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CHAPTER 8

CHAPTER 8. STOCKS AND THEIR VALUATION. Facts about Common Stock. Represents ownership. Ownership implies control. Stockholders elect directors. Directors elect management. Management’s goal: Maximize the stock price. When is a stock sale an initial public offering (IPO)?.

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CHAPTER 8

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  1. CHAPTER 8 STOCKS AND THEIR VALUATION

  2. Facts about Common Stock • Represents ownership. • Ownership implies control. • Stockholders elect directors. • Directors elect management. • Management’s goal: Maximize the stock price. SITI AISHAH BINTI KASSIM (FM2)

  3. When is a stock sale an initial public offering (IPO)? A firm “goes public” through an IPO when the stock is first offered to the public. SITI AISHAH BINTI KASSIM (FM2)

  4. Different Approaches for Valuing Common Stock • Dividend growth model: - Constant Growth (Gordon) Model - Supernormal (Non-constant) Growth Stock - Erratic Growth Stock • Free cash flow method • Using the multiples of comparable firms SITI AISHAH BINTI KASSIM (FM2)

  5. When to use the models? • Constant growth model: most appropriate for mature companies w stable history of growth, and stable future dividends. • Free cash flow method: good for the large number of companies that don’t pay a dividend, or for whom it is hard to forecast dividends. SITI AISHAH BINTI KASSIM (FM2)

  6. Stock Value = PV of Dividends What is a constant growth stock? A stock whose dividends are expected to grow forever at a constant rate, g. SITI AISHAH BINTI KASSIM (FM2)

  7. For a Constant Growth Stock D1 = D0(1 + g)1 D2 = D0(1 + g)2 =D1(1+g)1 Dt = D0(1 + g)t If g is constant, then: P0 = = D0(1 + g) ks – g D1 ks – g ^ SITI AISHAH BINTI KASSIM (FM2)

  8. D1 ks – g = requires ks > g What happens if g > ks? • If ks< g, get negative stock price, which is nonsense. • We can’t use model unless: • (1) ks > g and • (2) g is expected to be constant forever. SITI AISHAH BINTI KASSIM (FM2)

  9. Examples: Assume beta = 1.2, kRF = 7%, and kM = 12%. What is the required rate of return (ks) on the firm’s stock? Use the SML to calculate ks: ks= kRF + (kM – kRF) βFirm = 7% + (12% – 7%) (1.2) = 13% SITI AISHAH BINTI KASSIM (FM2)

  10. Examples: D0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs (ks = 13%) 0 1 2 3 g = 6% 2.12 2.247 2.382 D0=2.00 13% $1.8761 $1.7599 $1.6509 SITI AISHAH BINTI KASSIM (FM2)

  11. Examples: What’s the stock’s market value? D0 = 2.00, ks = 13%, g = 6% Constant growth model: D1 $2.12 P0 = = ks – g 0.13 – 0.06 $2.12 = = $30.29 0.07 SITI AISHAH BINTI KASSIM (FM2)

  12. Examples: What is the stock’s market value one year from now, P1? • D1 will have been paid, so expected dividends are D2,D3, D4 and so on. With P0= $30.29, D2=D1(1+g)=$2.12(1.06)=$2.247; Could also find P1 as follows: D2 $2.247 ^ P1 = = ks – g 0.13 – 0.06 = $32.10 ^ P1= P0(1.06)=30.29(1.06)=$32.10 SITI AISHAH BINTI KASSIM (FM2)

  13. Examples: Find the expected dividend yield, capital gains yield, and total return during the first year. D1 $2.12 Dividend yield = = = 7.0% P0 $30.29 ^ P1– P0 $32.10 – $30.29 Cap gains yield = = $30.29 P0 = 6.0% Total return = 7.0% + 6.0% = 13.0% SITI AISHAH BINTI KASSIM (FM2)

  14. What would P0 be if g = 0? ^ The dividend stream would be a perpetuity. 0 1 2 3 13% ... 2.00 2.00 2.00 ^ PMT k $2.00 0.13 P0 = = =$15.38 SITI AISHAH BINTI KASSIM (FM2)

