Copyright © 2006 McGraw Hill Ryerson Limited6-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition

Copyright © 2006 McGraw Hill Ryerson Limited6-2 Chapter 6 Valuing Stocks Stocks and the Stock Market Book Values, Liquidation Values, and Market Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks No free lunches on Bay Street

Copyright © 2006 McGraw Hill Ryerson Limited6-3 Stocks and the Stock Market Definitions  Primary Market: Place where the sale of new stock first occurs.  Initial Public Offering (IPO): First offering of stock to the general public.  Seasoned Issue: Sale of new shares by a firm that has already been through an IPO.  Secondary Market: Market in which already issued securities are traded by investors.

Copyright © 2006 McGraw Hill Ryerson Limited6-4 Stocks and the Stock Market Definitions  Common Stock: Ownership shares in a publicly held corporation.  Dividend: Periodic cash distribution from the firm to the shareholders.  P/E Ratio: Price per share divided by earnings per share.

Copyright © 2006 McGraw Hill Ryerson Limited6-5 Stocks and the Stock Market Dividends and Retained Earnings  Dividends represent that share of the firm’s profits which are distributed.  Profits that are retained in the firm and reinvested in its operations are called retained earnings.

Copyright © 2006 McGraw Hill Ryerson Limited6-6 Stocks and the Stock Market Book Value, Liquidation Value, Market Value  There are three methods used for valuing a company’s shares:  Book Value  Liquidation Value  Market Value

Copyright © 2006 McGraw Hill Ryerson Limited6-7 Stocks and the Stock Market Definitions  Book Value: Net worth of the firm according to the balance sheet.  Liquidation Value: Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.  Market Value Balance Sheet: Financial statement that uses market value of assets and liabilities.

Copyright © 2006 McGraw Hill Ryerson Limited6-8 Valuing a Stock Going Concern Value  Going concern value means that a well managed, profitable firm is worth more than the sum of the value of its assets. ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million Assets sold separately have liquidation value of $11 million ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million The same assets functioning as a firm have going concern value of $15 million

Copyright © 2006 McGraw Hill Ryerson Limited6-9 Valuing a Stock Sources of Going Concern Value Extra earning power Intangible assets Value of future investments

Copyright © 2006 McGraw Hill Ryerson Limited6-10 Valuing Common Stocks Expected Return  Expected Return: The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR).

Copyright © 2006 McGraw Hill Ryerson Limited6-11 Valuing Common Stocks Expected Return Dividend YieldCapital Gains Yield

Copyright © 2006 McGraw Hill Ryerson Limited6-12 Valuing Common Stocks Expected Return  Assume that for Blue Sky shares:  The current price of the shares is $75.  The expected price a year from now is $81.  The expected dividend a year from now is $3. What is Blue Sky’s expected return?

Copyright © 2006 McGraw Hill Ryerson Limited6-13 Valuing Common Stocks Expected Return  Blue Sky’s expected return is: Expected Return = D 1 + P 1 – P 0 P 0 = $ – 75 $75 = 0.12 = 12%

Copyright © 2006 McGraw Hill Ryerson Limited6-14 Valuing Common Stocks Expected Return  For Blue Sky: Expected return = Dividend Yield + Capital Gain = D 1 + P 1 – P 0 P 0 P 0 = $3 + $81 - $75 $75 $75 = 4% + 8% = 12%

Copyright © 2006 McGraw Hill Ryerson Limited6-15 Valuing Common Stocks Dividend Discount Model (DDM)  Today’s stock price equals the present value of all expected future dividends:

Copyright © 2006 McGraw Hill Ryerson Limited6-16 Valuing Common Stocks Example  XYZ Company is expected to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

Copyright © 2006 McGraw Hill Ryerson Limited6-17 Valuing Common Stocks Example  XYZ Company is expected to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

Copyright © 2006 McGraw Hill Ryerson Limited6-18 Valuing Common Stocks Simplifying the DDM  The PV of a constant perpetuity is calculated by dividing the cash payment (the dividend) by the discount rate:

