1. Chapter 8 - The Valuation and Characteristics of Stock

2. Common Stock Corporations are owned by common stockholders
Most large companies are “widely held’
Ownership spread among many investors.
Investors don’t think of their role as owners

3. The Return on an Investment in Common Stock
Income in a stock investment comes from:
dividends
gain or loss on the difference between the purchase and sale price
If you buy a stock for price P0, hold it for one year, receive a dividend of D1, then sell it for price P1, you return, k, would be:
A capital gain (loss) occurs if you sell the stock for a price greater (lower) than you paid for it.

4. The Return on an Investment in Common Stock
Solve the previous equation for P0, the stock’s price today:

5. The Return on an Investment in Common Stock
The return on a stock investment is the interest rate that equates the present value of the investment’s expected future cash flows to the amount invested today, the price, P0

6. Figure 8-1 Cash Flow Time Line for Stock Valuation

7. The Nature of Cash Flows from Stock Ownership
Comparison of Cash Flows from Stocks and Bonds
For stockholders:
Expected dividends and future selling price are not known with any precision
Similarity to bond cash flows is superficial – both involve a stream of small payments followed by a larger payment
When selling, investor receives money from another investor
For bondholders:
Interest payments are guaranteed, constant
Maturity value is fixed
At maturity, the investor receives face value from the issuing company.

8. The Basis of Value
The basis for stock value is the present value of expected cash inflows even though dividends and stock prices are difficult to forecast

9. Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows
Joe Simmons is interested in the stock of Teltex Corp. He feels it is going to have two very good years because of a government contract, but may not do well after that.
Joe thinks the stock will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now.
People who have invested in stocks like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex?

10. Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows
Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and $3.50 plus $75 at the end of two years.

11. The Intrinsic (Calculated) Value and Market Price
A stock’s intrinsic value is based on assumptions about future cash flows made from fundamental analysis of the firm and its industry
Different investors with different cash flow estimates will have different intrinsic values

12. Growth Models of Common Stock Valuation
Based on predicted growth rates since forecasting exact future prices and dividends is difficult
More likely to forecast a growth rate of earnings rather than cash flows

13. Developing Growth-Based Models
A stock’s value today is the sum of the present values of the dividends received while the investor holds it and the price for which it is eventually sold
An Infinite Stream of Dividends
Many investors buy a stock, hold for awhile, then sell, as
represented in the above equation

14. Developing Growth-Based Models
A person who buys stock at time n will hold it until period m and then sell it
Their valuation will look like this:
Repeating this process until infinity results in:

15. The Constant Growth Model
If dividends are assumed to be growing at a constant rate forever and the last dividend paid is, D0, then the model is:
This represents a series of fractions as follows
If k>g, the fractions get smaller (approach zero) as exponents get larger

16. Constant Normal Growth The Gordon Model
Constant growth model can be simplified to
k must be greater than g.
The Gordon Model is a simple expression for forecasting the price of a stock that’s expected to grow at a constant, normal rate

17. Concept Connection Example 8-3 Constant Normal Growth - The Gordon Model
Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on stocks similar to Atlas is about 11%. What should a share of Atlas Motors sell for today?

18. The Zero Growth Rate Case — A Constant Dividend
If a stock is expected to pay a constant, non-growing dividend, each dollar dividend is the same
Gordon model simplifies to:
A zero growth stock is a perpetuity to the investor

19. The Expected Return
Recast Gordon model to focus on the return (k) implied by the constant growth assumption
The expected return reflects investors’ knowledge of a company
If we know D0 (most recent dividend paid) and P (current actual stock price), investors’ expectations are input via the growth rate assumption

20. Two Stage Growth
At times, a firm’s future growth may not be expected to be constant
A new product may lead to temporary high growth
The two-stage growth model values a stock that is expected to grow at an unusual rate for a limited time
Use the Gordon model to value the constant portion
Find the present value of the non-constant growth periods

21. Figure 8-2 Two Stage Growth Model

22. Concept Connection Example 8-5 Valuation Based on Two Stage Growth
Zylon Corporation’s stock is selling for $48 a share.
We’ve heard a rumor that the firm will make an exciting new product announcement next week.
We’ve concluded that this new product will support an overall company growth rate of 20% for about two years.

23. Concept Connection Example 8-5 Valuation Based on Two Stage Growth
We feel growth will slow rapidly and level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company.
The rate of return on stocks like Zylon is approximately 10%.
Is Zylon a good buy at $48?

24. Concept Connection Example 8-5 Valuation Based on Two Stage Growth
D1 = D0 (1+g1) = $2.00(1.20) = $2.40
D2 = D1 (1+g1) = $2.40(1.20) = $2.88
D3 = D2(1+g2) = $2.88(1.06) = $3.05

25. Concept Connection Example 8-5 Valuation Based on Two Stage Growth
We’ll develop a schedule of expected dividend payments:
Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2, so:
Year
Expected Dividend
Growth 1
$2.40
20% 2
$2.88
20% 3
$3.05 6%

26. Concept Connection Example 8-5 Valuation Based on Two Stage Growth
Then we take the present value of D1, D2 and P2:
Compare $67.57 to the listed price of $ If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy Zylon’s stock.

