1. CHAPTER 9 Stocks and Their Valuation
Features of common stock
Determining common stock values
Efficient markets
Preferred stock

2. Facts about common stock
Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Management’s goal: Maximize the stock price

3. Types of stock market transactions
Initial public offering market (“going public”) (Company sells shares to the public for the 1st times.)
Secondary market (stockholders sell shares to each other)
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4. Stock Market Transactions
Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction?
Since new shares of stock are being issued, this is a primary market transaction.
What if instead an investor buys existing shares of Apple stock in the open market – is this a primary or secondary market transaction?
Since no new shares are created, this is a secondary market transaction.
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5. Different approaches for valuing common stock
Dividend growth model
Corporate value model
Using the multiples of comparable firms
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6. Dividend growth model
Value of a stock is the present value of the future dividends expected to be generated by the stock.
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7. Constant growth stock
A stock whose dividends are expected to grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
If g is constant, the dividend growth formula converges to:
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8. What happens if g > rs?
If g > rs, the constant growth formula leads to a negative stock price, which does not make sense.
The constant growth model can only be used if:
rs > g
g is expected to be constant forever
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9. Use the SML to calculate the required rate of return (rs):
If rRF = 7%, rM = 12%, and b = 1.2, what is the required rate of return on the firm’s stock?
Use the SML to calculate the required rate of return (rs):
rs = rRF + (rM – rRF)b
= 7% + (12% - 7%)1.2
= 13%
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10. If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs. 1
2.247 2
2.382 3
2.12
rs = 13%
g = 6%
1.8761
1.7599
D0 = 2.00
1.6509
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11. What is the stock’s intrinsic value?
Using the constant growth model:
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12. What is the expected market price of the stock, one year from now?
D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc.
Could also find expected P1 as:
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13. What are the expected dividend yield, capital gains yield, and total return during the first year?
= D1 / P0 = $2.12 / $30.29 = 7.0%
Capital gains yield
= (P1 – P0) / P0
= ($ $30.29) / $30.29 = 6.0%
Total return (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
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14. What would the expected price today be, if g = 0?
The dividend stream would be a perpetuity.
2.00 1 2 3
rs = 13%
...
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15. Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
Can no longer use just the constant growth model to find stock value.
However, the growth does become constant after 3 years.
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16. Valuing common stock with nonconstant growth1 2 3 4
D0 =
...
4.658
rs = 13%
g = 30%
g = 6%
2.301
2.647
3.045
46.114
= P0 =
0.06
$66.54 3
4.658
0.13 - $ P ^
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17. If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value?
The firm still has earnings and pays dividends, even though they may be declining, they still have value.
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18. Find expected annual dividend and capital gains yields.
Dividend yield
= 13.00% - (-6.00%) = 19.00%
Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.
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19. Corporate value model
Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows.
Remember, free cash flow is the firm’s after-tax operating income less the net capital investment
FCF = NOPAT – Net capital investment
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20. Applying the corporate value model
Find the market value (MV) of the firm.
Find PV of firm’s future FCFs
Subtract MV of firm’s debt and preferred stock to get MV of common stock.
MV of = MV of – MV of debt and common stock firm preferred
Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).
P0 = MV of common stock / # of shares
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21. Issues regarding the corporate value model
Often preferred to the dividend growth model, especially when considering number of firms that don’t pay dividends or when dividends are hard to forecast.
Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate.
Terminal value (TVn) represents value of firm at the point that growth becomes constant.
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22. Given the long-run gFCF = 6%, and WACC (weighted average cost of capital) of 10%, use the corporate value model to find the firm’s intrinsic value.
21.20 1 2 3 4
...
g = 6%
r = 10%
-4.545
8.264
15.026
21.20
530 = = TV3
0.10
0.06 -
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23. If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s intrinsic value per share?
MV of equity = MV of firm – MV of debt
= $416.94m - $40m
= $ million
Value per share = MV of equity / # of shares
= $376.94m / 10m
= $37.69
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24. Firm multiples method
Analysts often use the following multiples to value stocks.
