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The Valuation of Common Stock
Ch7 & 8
Chapter 7The Valuation of
Common Stock
Acquiring ownership in a corporation
Investing in Stock
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.
Corporations
Charter – A document specifying the relationship between a firm and the state in which it is incorporated
Bylaws - specifies the relationship with stockholders
Corporations
Director: A person who is elected by stockholders to determine the goals and policies of the firm.
The Board of Directors
Right of stockholde
r
Preemptive rights
Cumulative voting
Voting authority
Rights offering
Right of stockholder
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.
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.
Rights of Stockholders
Dividends/earnings
Stability of the payout ratio
Stability of dividend payments
Payout Ratio
Dividends
Stock Dividends
Cash Dividends
Kind of Dividends
Distribution from earnings Regular quarterly dividends Extra dividends Irregular dividends Dividends paid in property
Cash Dividends
Date of recordStock trading ex dividendEx-dividend dateDistribution date
Distribution of Dividends
The retention ratio:earnings retained/earnings
or1 - payout ratio
Payout Ratio
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.
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.
Distribution of Dividends
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.
The Stock Dividend
Does not affect proportionate ownership
Does not affect assetsDoes not affect liabilitiesDoes not affect total equity
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 dividendA 10% stock dividendCauses a $20 stock price to fall to $18.18 ($20/1.1)
The Stock Dividend
Does not affect proportionate ownership
Does not affect assetsDoes not affect liabilitiesDoes not affect total equity
The Stock Split
Does affect the stock's priceA 2 for 1 stock splitCauses a $80 stock price to decline to $40 ($80/2)
The Stock Split
Cash dividends used to purchase additional shares
Additional cash contributions may be allowed
Expenses often paid by the firmAre automatic; an easy means to save
Dividend Reinvestment Plans
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
Stock Repurchases
Stockholders do not have to sell their shares
Sales are◦Realized capital gains◦Subject to capital gains taxation
Stock Repurchases and Capital Gains
25
Preferred Stock Hybrid security. Similar to bonds in that preferred
stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock.
However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.
The dividends is % of the par value
26
Expected return, given Vps = $50 and annual dividend = $5
Vps = $50 = $5rps^
rps$5
$50^ = = 0.10 = 10.0%
Corporate liquidations are rareCompany◦Ceases operations◦Pays off its liabilities◦Distributes its remaining assets to stockholders
Corporate Liquidations
THE LOGICAL PROCESS OF SECURITIES VALUATION
Ch8
1. Evaluate the economic environment Including estimates of economic growth, employment, inflation, and the geopolitical environment in which firms operate.
The valuation of a stock includes:
2. Evaluate regulatory issues and the impact of government policy and intervention.
The valuation of a stock includes:
3. Analyst then moves to the various sectors of the economy.
Within each industry the analyst needs to be aware of the degree of competition, cost structures, the pricing environment, and anticipated growth. Such background is necessary prior to analyzing an individual firm.
The valuation of a stock includes:
4. The securities analyst progresses to consider specific firms.
Ultimately the purpose of the analysis is to determine if the firm’s securities (i.e., its stocks and bonds) are undervalued and should be purchased for inclusion in an individual’s or investment company’s portfolio.
The valuation of a stock includes:
Investors purchase stock with the anticipation of a total return consisting of a dividend yield and a capital gain.
If a firm’s $0.93 dividend is expected to grow at 7 percent to $1.00 and the price of the stock is $25, the anticipated annual return on an investment in the stock is:
The investor expected return
R(E) = E(D) /P + E(g)
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
Estimation of Growth Rates
Increased growth should increase a stock’s price
Increased growth at the expense of dividends may reduce a stock’s price
Impact of Increased Growth on Stock Prices
Growth or income
Question of what is the best use of the funds - retention versus distribution
What Do Investors Want?
Dividends: Regular, extra, and irregular.
Payout: The ratio of dividends to earnings.
Retention ratio: The ratio of earnings not distributed to earnings.
Source of Return
Difference in short and long-term capital gains taxation favor capital gains
Transaction costs (e.g., commissions) favor dividend income
Sources of Return
Capital gain Dividends'
Low taxation Higher taxation
Long term Short term
Pay commission for selling and buying
No commission for selling and buying
Difference between capital gain and dividends
40
Different Approaches for Valuing Common Stock Dividend growth model
◦ Constant growth stocks◦ Nonconstant growth stocks
Free cash flow method. Using the multiples of comparable firms
41
Stock Value = PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever at a constant rate, g.
