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8/3/2019 Ch08 Ppt Brighamfm1ce
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PowerPoint Presentationprepared by
Traven ReedCanadore College
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CH8
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-3
Corporate Valuation andStock Risk
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-4
Topics in Chapter
Features ofcommon stock
Determining common stock values
Efficient markets
Preferred stock
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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 ofshareholders, they always solicitshareholders proxies and usuallysucceed.
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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 alsoprevents dilution of their value
The preemptive right makes it moredifficult to raise equity capital from newlarge shareholders
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-6
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Types of Common Stock
Not all common shares are createdequally
Most firms have only one type ofcommon stock
A system of dual-class shares is
used to meet the special needs ofthe company
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-7
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-8
Classified Stock
Classified stockhas specialprovisions.
Could classify existing stock asfounders shares, with voting rightsbut dividend restrictions.
New shares might be called ClassA shares, with voting restrictionsbut full dividend rights.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-9
Stock Market Reporting
In the past, tracking stock is through thebusiness section of a daily newspaper.
Today, wecan get quotes all during t
he dayfrom a wide variety of Internet sources (e.g.
Globeinvestor.com).
Comparing with once a day from thenewspaper 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 someonecan sell the stock (Bid) for.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-10
Different Approaches forValuing Common Stock
Most stocks expected total return =dividend yield + capital gains yield
Intrinsic value of a stock is thepresent value of its expected futurecash flow stream
Dividend growth model Free cash flow approach
Using the multiples ofcomparable firms
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-11
Stock Value = PV ofexpected future dividends
What is a constant growth stock?
One whose dividends are expectedto grow forever at a constant rate, g.
P0 =^
(1+rs)1 (1+rs)2 (1+rs)3 (1+rs)
D1 D2 D3 D
++ ++
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-12
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=
D1rs - g
Use decimals, not % in the calculation
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Dividend and Earnings
Growth Growth in dividends occurs primarily as
a result of growth in EPS.
Earnings growth results from a numberof factors: (1) inflation, (2) reinvestedprofit, and (3) ROE.
Firms cannot increase stock price by justraising the current dividend.
There is a tradeoff between current
dividends and future dividends.
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-13
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-14
Intrinsic Stock Value vs.Quarterly Earnings
If most of a stocks 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 changesin cash flows. This would affect the
current stock price.
Sometimes managers have bonuses tiedto quarterly earnings.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-15
Dividend Growth and PV ofDividends: P
0= (PVof D
t)
$
0.25
Years (t)
Dt = D0(1 + g)t
PV of Dt =Dt
(1 + rS)t
If g > rs , P0 = !
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-16
What happens if g > rs?
P0 =^
(1+rs)1 (1+rs)2 (1+rs)
D0(1+g)1 D0(1+g)
2 D0(1+rs)
+ ++
(1+g)t
(1+rs)t
If g > rIf g > rss, then, then P0 = ^
> 1, and
So g must be less than rs to use theconstant growth model.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-17
Projected Dividends
D0 = $2 and constant g = 6% = 0.06
D1 = D0(1+g) = 2(1.06) = $2.12
D2 = D1(1+g) = 2.12(1.06) =$2.2472
D3 = D2(1+g) = 2.2472(1.06) =$2.3820
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-18
Expected Dividends and PVs(r
s= 13%, D
0= $2, g = 6%)
0 1
2.2472
2
2.3820
3g=6%
4
1.8761
1.75991.6508
13 %
2.12
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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:
= = $30.290.13 - 0.06
$2.12 $2.12
0.07
P0 =^ D0(1+g)
rs - g=
D1rs - g
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-20
Expected value one yearfrom now:
D1 will have been paid, so expecteddividends are D2, D3, D4 and so on.
P1 =^ D2
rs - g=
$2.2427
0.07
= $32.10 = $30.29(1+0.06)
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-21
Expected Dividend Yield andCapital Gains Yield (Year 1)
Dividend yield = = = 7.0%$2.12$30.29
D1P0
CG Yield = =P1 - P0^
P0$32.10 - $30.29
$30.29
= 6.0%
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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% = rs For constant growth stock:
Capital gains yield = 6% = g
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-23
Expected Rate of Return on
a Constant Growth
Stock
Then, rs = $2.12/$30.29 + 0.06= 0.07 + 0.06 = 13%
^
P0
=^ D1
rs - gto
D1
P0
rs
^
=+ g
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-24
If g = 0, the dividend streamis a perpetuity
2.00 2.002.00
0 1 2 3rs=13%
P0 = = = $15.38PMT
r
$2.00
0.13^
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-25
Supernormal (Non-constant)Growth Stock
Supernormal growth of 30% for 3years, and then long-run constant g
= 6%.
