Money and Banking Lecture 19

Review of the Previous Lecture Bonds and Their Characteristics Stocks Essential Characteristics Process Measuring Level of a Stock Market

Topics under Discussion Valuing Stocks Fundamental Value and Dividend Discount Model Risk and Value of Stocks

Valuing Stocks People differ in their opinions of how stocks should be valued Chartists believe that they can predict changes in a stock’s price by looking at patterns in its past price movements Behavioralists estimate the value of stocks based on their perceptions of investor psychology and behavior

Valuing Stocks Others estimate stock values based on a detailed study of the fundamentals, which can be analyzed by examining the firm’s financial statements. In this view the value of a firm’s stock depends both on its current assets and estimates of its future profitability

Valuing Stocks The fundamental value of stocks can be found by using the present value formula to assess how much the promised payments are worth, and then adjusting to allow for risk Chartists and Behavioralists focus instead on estimates of the deviation of stock prices from those fundamental values

Fundamental Value and the Dividend-Discount Model As with all financial instruments, a stock represents a promise to make monetary payments on future dates, under certain circumstances With stocks the payments are in the form of dividends, or distributions of the firm’s profits The price of a stock today is equal to the present value of the payments the investor will receive from holding the stock

Fundamental Value and the Dividend-Discount Model This is equal to the selling price of the stock in one year’s time plus the dividend payment received in the interim Thus the current price is the present value of next year’s price plus the dividend

Fundamental Value and the Dividend-Discount Model If Ptoday is the purchase price of stock, Pnext year is the sales price one year later and Dnext year is the size of the dividend payment, we can say: Next year year next today i P D ) 1 ( + =

Fundamental Value and the Dividend-Discount Model What if investor plans to hold stock for two years? In two years year next today i P D )2 1 ( ) + =

Fundamental Value and the Dividend-Discount Model Generalizing for n years:

Fundamental Value and the Dividend-Discount Model If a stock does not pay dividends the calculation can still be performed; a value of zero is used for the dividend payments

Fundamental Value and the Dividend-Discount Model Future dividend payments can be estimated assuming that current dividends will grow at a constant rate of g per year.

Fundamental Value and the Dividend-Discount Model For multiple periods: )n 1 ( g D today n years from now + =

Fundamental Value and the Dividend-Discount Model Price equation can now be re-written as:

Fundamental Value and the Dividend-Discount Model Assuming that the firm pays dividends forever solves the problem of knowing the selling price of the stock; the assumption allows us to treat the stock as we did a consol This relationship is the dividend discount model

Fundamental Value and the Dividend-Discount Model The model tells us that stock price should be high when dividends are high Dividend growth is rapid, or Interest rate is low

Why stocks are risky? Stockholders receive profits only after the firm has paid everyone else, including bondholders It is as if the stockholders bought the firm by putting up some of their own wealth and borrowing the rest This borrowing creates leverage, and leverage creates risk

Why stocks are risky? Imagine a software business that needs only one computer costing $1,000 and purchase can be financed by any combination of stocks (equity) and bonds (debt). Interest rate on bonds is 10%. Company earns $160 in good years and $80 in bad years with equal probability

Why stocks are risky? Returns distributed to debt and equity holders under different financing assumptions Percent Equity (%) Percent Debt (%) Required payments on 10% bonds Payment to equity holders Equity Return (%) Expected Equity Return (%) St. Dev. of Equity Return 100% $80-160 8-16% 12% 4% 50% $50 $30-110 6-22% 14% 8% 30% 70% $70 $10-90 3.3-30% 16.67% 13.3% 20% 80% $80 $0-80 0-40%

Why stocks are risky? If the firm were only 10% equity financed, shareholders’ liability could come into play. Issuing $900 worth of bonds means $90 for interest payments. If the business turned out to be bad, the $80 revenue would not be enough to pay the interest Without their limited liability, stockholders will be liable for $10 shortfall. But actually, they will lose only $100 investment and not more and the firm goes bankcrupt.

Why stocks are risky? Stocks are risky because the shareholders are residual claimants. Since they are paid last, they never know for sure how much their return will be. Any variation in the firm’s revenue flows through to stockholders dollar for dollar, making their returns highly volatile

Summary Valuing Stocks Fundamental Value and Dividend Discount Model Why Stocks are risky?