27. Practical Limitations of Pricing Models
Stock valuation models give estimated results since the inputs are approximations of reality
Actual growth rate can be VERY different from predicted growth rates

28. Practical Limitations of Pricing Models
Comparison to Bond Valuation
Bond valuation is precise because the inputs are precise.
Future cash flows are guaranteed in amount and time, unless firm defaults.
Stocks That Don’t Pay Dividends
Have value because of expectation that they will someday pay them.
Some firms don’t pay dividends even if they are profitable
Firms are growing and using profits to finance the growth

29. Valuing New Stocks Investment Banking and The Initial Public Offering (IPO)
IPOs are the first public sales of a new company stocks

30. IPO Process Investment Banking Syndication Registration Underwriting
Best Efforts

31. Promoting and Pricing the IPO
Quiet Period
Book Building and the Road Show
Ends before the IPO date

32. Prices After the IPO The Investment Bank in the Middle
Underpricing and IPO Pops
A little Big Pop History
POP Strategies
Market Stabilization

33. Insights – Practical Finance
Facebook’s IPO
Most anticipated IPO in history
NASDAQ trading issues
Fourth largest IPO in history

34. Some Institutional Characteristics of Common Stock
Corporate Organization and Control
Controlled by Board of Directors
elected by stockholders
Board appoints top management who appoint middle/lower management
Board consists of top managers and outside directors (may include major stockholders)
In widely held corporations, top management in “control”

35. Some Institutional Characteristics of Common Stock
Preemptive Rights
Allows stockholders to maintain a proportionate share of ownership
If firm issues new shares, existing shareholders can purchase pro rata share of new issue

36. Voting Rights and Issues
Each share of common stock has one vote
Vote for directors and other issues at the annual stockholders’ meeting
Vote usually cast by proxy

37. Majority and Cumulative Voting
Majority Voting
gives the larger group control of the company
Cumulative Voting
gives minority interest a chance at some representation on the board
Shares With Different Voting Rights
Different classes of stock can be issued different rights
Some stock may be issued with limited or no voting rights

38. Stockholders’ Claim on Income And Assets
Stockholders have a residual claim on income and assets
What is not paid out as dividends is retained for reinvestment in the business (retained earnings)
Common stockholders are last in line, they bear more risk than other investors

39. A hybrid security with characteristics of common stock and bonds
Preferred Stock
A hybrid security with characteristics of common stock and bonds
Pays a constant dividend forever
Specifies the initial selling price and the dividend
No provision for the return of capital to the investor

40. Valuation of Preferred Stock
Since securities are worth the present value of their future cash flows, preferred stock is worth the present value of the indefinite stream of dividends.

41. Concept Connection Example 8-6 Pricing Preferred Stock
Roman Industries’ $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Roman’s preferred sell for today?
Just substitute the new market interest rate into the preferred stock valuation model to determine today’s price:

42. Characteristics of Preferred Stock
Cumulative Feature - can’t pay common dividends unless cumulative preferred dividends are current
Never returns principal
Stockholders cannot force bankruptcy
Receives preferential treatment over common stock in bankruptcy
No voting rights
Dividend payments not tax deductible to the firm

43. Securities Analysis The art and science of selecting investments
Fundamental analysis looks at a company’s business to forecast value
Technical analysis bases value on the pattern of past prices and volume
The Efficient Market Hypothesis (EMH) - financial markets are efficient since new information is instantly disseminated

44. Options and Warrants
Options and warrants make it possible to invest in stocks without holding shares
Options
Gives the holder the temporary right to buy or sell an asset at a fixed price
Speculate on price changes without holding the asset
Warrants
Similar but less common

45. Stock Options Stock options speculate on stock price movements
Trade in financial markets
Call option — option to buy
Put option — option to sell
Options are Derivative Securities
Derive value from prices of underlying securities
Provide leverage – amplifying returns

46. Call Option Basic Call Option
Gives owner (the holder) the right to buy stock at a fixed price (the exercise or strike price) for a specified time period
Once expired, it can’t be exercised
Option price < price of the underlying stock

47. Figure 8-3 Basic Call Option Concepts

48. The more volatile the stock’s price, the more attractive the option
Call Options
The more volatile the stock’s price, the more attractive the option
Stock’s price more likely to exceed the strike price before the option expires
The longer the time until expiration the more attractive the option
The stock’s price is more likely to exceed the strike price before the option expires

49. The Call Option Writer
The option writer originates the contract
The original writer must stand ready to deliver on the contract regardless of how many times the option is sold
Call writer hopes stock price will remain stable or not rise

