1. Chapter 7
Stocks, Stock Valuation, and
Stock Market Equilibrium

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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”

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

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17. 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).

18. Basic Valuation Model V0 = CF1 + CF2 + … + CFn
(1 + k) (1 + k) (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

19. 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

20. 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) + ( ) / (1.2)2 = 13.33

21. 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

22. 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.

23. The Zero Growth Model

24. 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.

25. The Constant Growth Model

26. 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

27. 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.

28. 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.

29. 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

30. 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.

31. 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.
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32. Stock Market Equilibrium
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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

33. In Equilibrium, Expected Returns Must Equal Required Returns:
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In Equilibrium, Expected Returns Must Equal Required Returns:
rs = D1/P0 + g = rs = rRF + (rM – rRF)b ^ 25

34. How is Equilibrium Established?
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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

35. 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

36. Markets are Generally Efficient Because:
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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