  15. If we have supernormal growth of 30% for 3 years, then a long-run constant, g = 6%, what is P0? ks is still 13%. ^ • Can no longer use constant growth model. • However, growth becomes constant after 3 years. SITI AISHAH BINTI KASSIM (FM2)

  16. Valuing a Supernormal/Non-constant Growth Stock Supernormal/non-constant growth is that part of the firm’s life cycle in which it grows faster than the economy as a whole. Steps to Value Supernormal Growth Stock: • Compute the expected future cash dividends • Compute the stock’s price at a future point in time, using constant growth model Pt = Dt+1/(r-g). (You must pick a point after the dividend growth rate has become constant) • Compute the PV of the expected future sale price and add that to the PV of all the expected cash dividends between now and then. (Source: Emery, D.R., J.D. Finnerty and J.D. Stowe.1998. Principles of Financial Management. Prentice Hall, pp 172-173) SITI AISHAH BINTI KASSIM (FM2)

  17. Non-constant growth followed by constant growth: 0 1 2 3 4 ... ks = 13% g = 30% g = 30% g = 30% g = 6%... D0 = 2.00 2.600 3.380 4.394 4.658 2.301 2.647 3.045 4.658 . $ P = = $66.54 46.114 3 . 13 - 0 . 06 0 ^ 54.107 = P0 SITI AISHAH BINTI KASSIM (FM2)

  18. What is the expected dividend yield and capital gains yield at t = 0? At t = 4? (Div yield0=Div1/Price) $2.60 $54.11 Div. yield0 = = 4.81%. Cap. gain0 = (ks- div yield) =13.00% – 4.81% = 8.19%. SITI AISHAH BINTI KASSIM (FM2)

  19. During non-constant growth, dividend yield (D/P) and capital gains yield are not constant, and capital gains yield is not equal to g. • After t = 3, g = constant = 6% = capital gains yield; ks = 13%; so D/P = 13% – 6% = 7%. SITI AISHAH BINTI KASSIM (FM2)

  20. Examples: • Netscape is operating in a new industry that has recently caught on with the public. Sales are growing at 80% per year. This high sales growth is expected to translate into a 25% growth rate in cash dividends for each of the next 4 years.After that, the dividend growth rate is expected to be 5% forever. Annual dividend paid yesterday is $0.75. The stock’s required return is 22%. What is Netscape’s stock’s price? (Source: Emery et al, Principles of Financial Management. 1998. pp 172-173) SITI AISHAH BINTI KASSIM (FM2)

  21. i) Compute the expected future cash dividends: Time 0 1 2 3 4 5 6 ... Div($) 0.75 0.938 1.172 1.465 1.831 1.923 2.019 … g(%) 25% 25% 25% 25% 5% 5% 5% … ii) Find the stock price at a future time, a point after which the dividend growth rate has become constant forever. That point is at year 5, thus: P5 = D6/(r-g) = $2.019/(0.22-0.05) = $11.876 iii) Compute the PVs of all the future expected cash dividends found in step (i) and add to the PV of the expected future sale price (P5) calculated in step (ii): P0 = 0.938/1.221 + 1.172/1.222 + 1.465/1.223 + 1.831/1.224 + 1.923/1.225 + 11.876/1.225 = $(0.768 + 0.787 + 0.807 + 0.827 + 0.711 + 4.394) = $8.295 SITI AISHAH BINTI KASSIM (FM2)

  22. Free Cash Flow Method/Total Company or Corporate Valuation Model • The free cash flow method suggests that the value of the entire firm equals the present value of the firm’s free cash flows (calculated on an after-tax basis). • Recall that the free cash flow in any given year can be calculated as: NOPAT – Net capital investment (NOPAT= Net operating profit after taxes) SITI AISHAH BINTI KASSIM (FM2)