50. Intrinsic Value
Intrinsic value of a call is the difference between the underlying stock’s current price and the option’s strike price
If out-of-the-money, intrinsic value is zero
Option always sells for intrinsic value or above
Time premium - difference between option’s intrinsic value and price

51. Figure 8-4 The Value of a Call Option

52. Options and Leverage
Financial leverage – magnifies return on investment
Options offer leverage due to the lower price at which the option can be purchased when compared to the price of the underlying stock

53. Options that Expire Options are worthless at expiration
Risky because they expire after a short time
If the price of an out-of-the-money option does not exceed the strike price prior to expiration, the option expires and is worthless
Results in a 100% loss
The time premium approaches zero as the expiration date approaches

54. Trading in Options
Options can be bought and sold at any time prior to expiration
Chicago Board Options Exchange (CBOE)
Price volatility in the options market
As the underlying stock’s price changes, the option’s price changes by a greater relative movement due to the option’s lower price
Options are rarely exercised before expiration
If the price of a call option is not expected to increase, the option is sold, not exercised

55. Writing Options
People write options for the premium income, hoping that the option will never be exercised
Option writers give up what option buyers make
Covered option — writer owns underlying stock
Naked option — writer does not own the underlying stock

56. Concept Connection Example 8-7 Stock Options
The following information refers to a three-month call option on the stock of Oxbow, Inc.
Price of the underlying stock: $30
Strike price of the three-month call: $25
Market price of the option: $8
a. What is the intrinsic value of the option?
The intrinsic value represents by how much the option is in-the-money. Since the stock price is $30 and the call option’s strike price is $25, the option is in-the-money by $5, which is the intrinsic value.

57. Concept Connection Example 8-7 Stock Options
b. What is the option’s time premium at this price?
The time premium represents the difference between the market price of the option and the intrinsic value, or $8 - $5 = $3.
c. Is the call in or out of the money?
The call option is in the money because it has a positive intrinsic value
d. If an investor writes and sells a covered call option, acquiring the covering stock now, how much has he invested?
The premium ($8) that the writer receives for the option will offset some of the purchase price of the stock ($30), therefore the investor has invested $30 - $8 = $22.

58. Concept Connection Example 8-7 Stock Options
e. What is the most the buyer of the call can lose?
The buyer can lose, at most, 100% of his investment which is the purchase price of the option of $8.
f. What is the most the writer of a naked call option on this stock can lose?
In theory since the stock price can rise to any price the writer can lose an infinite amount. However, a prudent writer would limit his losses by purchasing the stock once it started to rise in value.

59. Concept Connection Example 8-7 Stock Options
Just before the option’s expiration Oxbow is selling for $32.
g. What is the profit or loss from buying the call?
The buyer would exercise the option paying $25 for the stock and simultaneously selling the stock for $32, resulting in a gain of $7. However, this gain would be offset by the $8 premium paid for the option, resulting in an overall loss of $1.

60. Concept Connection Example 8-7 Stock Options
h. What is the profit or loss from writing the call naked?
A naked writer would have to buy the stock for $32 and sell it to the option owner for $25, resulting in a loss of $7. However, this loss would be offset by the premium received on the writing of the option of $8, resulting in an overall gain of $1.
i. What is the profit or loss from writing the call covered if the covering stock was acquired at the time the call was written?
The call writer bought the stock for $30 and sold it for $25, resulting in a loss of $5, but the loss is offset by the $8 premium received for writing the option. The overall gain is $3.

61. Put Options
Option to sell stock at a specified price by a specified date
Put buyer profits if underlying stock declines
Intrinsic value – “in-the-money”
difference between the option’s strike price and the current stock price (when positive),
Option is out-of-the-money if the strike price is above the current stock price

62. Figure 8-5 Basic Put Option Concepts

63. Figure 8-6 The Value of a Put Option

64. Option Pricing Models
Option pricing model is more difficult than pricing models for stocks and bonds
Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model
Determines option’s price based on
Price of underlying stock
Strike price of option
Time remaining until expiration of option
Volatility of underlying stock’s market price
Risk-free interest rate

65. Warrants
Options
Trade between investors, not between the companies that issue the underlying stocks
Secondary market instruments
Warrants
Issued by underlying company
When exercised – new stock is issued and company receives the exercise price
Primary market instruments while options are secondary market instruments

66. Warrants
Similar to calls with a longer expiration period (several years vs. months)
Issued as a “sweetener” (especially for risky bonds)
Can generally be detached from another issue and sold separately

67. Employee Stock Options
More like warrants than traded options
Expire after several years
Strike price set far out of the money
May receive options instead of salary increases
Wanted if future expectations are good
Companies offering options may pay lower salaries

68. Employee Stock Options
Executive Stock Option Problem
Senior executives may receive most of the stock options
Provide an incentive for executives to misstate financial statements and inflate stock prices