aren’t volatile, then this means there isn’t a good flow of information.

26. What is 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.
(More…) 25

27. In equilibrium, expected returns must equal required returns:
rs = D1/P0 + g = rs = rRF + (rM - rRF)b. ^ 25

28. 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

29. What’s the Efficient Market Hypothesis (EMH)?
Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information.
(More…) 28

30. Weak-form EMH
Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but “technical analysis” is still used. 29

31. Semistrong-form EMH
All publicly available information is reflected in stock prices, so it doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true. 30

32. Strong-form EMH
All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal. 31

33. 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