1. PowerPoint Presentation prepared by Traven Reed Canadore College

2. chapter 8 Stocks, Stock Valuation, and Stock Equilibrium

3. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-3 Corporate Valuation and Stock Risk

4. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-4 Topics in Chapter Features of common stock Determining common stock values Efficient markets Preferred stock

5. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-5 Common Stock: Owners, Directors, and Managers Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Managers are “agents” of shareholders, they always solicit shareholders’ proxies and usually succeed.

6. CH8 Control of the Firm Shareholders often have the right (i.e. preemptive right) to purchase any additional shares sold by the firm This preemptive right protects the control of the present shareholders and also prevents dilution of their value The preemptive right makes it more difficult to raise equity capital from new large shareholders Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-6

7. CH8 Types of Common Stock Not all common shares are created equally Most firms have only one type of common stock A system of dual-class shares is used to meet the special needs of the company Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-7

8. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-8 Classified 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.

9. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-9 Stock Market Reporting In the past, tracking stock is through the business section of a daily newspaper. Today, we can get quotes all during the day from a wide variety of Internet sources (e.g. Globeinvestor.com). Comparing with once a day from the newspaper prints, the 20-minute delay with the Internet information is nothing. The quote provides the price a buyer would have to pay (“Ask”) and the price someone can sell the stock (“Bid”) for.

10. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-10 Different Approaches for Valuing Common Stock Most stock’s expected total return = dividend yield + capital gains yield Intrinsic value of a stock is the present value of its expected future cash flow stream –Dividend growth model –Free cash flow approach –Using the multiples of comparable firms

11. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-11 Stock Value = PV of expected future dividends What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g. P 0 = ^ (1+r s ) 1 (1+r s ) 2 (1+r s ) 3 (1+r s ) ∞ D 1 D 2 D 3 D ∞ + ++…+

12. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-12 For a constant growth stock: D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D 0 (1+g) t If g is constant and less than r s, then: P 0 = ^D 0 (1+g) r s - g = D1D1 Use decimals, not % in the calculation

13. CH8 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-13

14. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-14 Intrinsic Stock Value vs. Quarterly Earnings 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.

15. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-15 Dividend Growth and PV of Dividends: P 0 = ∑(PVof D t ) $ 0.25 Years (t) D t = D 0 (1 + g) t PV of D t = DtDt (1 + r S ) t If g > r s, P 0 = ∞ !

16. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-16 What happens if g > r s ? P 0 = ^ (1+r s ) 1 (1+r s ) 2 (1+r s ) ∞ D 0 (1+g) 1 D 0 (1+g) 2 D 0 (1+r s ) ∞ + +…+ (1+g) t (1+r s ) t If g > r s, then P 0 = ∞ ^ > 1, and So g must be less than r s to use the constant growth model.

17. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-17 Projected Dividends D 0 = $2 and constant g = 6% = 0.06 D 1 = D 0 (1+g) = 2(1.06) = $2.12 D 2 = D 1 (1+g) = 2.12(1.06) = $2.2472 D 3 = D 2 (1+g) = 2.2472(1.06) = $2.3820

18. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-18 Expected Dividends and PVs (r s = 13%, D 0 = $2, g = 6%) 01 2.2472 2 2.3820 3 g=6% 4 1.8761 1.7599 1.6508 13 % 2.12

19. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-19 Intrinsic Stock Value: D 0 = $2.00, r s = 13%, g = 6% Constant growth model: = = $30.29 0.13 - 0.06 $2.12 0.07 P 0 = ^D 0 (1+g) r s - g = D1D1

20. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-20 Expected value one year from now: D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. P 1 = ^ D2D2 r s - g = $2.2427 0.07 = $32.10 = $30.29(1+0.06)

21. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-21 Expected Dividend Yield and Capital Gains Yield (Year 1) Dividend yield = = = 7.0% $2.12 $30.29 D1D1 P0P0 CG Yield = = P 1 - P 0 ^ P0P0 $32.10 - $30.29 $30.29 = 6.0%

22. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-22 Total Year-1 Return Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13% Total return = 13% = r s For constant growth stock: – Capital gains yield = 6% = g

23. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-23 Expected Rate of Return on a Constant Growth Stock Then, r s = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13% ^ P 0 = ^ D1D1 r s - g to D1D1 P0P0 rsrs ^ = + g

24. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-24 If g = 0, the dividend stream is a perpetuity 2.00 0123 r s =13% P 0 = = = $15.38 PMT r $2.00 0.13 ^

25. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-25 Supernormal (Non-constant) 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.

26. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-26 Nonconstant growth followed by constant growth (D 0 = $2): 0 2.3009 2.6470 3.0453 46.1135 1234 r s =13% 54.1067 = P 0 g = 30% g = 6% 2.603.38 4.394 4.6576 ^ P 3 = ^ $4.6576 0.13 – 0.06 = $66.5371

27. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-27 Dividend Growth Rates

28. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-28 Suppose g = 0 for t = 1 to 3, and then g is a constant 6% 0 1.7699 1.5663 1.3861 20.9895 1234 r s =13% 25.7118 g = 0% g = 6% 2.00 2.00 2.00 2.12 2.12  P 3 0.07 30.2857 

29. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-29 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0: ^ = = = $9.89 $2.00(0.94) 0.13 - (-0.06) $1.88 0.19 P 0 = ^ D 0 (1+g) r s - g = D1D1

30. CH8 Stock Valuation: FCF Approach Firm value is the present value of its future expected free cash flows (FCF) discounted at the WACC. Since PV (FCF) is the present value of a growing annuity, we have Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-30

31. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-31 Using Stock Price Multiples to Estimate Stock Price Analysts often use the P/E multiple (the price per share divided by the earnings per share). Example: –Estimate the average P/E ratio of comparable firms. This is the P/E multiple. –Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.

32. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-32 Using Entity Multiples The entity value (V) is: –the market value of equity (# shares of stock multiplied by the price per share) –plus the value of debt. Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example, –V/EBITDA –V/Customers

33. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-33 Using Entity Multiples (cont’d) Find the entity value of the firm in question. For example, –Multiply the firm’s sales by the V/Sales multiple. –Multiply the firm’s # of customers by the V/Customers ratio The result is the total value of the firm. Subtract the firm’s debt to get the total value of equity. Divide by the number of shares to get the price per share.

34. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-34 Problems with Market Multiple Methods It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range. –For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?

35. CH8 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. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-35

36. CH8 Preferred Stock Valuation Similar to the valuation of perpetual bonds A preferred stock pays a quarterly dividend of $1.25 ($5 per year) with a required return of10%. Its value is Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-36

37. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-37 Expected return: given V ps = $50 and annual dividend = $5 V ps = $50 = $5 r ps ^ $5 $50 ^ = = 0.10 = 10.0%

38. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-38 Stock Price Volatility for changes in r S and g Are volatile stock prices consistent with rationing pricing? Small changes in expected g and r s cause large changes in stock prices. As new information arrives, investors continually update their estimates of g and r s. If stock prices are not volatile, then this means there is not a good flow of information.

39. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-39 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.

40. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-40 r s = D 1 /P 0 + g = r s = r RF + (r M - r RF )b ^ In equilibrium, expected returns must equal required returns:

41. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-41 If r s = + g > r s, then P 0 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: D 1 /P 0 + g = r s = r s ^ ^ D1P0D1P0 ^ How is equilibrium established?

42. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-42 Efficient Market Hypothesis Securities are normally in equilibrium and are “fairly priced.” Investors cannot “beat the market” except through good luck or inside information. The prices of securities fully reflect available information. They will adjust immediately to any new development.

43. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-43 Weak-form EMH Investors buying bonds and stocks cannot 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.

44. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-44 Semistrong-form EMH All publicly available information is reflected in stock prices, so it does not pay to pore over annual reports looking for undervalued stocks. Largely true.

45. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-45 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 is illegal!

46. CH8 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 8-46 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 P 0 almost instantaneously.