Can no longer use constant growthmodel.
However, growth becomes constantafter 3 years.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-26
Nonconstant growth followedby constant growth (D
0
= $2):
0
2.3009
2.6470
3.0453
46.1135
1 2 3 4rs=13%
54.1067 = P0
g = 30% g = 30% g = 30% g = 6%2.60 3.38 4.394 4.6576
^ P3 =^ $4.6576
0.13 0.06= $66.5371
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-27
Dividend Growth Rates
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-28
Suppose g = 0 for t = 1 to 3, andthen g is a constant 6%
0
1.7699
1.56631.386120.9895
1 2 3 4rs=13%
25.7118
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
2.12P3
0.0730.2857! !
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-29
If g = -6%, would anyone buythe 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
rs
- g
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Stock Valuation:
FCF Approach
Firm value is the present value ofits future expected free cash flows
(FCF) discounted at the WACC.
Since PV (FCF) is the present valueof a growing annuity, we have
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-30
gWACC
gFCFV
!
)1(
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-31
Using Stock Price Multiplesto 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 ofcomparable firms. This is the P/E
multiple. Multiply this average P/E ratio by the
expected earnings of the company toestimate its stock price.
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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 ofcomparable firms. Forexample, V/EBITDA V/Customers
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-33
Using Entity Multiples (contd)
Find the entity value of the firm inquestion. For example, Multiply the firms sales by the V/Sales
multiple. Multiply the firms # ofcustomers by the
V/Customers ratio
The result is the total value of the firm.
Subtract the firms debt to get t
he totalvalue of equity.
Divide by the number of shares to getthe price per share.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-34
Problems with MarketMultiple Methods
It is often hard to find comparable firms.
The average ratio for the sample of
comparable firms often has a widerange.
For example, the average P/E ratio might be20, but the range could be from 10 to 50.
How do you know whether your firm shouldbe compared to the low, average, orhighperformers?
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Preferred Stock
Hybrid security.
Similar to bonds in that preferred
stockholders receive a fixed dividendwhich must be paid before dividendscan be paid on common stock.
However, unlike bonds, preferredstock dividends can be omittedwithout fear of pushing the firm intobankruptcy.
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-35
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Preferred Stock Valuation
Similar to the valuation of perpetualbonds
A preferred stock pays a quarterlydividend of $1.25 ($5 per year) with
a required return of10%. Its valueis
Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-36
PS
PS
PSr
D
V !
50$1.0
5$
1.0
)25.1($4!!!!
PS
PS
PS
r
DV
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-37
Expected return: given Vps = $50and annual dividend = $5
Vps = $50 = $5
rps^
rps$5
$50
^= = 0.10 = 10.0%
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-38
Stock Price Volatility forchanges in rS and g
Are volatile stock prices consistent withrationing pricing?
Small changes in expected g and rscause large changes in stock prices.
As new information arrives, investorscontinually update their estimates of g
and rs. If stock prices are not volatile, then thismeans there is not a good flow ofinformation.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-39
Stock Market Equilibrium
In equilibrium, stock prices arestable. There is no general
tendency for people to buy versusto sell.
The expected price, P, must equalthe actual price, P. In other words,the fundamental value must be thesame as the price.
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rs = D1/P0 + g = rs = rRF + (rM - rRF)b^
In equilibrium, expected returnsmust equal required returns:
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If rs
= + g > rs, then P
0is too low.
If the price is lower than the fundamentalvalue, then the stock is a bargain. Buy
orders will exceed sell orders, the pricewill be bid up until:
D1/P0 + g = rs = rs
^
^
D1P0
^
How is equilibriumestablished?
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-42
Efficient Market Hypothesis
Securities are normally in equilibriumand are fairly priced.
Investors cannot beat the marketexcept through good luck or insideinformation.
The prices of securities fully reflectavailable information. They will adjustimmediately to any new development.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-43
Weak-form EMH
Investors buying bonds and stockscannot profit by looking at past
trends. A recent decline is noreason to think stocks will go up (ordown) in the future. Evidence
supports weak-form EMH, buttechnical analysis is still used.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-44
Semistrong-form EMH
All publicly available information isreflected in stock prices, so it does
not pay to pore over annual reportslooking for undervalued stocks.Largely true.
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-45
Strong-form EMH
All information, even insideinformation, is embedded in stock
prices. Not true--insiders can gainby trading on the basis of insiderinformation, but that is illegal!
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8 46
Markets are generallyefficient 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.