Copyright © 2003 South-Western/Thomson Learning All rights reserved. Chapter 7 The Valuation of Common Stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Investing in Stock Acquiring ownership in a corporation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Corporations Formed by a state: A corporation is an artificial legal economic unit established (i.e., chartered) by a stat Certificate of incorporation : A document creating a corporation.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Corporations Charter – A document specifying the relationship between a firm and the state in which it is incorporated Bylaws - specifies the relationship with stockholders

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Board of Directors Director: A person who is elected by stockholders to determine the goals and policies of the firm.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rights of Stockholders Voting authority to elect a board of directors Cumulative voting: The alternative system, cumulative voting, gives minority stockholders a means to obtain representation on the firm’s board.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rights of Stockholders Preemptive rights: The right of current stockholders to maintain their proportionate ownership in the firm. Rights offering: Sale of new securities to existing stockholders.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Payout Ratio Dividends/earnings Stability of the payout ratio Stability of dividend payments

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Cash Dividends Distribution from earnings Regular quarterly dividends Extra dividends Irregular dividends Dividends paid in property

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Distribution of Dividends Date of record Stock trading ex dividend Ex-dividend date Distribution date

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Payout Ratio The retention ratio: earnings retained/earnings or 1 - payout ratio

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Distribution of Dividends Date of record: The day on which an investor must own shares in order to receive the dividend payment. Stock trading ex dividend: Stock that trades exclusive of any dividend payment.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Distribution of Dividends Ex-dividend date is two trading days prior to the date of record Distribution date: The date on which a dividend is paid to stockholders.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Stock Dividend Some firms pay stock dividends in addition to or in lieu of cash dividends. Stock dividends are a form recapitalization and do not affect the assets or liabilities of the firm.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Stock Dividend Does not affect proportionate ownership Does not affect assets Does not affect liabilities Does not affect total equity

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Stock Dividend Dilution of existing shares: A reduction in earnings per share due to the issuing of new securities. Price adjusts for a stock dividend A 10% stock dividend –Causes a $20 stock price to fall to $18.18 ($20/1.1)

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Stock Split Does not affect proportionate ownership Does not affect assets Does not affect liabilities Does not affect total equity

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Stock Split Does affect the stock's price A 2 for 1 stock split –Causes a $80 stock price to decline to $40 ($80/2)

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Dividend Reinvestment Plans Cash dividends used to purchase additional shares Additional cash contributions may be allowed Expenses often paid by the firm Are automatic; an easy means to save

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Repurchases Corporations with cash may reduce the number of existing shares through buy back programs The decrease in outstanding shares may –Increase earnings per share –Increase the price of the stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Repurchases and Capital Gains Stockholders do not have to sell their shares Sales are –Realized capital gains –Subject to capital gains taxation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Corporate Liquidations Corporate liquidations are rare Company –Ceases operations –Pays off its liabilities –Distributes its remaining assets to stockholders

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Estimation of Growth Rates An estimate of the firm's dividend growth rate is used in the dividend- growth model Estimates often based on accounting data Historical earnings or dividend payments

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Estimation of Growth Rates Return on equity times the retention ratio: –g = ROE x RR Use of initial and terminal values –D 0 (1 + g) n = D n

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Estimation of Growth Rates Averaging the annual percentage change in the dividend payment or in earnings Use of regression analysis Analyst’s estimates are available through the internet

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Impact of Increased Growth on Stock Prices Increased growth should increase a stock’s price Increased growth at the expense of dividends may reduce a stock’s price

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. What Do Investors Want? Growth or income Question of what is the best use of the funds - retention versus distribution

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Source of Return Dividends: Regular and extra, irregular. Payout: The ratio of dividends to earnings. Retention ratio: The ratio of earnings not distributed to earnings.

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Sources of Return Difference in short and long-term capital gains taxation favor capital gains Transaction costs (e.g., commissions) favor dividend income

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Valuation The determination of what a stock is worth; the stock's intrinsic value If the price exceeds the valuation, buy the stock If the price is less than the valuation, short the stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. If the Dividend Is Fixed Valuation is V=D/k

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. If the Dividend Grows at a Constant Rate Valuation is V=D 0 (1+g)/(k - g)

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Dividend Growth Model Value depends on the –the required return –the dividend –the growth in the dividend

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Required Return (k) Depends on –the risk-free rate (r f ) –the return on the market (r m ) –the stock's beta

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Risk and Required Rate of Return

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Alternative Valuation Techniques A price-earnings multiple times earnings P=(m)(EPS)

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Weakness in the Use of P/E Ratios Different definitions of earnings Differences in estimated earnings Question of the appropriate multiple

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price to Book Value and Price to Sales Conceptually the same as using P/E ratios Same weaknesses apply

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The PEG Ratio Standardizes the P/E ratio for growth P/E Earnings growth Low PEG ratios (below 1.0) suggest undervaluation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Substitution of Cash Flow for Earnings and Dividends Emphasis on firm’s ability to generate cash May be applied when firm does not pay a dividend

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Substitution of Cash Flow for Earnings and Dividends May be applied if firm operates at a loss Value investing employs all of the alternative methods

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Efficient Market Hypothesis Hard to beat the market on a risk- adjusted basis consistently Earning a higher return is not necessarily outperforming the market Considering risk is also important

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Assumptions Concerning Efficient Markets Large number of competing participants Information is readily available Transaction costs are small

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk Another term for efficient markets Does not imply security prices are randomly determined Implies day-to-day price changes are random

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk Successive prices changes are independent Today's price does not forecast tomorrow's price Current price embodies all known information

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk New information must be random IF NOT An opportunity to earn an excess return would exist

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Undervaluation and Overvaluation Undervaluation drives prices up returns decline Overvaluation drives prices down returns increase

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Undervaluation and Overvaluation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Random Walk Prices change quickly to new information By the time most investors know the information the price change has already occurred

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Adjustments to New Information

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Degree of Market Efficiency The forms of the efficient market hypothesis: –the weak form –the semi-strong form –the strong form

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Degree of Market Efficiency Even if financial markets are efficient, that does not answer the question "How efficient?”

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Weak Form Studying past price and volume data will not lead to superior investment results While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior returns

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Semi-Strong Form Studying economic and accounting data will not lead to superior investment returns Studying inside information may lend to superior returns

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Strong Form Using inside information will not lead to superior investment returns

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Anomalies Empirical results generally support –the weak form –the semi-strong form Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Examples of Anomalies Low P/E stocks The small firm effect The January effect The neglected firm effect

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Examples of Anomalies The day-of-the-week effect The Value Line effect The overreaction effect Drifts in security prices

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Anomalies and Returns Empirical evidence of the existence of an anomaly, however, does not mean the individual can take advantage of the anomaly The anomaly can still exist and the market be effectively efficient from the individual investor's perspective

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Implications of Efficient Markets Security prices embody known information The playing field is level Specifying financial goals may be more important than seeking undervalued stocks

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Implications of Efficient Markets Other markets may not be efficient Importance of reducing transactions costs: the argument for a buy-and-hold strategy