P0 =^
(1 + ks)1 (1 + ks)2 (1 + ks)3 (1 +ks)∞
D1 D2 D3 D∞+ + + … +
42
For a constant growth stock:
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
If g is constant and less than rs, then:
P0 = ^ D0(1 + g)ks – g
=D1
ks – g
43
Dividend Growth and PV of Dividends: P0 = ∑(PV of Dt)
$
0.25
Years (t)
Dt = D0(1 + g)t
PV of Dt =
Dt
(1 + r)t
If g > r, P0 = ∞ !
Valuation is
V=D/k If a stock pays a dividend of $1 and the investor’s required rate of return is 12 percent, then the valuation is = 1/12%= 8.33$
If the Dividend Is Fixed
Valuation is
V=D0 (1+g)/(k - g)
If the Dividend Grows at a Constant Rate
46
Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6%
Constant growth model:
= = = $30.29.0.13 – 0.06
$2.12
P0 = ^ D0(1 + g)
ks – g=
D1
ks – g
47
Expected value one year from now:
P1 = ^ D2
ks – g=
$2.2472
0.07= $32.10
D1 will have been paid, so expected dividends are D2, D3, D4 and so on.
Value depends on the◦the required return◦the dividend◦the growth in the dividend
The Dividend Growth Model
value
the required return
the dividend
the growth in the
dividend
Value depends on the
Depends on◦the risk-free rate (rf)
◦the return on the market (rm)◦the stock's beta
The Required Return (k)
The Required Return
(k)
the stock's beta
the risk-free rate
(rf)
the return on the
market (rm)
Depend on The Required Return (k)
Risk and Required Rate of Return
P/E ratio is a price-earnings multiple times earnings
P=(m)(EPS) if the analyst determines that the appropriate P/E is 10 and the firm’s per-share earnings are $4.50, the value of the stock is 45
Alternative Valuation Techniques
Different definitions of earnings
Differences in estimated earnings
Question of the appropriate multiple
Weakness in the Use of P/E Ratios
Conceptually the same as using P/E ratios
Same weaknesses apply
Price to Book Value and Price to Sales
Standardizes the P/E ratio for growth
P/EEarnings growth
Low PEG ratios (below 1.0) suggest undervaluation
The PEG Ratio
Emphasis on firm’s ability to generate cash
May be applied when firm does not pay a dividend
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
Substitution of Cash Flow for Earnings and Dividends
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
The Efficient Market Hypothesis
Large number of competing participants
Information is readily available
Transaction costs are small
Assumptions Concerning Efficient Markets
Another term for efficient markets
Does not imply security prices are randomly determined
Implies day-to-day price changes are random
Random Walk
Successive prices changes are independent
Today's price does not forecast tomorrow's price
Current price embodies all known information
Random Walk
New information must be random
IF NOT
An opportunity to earn an excess return would exist
Random Walk
Undervaluationdrives prices up
returns decline
Overvaluationdrives prices down
returns increase
Undervaluation and Overvaluation
Undervaluation and Overvaluation
Prices change quickly to new information
By the time most investors know the information the price change has already occurred
Random Walk
Price Adjustments to New Information
The forms of the efficient market hypothesis:◦the weak form◦the semi-strong form◦the strong form
Degree of Market Efficiency
Even if financial markets are efficient, that does not answer the question "How efficient?”
Degree of Market Efficiency
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
The Weak Form
Studying economic and accounting data will not lead to superior investment returns
Studying inside information may lend to superior returns
The Semi-Strong Form
Using inside information will not lead to superior investment returns
The Strong Form
The Strong Form
The Semi-Strong Form
The Weak Form
Empirical results generally support◦the weak form◦the semi-strong form
Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist
Anomalies
Low P/E stocksThe small firm effectThe January effectThe neglected firm effect
Examples of Anomalies
The day-of-the-week effect
The Value Line effect
The overreaction effect
Drifts in security prices
Examples of Anomalies
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
Anomalies and Returns
Security prices embody known information
The playing field is levelSpecifying financial goals may be more important than seeking undervalued stocks
Implications of Efficient Markets
Other markets may not be efficient
Importance of reducing transactions costs: the argument for a buy-and-hold strategy
Implications of Efficient Markets
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