P / E
P / CF
P / Sales
EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings per share to back out an estimate of the stock price.
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25. What is market equilibrium?
In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell.
In equilibrium, two conditions hold:
The current market stock price equals its intrinsic value (P0 = P0).
Expected returns must equal required returns. ^
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26. Market equilibrium
Expected returns are obtained by estimating dividends yield and expected capital gains yield.
Required returns are obtained by estimating risk and applying the CAPM.
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27. How is market equilibrium established?
If expected return exceeds required return …
The current price (P0) is “too low” and offers a bargain.
Buy orders will be greater than sell orders.
P0 will be bid up until expected return equals required return
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28. Factors that affect stock price
Required return (rs) could change
Changing inflation could cause rRF to change
Market risk premium or exposure to market risk (β) could change
Growth rate (g) could change
Due to economic (market) conditions
Due to firm conditions
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29. Stock Market Reporting
Gap has been as high as $52.75 in the last year.
Gap has been as low as $19.06 in the last year.
Given the current price, the dividend yield is ½ %
Gap pays a dividend of 9 cents/share
Given the current price, the PE ratio is 15 times earnings
6,517,200 shares traded hands in the last day’s trading
Gap ended trading at $19.25, down $1.75 from yesterday’s close
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30. Where can you find a stock quote, and what does one look like?
Stock quotes can be found in a variety of print sources (Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).
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31. Efficient Capital Markets
Stock prices are in equilibrium or are “fairly” priced
If this is true, then you should not be able to earn “abnormal” or “excess” returns, in expectation.
Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market.
They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns.
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32. What is the Efficient Market Hypothesis (EMH)?
Securities are normally in equilibrium and are “fairly priced.”
Investors cannot “beat the market” except through good luck or better information.
Levels of market efficiency
Weak-form efficiency
Semistrong-form efficiency
Strong-form efficiency
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33. Weak-form efficiency
Can’t profit by looking at past price trends. A recent decline is no reason to think stocks will go up (or down) in the future. There is no predictable price pattern based on price path.
Real world evidence supports weak-form EMH, but “technical analysis” is still used by some people.
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34. Efficient Market Theory
Technical Analysts
Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)
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35. Semistrong-form efficiency
All publicly available information is reflected in stock prices, so it doesn’t pay to over-analyze annual reports looking for undervalued stocks.
Largely true in real world, but superior analysts can still profit by finding and using new information
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36. Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and the Market Index
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37. Implications of market efficiency
You hear in the news that a medical research company received FDA approval for one of its products. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing the stock?
No – if the market is semi-strong efficient, this information will already have been incorporated into the company’s stock price. So, it’s probably too late …
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38. One-year-ahead hedge returns based on capital investment levels.
Go long the lowest investment stocks.
Go short the highest investment stocks.
12 month size adjusted buy and hold hedge returns after May each year.
Positive in 36 out of 39 years, average 12.6%
Pattern is consistent with market mispricing.
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39. Strong-form efficiency
All information, even inside information, is embedded in stock prices. That is, one cannot profit even on private information.
Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.
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40. Is the stock market efficient?
Empirical studies have tried to test the three forms of efficiency.
Highly efficient in the weak form.
Reasonably efficient in the semistrong form.
Not efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits.
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41. What Makes Markets Efficient?
There are many investors out there doing research
As new information comes to market, this information is analyzed and trades are made based on this information
Therefore, prices should reflect all available public information, and almost instantly.
Point out that one consequence of the wider availability of information and lower transaction costs is that the market will be more volatile. It is easier to trade on “small” news instead of just big events.
It is also important to remember that not all available information is reliable information. It’s important to still do the research and not just jump on everything that crosses the news wire. The case of Emulex, discussed earlier, is an excellent example.
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42. Preferred stock Hybrid security.
Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders.
However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.
No voting right.
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43. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return?
Price= D / rp
$50 = $5 / rp
rp = $5 / $50
= 0.10 = 10%
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