  23. The Corporate Valuation Model Market Value=Vcompany= PV of expected future free cash flows of company = FCF1/(1+r)1 +FCF2/(1+r)2+…FCFn/(1+r)n FCF = (EBIT(1-T) + Dep + Amort) - (Cap Exp + Change in NOWC); or FCF = NOPAT – New Investment in Operating Cap SITI AISHAH BINTI KASSIM (FM2)

  24. Using the Free Cash Flow Method • Once the value of the firm is estimated, an estimate of the stock price can be found as follows: • MV of common stock (market capitalization) = MV of firm – MV of debt and preferred stock. • P = MV of common stock/# of shares. ^ SITI AISHAH BINTI KASSIM (FM2)

  25. Issues Regarding the Free Cash Flow Method • Free cash flow method is often preferred to the dividend growth model - particularly for the large number of companies that don’t pay a dividend, or for whom it is hard to forecast dividends. • Similar to the dividend growth model, the free cash flow method generally assumes that at some point in time, the growth rate in free cash flow will become constant. • Terminal value represents the value of the firm at the point in which growth becomes constant. SITI AISHAH BINTI KASSIM (FM2)

  26. Calculating Price per Share If the firm has $40 million in debt and has 10 million shares of stock, what is the price per share? Value of equity = Total value – Value of debt = $416.94 – $40 = $376.94 million Price per share = Value of equity/# of shares = $376.94/10 = $37.69 SITI AISHAH BINTI KASSIM (FM2)

  27. Using the Multiples of Comparable Firms to Estimate Stock Price • Analysts often use the following multiples to value stocks: • P/E • P/CF • P/Sales • P/Customer • Example: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. SITI AISHAH BINTI KASSIM (FM2)

  28. What is market equilibrium? • In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. • In equilibrium, expected returns must equal required returns: ^ ks = (D1/P0) + g = ks = kRF + (kM – kRF)βfirm SITI AISHAH BINTI KASSIM (FM2)

  29. Expected returns are obtained by estimating dividends and expected capital gains (which can be found using any of the three common stock valuation approaches). Ks = (D1/P0) + g • Required returns are obtained from the CAPM: ks = kRF + (kM – kRF)βfirm ^ SITI AISHAH BINTI KASSIM (FM2)

  30. How is equilibrium established? ^ D1 P0 If ks = + g > ks (CAPM) then P0 is “too low” (a bargain). Buy orders > sell orders; P0 bid up; D1/P0 falls until (D1/P0) + g = ks = ks ^ SITI AISHAH BINTI KASSIM (FM2)

  31. Why do stock prices change? D1 ki – g ^ P0 = ki could change: ki = kRF + (kM – kRF )bi. kRF = k* + IP. 2. g could change due to economic or firm situation. SITI AISHAH BINTI KASSIM (FM2)

  32. What is the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or better information. SITI AISHAH BINTI KASSIM (FM2)

  33. 1. Weak-form EMH: 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. Evidence supports weak-form EMH, but “technical analysis” is still used. SITI AISHAH BINTI KASSIM (FM2)

  34. Semistrong-form EMH: All publicly available information is reflected in stock prices, so doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information. SITI AISHAH BINTI KASSIM (FM2)

  35. 3. 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’s illegal. SITI AISHAH BINTI KASSIM (FM2)

  36. Markets are generally efficient because: 1. 15,000 or so trained analysts; MBAs, CFAs, Technical PhDs. 2. Work for firms like Merrill, Morgan, Prudential, which have a lot of money. 3. Have similar access to data. 4. Thus, news is reflected in P0 almost instantaneously. SITI AISHAH BINTI KASSIM (FM2)

  37. Preferred Stock • Hybrid security. • Similar to bonds in that preferred stockholders receive a fixed dividend that must be paid before dividends can be paid on common stock. • However, unlike interest payments on bonds, companies can omit dividend payments on preferred stock without fear of pushing the firm into bankruptcy. SITI AISHAH BINTI KASSIM (FM2)

  38. Example: What is the expected return of preferred stock with Vp = $50 and annual dividend = $5? SITI AISHAH BINTI KASSIM (FM2)

  39. THE END SITI AISHAH BINTI KASSIM (FM2)

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