Unformatted text preview: Stocks and Their Valuation Stocks and Their Valuation
• Features of common • • •
stock Determining common stock values Efficient markets Preferred stock Facts about common stock Facts about common stock
• • • • •
Represents a share of ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock price Social/Ethical Question Social/Ethical Question
• Should management be equally concerned •
about employees, customers, suppliers, and “the public,” or just the stockholders? In an enterprise economy, management should work for stockholders subject to constraints (legal, environmental, fair hiring, etc.) and competition. Types of stock market Types of stock market transactions
• Secondary market: existing owners of stock sell to new owners. • Primary market: company issues more stock to the public. • Initial public offering market (“going public”): company’s first issue of stock to public. Different approaches for valuing Different approaches for valuing common stock
• Dividend growth model: present value of future dividends. • Corporate value model: present value of the firm’s future free cash flows. • Using the multiples of comparable firms: such as PE ratio. Dividend growth model Dividend growth model
• Value of a stock is the present value of the future dividends expected to be generated by the stock. D3 D1 D2 D∞ P0 = + + + ... + 1 2 3 ∞ (1 + k s ) (1 + k s ) (1 + k s ) (1 + k s )
^ Constant growth 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:
^ D0 (1 + g) D1 P0 = = k s g k s g What happens if g > ks? What happens if g > k
• 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 • Use the SML to calculate the required rate of return (ks): ks = kRF + (kM – kRF)β If kRF = 7%, kM = 12%, and β = 1.2, what If k is the required rate of return on the firm’s stock? = 7% + (12% 7%)1.2 = 13% If D0 = $2 and g is a constant 6%, find If D the expected dividend stream for the next 3 years, and their PVs. 0 g = 6% 1 2.12
ks = 13% 2 2.247 3 2.382 D0 = 2.00 1.8761 1.7599 1.6509 What is the stock’s market value? What is the stock’s market value?
• Using the constant growth model:
D1 $2.12 P0 = = k s g 0.13 0.06 $2.12 = 0.07 = $30.29 What is the expected market price of 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. ^ D2 $2.247 P = = 1 k s g 0.13 0.06 = $32.10 • Could also find expected P1 as: ^ P = P0 (1.06) = $32.10 1 What would the expected price What would the expected price today be, if g = 0?
• The dividend stream would be a perpetuity.
0 1 2.00
^ 2 2.00 3 ...
2.00 PMT $2.00 P0 = = = $15.38 k 0.13 Valuing common stock with Valuing common stock with nonconstant growth
0 k = 13% 1 s
g = 30% g = 30% 2
g = 30% 3
g = 6% 4 ... D0 = 2.00 2.301 2.647 3.045 46.114 54.107 2.600 3.380 4.394 4.658 = P0 ^ P3 = 4.658 0.13 − 0.06 = $66.54 Nonconstant growth: Nonconstant growth: What if g = 0% for 3 years before long run growth of 6%?
0 k = 13% 1 s
g = 0% g = 0% 2
g = 0% 3
g = 6% 4 ... D0 = 2.00 1.77 1.57 1.39 20.99 25.72 2.00 2.00 2.00 2.12 = P0 ^ P3 = 2.12 0.13 − 0.06 = $30.29 If the stock was expected to have negative 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. D0 ( 1 + g ) D1 P0 = = k s g k s g
^ $2.00 (0.94) $1.88 = = = $9.89 0.13 (0.06) 0.19 Corporate value model 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 future free cash flows. Remember, free cash flow is the firm’s net operating profit aftertax (NOPAT) less the net capital investment FCF = NOPAT – Net capital investment • • Applying the corporate value model Applying the corporate value model
• Find the market value (MV) of the firm. • • •
= PV of firm’s future free cash flows Subtract MV of firm’s debt and preferred stock to get MV of common stock. Divide MV of common stock by the number of shares outstanding to get intrinsic stock price. P0 = MV of common stock / # of common shares Issues regarding the corporate value model 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 longrun gFCF = 6%, and WACC of Given the longrun g 10%, use the corporate value model to find the firm’s intrinsic value. 0 k = 10% 1 -5 2 10 3 20
g = 6% 4 ... 21.20 -4.545 8.264 15.026 398.197 416.942 21.20
3 0.10 - 0.06 If the firm has $40 million in debt and has If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share? • MV of equity = MV of firm – MV of debt • = $416.94m $40m = $376.94 million Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69 Firm multiples method Firm multiples method
• Analysts often use the following multiples to value stocks.
– P / E – P / Cash Flow – P / Sales • EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings per share to estimate the stock price. What is market equilibrium? 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. D1 k s = + g = k s = k RF + (k M − k RF)β P 0
^ Factors that affect stock price Factors that affect stock price
• Required return (ks) could change
– Changing inflation could cause kRF to change – Market risk premium or exposure to market risk (β) could change – Due to economic (market) conditions – Due to firm conditions • Growth rate (g) could change What is the Efficient Market Hypothesis? What is the Efficient Market Hypothesis? • 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
– Weakform efficiency – Semistrongform efficiency – Strongform efficiency Weakform efficiency Weakform efficiency
• States that one 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. • Empirical evidence supports the weak form EMH. • But, contrary to the evidence, “technical analysis” is still used by some investors. Semistrongform efficiency Semistrongform efficiency
• States that all publicly available information is reflected in stock prices. • So it doesn’t pay to overanalyze annual reports looking for undervalued stocks. • Largely true, but superior analysts can still profit by finding and using new information Strongform efficiency Strongform efficiency
• States that all information, even inside information, is embedded in stock prices. • Not trueinsiders can gain by trading on the basis of insider information. • But insider trading is illegal. Is the stock market efficient? Is the stock market efficient?
– – – • Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest that the stock market is:
Highly efficient in the weak form. Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits. • Behavioral finance – incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations. Preferred stock 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 preferred stock with an annual dividend If 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% Summary: Stocks and Their Valuation Summary: Stocks and Their Valuation • Features of common • • • stock Determining common stock values Efficient markets Preferred stock ...
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- Spring '09
- dividend growth model, Char D2, Corporate Value Model