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CHAPTER 5Stocks and Their Valuation

Features of common stock Determining common stock

values Preferred stock

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Common Stock Stockholders are owners of the firm. Stockholders are residual claimants. Stockholders have the right to:

vote at company meetings dividends and other distributions sell their shares

Stockholders benefit in two ways: dividends capital gains

Stock is issued by public corporations to finance investments.

Stock is initially issued in the primary market (IPOs and secondary offerings).

Stock is traded in the secondary market on organized exchanges.

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Steps in raising equity

Founder’s equity+ Friends & Family

Angel Investors Venture capitalists Private financing Public offering (IPO)

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U. S. Stock MarketsMajor U. S. Stock Exchanges

New York Stock Exchange (NYSE) National Association of Securities Dealers (NASDAQ)

U. S. Stock Market INDU DOW JONES INDUS. AVGSPX S&P 500 INDEXCCMP NASDAQ COMB COMPOSITE IX

Other Indices NYSE Composite Russell 2000 Wilshire 5000 Value Line

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World Stock Markets

New York Tokyo London Frankfurt Paris

Sydney Switzerland Hong Kong

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International Stock Market Indices

UKX FT-SE 100 IndexCAC CAC 40 INDEXDAX DAX INDEXIBEX IBEX 35 INDEXMIB30 MILAN MIB30 INDEXBEL20 BEL20 INDEXAEX AMSTERDAM EXCHANGES INDXSMI SWISS MARKET INDEXNKY NIKKEI 225 INDEXHSI HANG SENG STOCK INDEXAS30 ASX ALL ORDINARIES INDXSTI SING: STRAITS TIMES INDUTS300 TSE 300 IndexMEXBOL MEXICO BOLSA INDEX

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Reading Stock Quotes

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Transactions Involving Stocks

Buy Savings motive Expect stock to

appreciate in value

Long position Sell

Liquidity needs Expect stock to

decline in value

Short Sell Sell stock without first owning

it. Borrow stock from your broker

with the promise to repay it at some later date.

Sell the borrowed stock. Repurchase it at a later date

to repay your broker. Responsible for all dividends

and other distributions while short the stock.

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Basic Valuation

From “The Time Value of Money” we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future.

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^ ^ ^

V CF1

1 k 1 CF2

1 k 2 CFN

1 k N

CFt

1 k tt1

N

Asset value

CFt = the cash flow expected to be generated by the asset in period t

^^

Basic Valuation

k = the return investors consider appropriate for holding such an asset--usually referred to as the required return-- based on riskiness and economic conditions.

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Different approaches for estimating the intrinsic value of a common stock

Dividend growth model Corporate value model Using the multiples of

comparable firms

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Dividend growth model Value of a stock is the present value of

the future dividends expected to be generated by the stock.

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Stock Valuation ModelsTerms: Expected DividendsExpected Dividends

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Terms: Market PriceMarket Price

Stock Valuation Models

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Terms: Intrinsic ValueIntrinsic Value

Stock Valuation Models

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Terms: Growth RateGrowth Rate

Stock Valuation Models

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Stock Valuation Models

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Terms: Dividend YieldDividend Yield

Stock Valuation Models

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Example: Dividend yield

If a firm is expected to pay a dividend of $2 (D1 = $2). The current stock price is $40, what is the dividend yield?

Dividend yield= D1/ P0 = 2 / 40 =5%

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Practice: Dividend yield

If a firm is expected to pay a dividend of $4 (D1 = $4). The current stock price is $60, what is the dividend yield?

Dividend yield= D1/ P0 = ?

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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:

g -r

D

g -r

g)(1D P

s

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00

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Example: Constant growth

If a firm just paid a dividend of $2 (D0 = $2). The growth rate is expected to be constant at 10 %. If the cost of equity is 15%, what is the value of this stock?

^P0 = D0(1+g) / (Ks – g) = 2(1.10)/(0.15-0.1) =44

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Practice: Constant growth

If a firm just paid a dividend of $5 (D0 = $5). The growth rate is expected to be constant at 20 %. If the cost of equity is 25%, what is the value of this stock?

^P0 = ???

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Example:Constant growth

ABC Inc. is expected to pay a dividend of $5 (D1 = $5) next year. The dividend is expected to grow at a constant rate of 6 %. If the cost of equity is 10%, what is the value of this stock?

^ P0 = D1 / (Ks – g) = 5 / (0.10-0.06) =125

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Practice: Constant growth

ABC Inc. is expected to pay a dividend of $2 (D1 = $2) next year. The dividend is expected to grow at a constant rate of 10 %. If the cost of equity is 14%, what is the value of this stock?

^ P0 = ?

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Example: Non-constant growth

A share just paid a dividend of $10. The dividend is expected to grow at 40 percent for the next three years. After that, dividend is expected to grow at a constant rate of 10 percent forever. The required rate of return is 20 percent. Calculate the value of this stock.

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Practice: Non-constant growth

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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.

Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs.

Subtract MV of firm’s debt to get MV of common stock.

Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).

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Applying the corporate value model

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Example: Corporate Value model

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Firm multiples method Analysts often use the following

multiples to value stocks. P / E P / CF P / Sales

EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.

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Practice: Multiples method

Lowell Inc. is going public soon. It is expected to earn $5 per share this year (EPS = $5). If a similar firm has a P/E ratio of 10, what should the value of Lowell Inc.’s stock?

P0 = 5 * 10 = $50

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Practice: Multiples method

Lowell Inc. is going public soon. It is expected to earn $6 cash per share this year (CF = $6). If a similar firm has a P/CF ratio of 15, what should the value of Lowell Inc.’s stock?

P0 = ?

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Firm multiples method

Lowell Inc. is going public soon. It is expected to have a sales of $10 million this year. It has 1 million shares outstanding. If a similar firm has a P/Sales ratio of 5, what should the value of Lowell Inc.’s stock?

P0 = ?

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Changes in Stock Prices

Investors change the rates of return required to invest in stocks.

Expectations change about the cash flows associated with particular stocks.

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The Efficient Markets Hypothesis

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

The semistrong formThe semistrong form states that current market prices reflect all publicly available information.

The strong formThe strong form states that current market prices reflect all pertinent information, whether publicly available or privately held.