Copyright © 2006 McGraw Hill Ryerson Limited6-19 Valuing Common Stocks Simplifying the DDM  The PV of a growing perpetuity is calculated by dividing the cash payment (the dividend) by the discount rate minus the constant growth rate:

Copyright © 2006 McGraw Hill Ryerson Limited6-20 Valuing Common Stocks Example  Calculate the price of Blue Sky shares if:  Next year’s dividend (D 1 ) will be $3.  Dividends grow at 8% in perpetuity.  The discount rate is 12%. Price of stock today = Div 1 r-g = $ – 0.08 $75.00=

Copyright © 2006 McGraw Hill Ryerson Limited6-21 Valuing Common Stocks Expected Rate of Return revisited  Rearranging the DDM gives us the expected rate of return: r = D 1 P0P0 + g Dividend YieldGrowth Rate

Copyright © 2006 McGraw Hill Ryerson Limited6-22 Valuing Common Stocks Example  What is the expected return for Blue Sky if:  Next year’s dividend (D1) will be $3.  Dividends grow at 8% in perpetuity.  The current price is $75.

Copyright © 2006 McGraw Hill Ryerson Limited6-23 Valuing Common Stocks Example  The expected rate of return on Blue Sky would be: r= D 1 P0P0 + g = Dividend Yield + Growth Rate = $3 $ = =4%+8%=12%

Copyright © 2006 McGraw Hill Ryerson Limited6-24 Growth Stocks and Income Stocks Definitions  The fraction of earnings retained by the firm is called the plowback ratio.  The fraction of earnings a company pays out in dividends is called the payout ratio.

Copyright © 2006 McGraw Hill Ryerson Limited6-25 Growth Stocks and Income Stocks Calculating “g” (growth rate)  The growth rate for a company can be computed by multiplying the return on equity by the plowback ratio: g= roe x plowback ratio

Copyright © 2006 McGraw Hill Ryerson Limited6-26 Growth Stocks and Income Stocks Example  Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 20%. Calculate the value of the stock before and after the plowback decision?

Copyright © 2006 McGraw Hill Ryerson Limited6-27 Growth Stocks and Income Stocks Example  D 1 = $5.00  r = 12%  Return on equity = 20% No Growth

Copyright © 2006 McGraw Hill Ryerson Limited6-28 Growth Stocks and Income Stocks Example  D 1 = $5.00  r = 12%  Return on equity = 20% With Growth

Copyright © 2006 McGraw Hill Ryerson Limited6-29 Growth Stocks and Income Stocks Example  Price without growth = $41.67  Price with growth = $75 Thus, growth accounts for $33.33 [=$75-$41.67] of the price. In other words, the Present Value of Growth Opportunities (PVGO) is $33.33.

Copyright © 2006 McGraw Hill Ryerson Limited6-30 Growth Stocks and Income Stocks Definitions  The Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.  Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.

Copyright © 2006 McGraw Hill Ryerson Limited6-31 Growth Stocks and Income Stocks Price-Earnings (P/E) Ratio P/E Ratio = Stock Price EPS Is a high P/E ratio always good?

Copyright © 2006 McGraw Hill Ryerson Limited6-32 No Free Lunches on Bay Street Definitions  Technical Analysis – Attempting to identify undervalued stocky by searching for patterns in past stock prices.  Random Walk – Security prices change randomly, with no predictable trends or patterns.  Fundamental Analysis – Attempting to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects.

Copyright © 2006 McGraw Hill Ryerson Limited6-33 No Free Lunches on Bay Street Random Walk

Copyright © 2006 McGraw Hill Ryerson Limited6-34 Summary of Chapter 6  Dividend Discount Model - price of a stock is the present value of its future dividends.  If dividends are expected to remain constant, the value of the stock is equal to:  P 0 = Div 1 / r  If dividends are expected to grow forever at a constant rate “g”, then the value of the stock is equal to:  P 0 = Div 1 / (r – g)

Copyright © 2006 McGraw Hill Ryerson Limited6-35 Summary of Chapter 6  The growth rate of a company is equal to:  g = return on equity × plowback ratio  The current stock price comprises:  The value of the assets in place; plus  The Present Value of Growth Opportunities (PVGO).