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Chapter 6Fundamentals of
CorporateFinance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Valuing Stocks
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 2
Topics Covered
Stocks and the Stock MarketBook Values, Liquidation Values and
Market ValuesValuing Common StocksSimplifying the Dividend Discount ModelGrowth Stocks and Income StocksThere are no free lunches on Wall StreetMarket Anomilies and Behavioral Finance
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 3
Stocks & Stock Market
Primary Market - Place where the sale of new stockfirst occurs.
Initial Public Offering (IPO) - First offering of stockto the general public.
Seasoned Issue - Sale of new shares by a firm thathas already been through an IPO
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 4
Stocks & Stock Market
Common Stock - Ownership shares in apublicly held corporation.
Secondary Market - market in which alreadyissued securities are traded by investors.
Dividend - Periodic cash distribution from thefirm to the shareholders.
P/E Ratio - Price per share divided byearnings per share.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 5
Stocks & Stock Market
Book Value - Net worth of the firm accordingto the balance sheet.
Liquidation Value - Net proceeds that wouldbe realized by selling the firm’s assets andpaying off its creditors.
Market Value Balance Sheet - Financialstatement that uses market value of assetsand liabilities.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 6
Valuing Common Stocks
Expected Return - The percentage yield that aninvestor forecasts from a specific investment overa set period of time. Sometimes called the holdingperiod return (HPR).
Expected Return
rDiv P P
P1 1 0
0
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6- 7
Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
Expected Return
rDivP
P PP
1
0
1 0
0
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6- 8
Valuing Common Stocks
Dividend Discount Model - Computation of today’sstock price which states that share value equals thepresent value of all expected future dividends.
H - Time horizon for your investment.
PDiv
rDiv
rDiv P
rH H
H01
12
21 1 1
( ) ( )
...( )
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6- 9
Valuing Common Stocks
ExampleCurrent forecasts are for XYZ Company to paydividends of $3, $3.24, and $3.50 over the nextthree years, respectively. At the end of three yearsyou anticipate selling your stock at a market priceof $94.48. What is the price of the stock given a12% expected return?
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 10
Valuing Common Stocks
ExampleCurrent forecasts are for XYZ Company to pay dividends of $3, $3.24,and $3.50 over the next three years, respectively. At the end of threeyears you anticipate selling your stock at a market price of $94.48.What is the price of the stock given a 12% expected return?
PV
PV
3 001 12
3 241 12
350 94 481 12
00
1 2 3
.( . )
.( . )
. .( . )
$75.
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6- 11
Blue Skies Value
0
10
20
30
40
50
60
70
80
Val
ue
per
shar
e,d
olla
rs
1 2 3 10 20 30 50 100
Investment Horizon, Years
PV (Terminal Value)PV (Dividends)
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6- 12
Valuing Common Stocks
If we forecast no growth, and plan to hold outstock indefinitely, we will then value the stock asa PERPETUITY.
Perpetuity PDiv
ror
EPSr
01 1
Assumes all earnings arepaid to shareholders.
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6- 13
Valuing Common Stocks
Constant Growth DDM - A version of thedividend growth model in which dividendsgrow at a constant rate (Gordon GrowthModel).
PDivr g0
1
Given any combination of variables in theequation, you can solve for the unknown variable.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 14
Valuing Common Stocks
ExampleWhat is the value of a stock that expects to pay a$3.00 dividend next year, and then increase thedividend at a rate of 8% per year, indefinitely?Assume a 12% expected return.
PDivr g0
1 0012 08
00
$3.
. .$75.
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6- 15
Valuing Common Stocks
Example- continuedIf the same stock is selling for $100 in the stockmarket, what might the market be assuming aboutthe growth in dividends?
$100$3.
..
0012
09g
g
AnswerThe market isassuming the dividendwill grow at 9% peryear, indefinitely.
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6- 16
Valuing Common Stocks
If a firm elects to pay a lower dividend, andreinvest the funds, the stock price may increasebecause future dividends may be higher.
Payout Ratio - Fraction of earnings paid out asdividends
Plowback Ratio - Fraction of earnings retained bythe firm.
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6- 17
Valuing Common Stocks
Growth can be derived from applying thereturn on equity to the percentage ofearnings plowed back into operations.
g = return on equity X plowback ratio
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6- 18
Valuing Common Stocks
ExampleOur company forecasts to pay a $5.00dividend next year, which represents100% of its earnings. This willprovide investors with a 12% expectedreturn. Instead, we decide to plowback 40% of the earnings at the firm’scurrent return on equity of 20%.What is the value of the stock beforeand after the plowback decision?
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin
6- 19
Valuing Common Stocks
ExampleOur company forecasts to pay a $5.00 dividend next year, whichrepresents 100% of its earnings. This will provide investors with a12% expected return. Instead, we decide to blow back 40% of theearnings at the firm’s current return on equity of 20%. What is thevalue of the stock before and after the plowback decision?
P0512
67 .
$41.
No Growth With Growth
g
P
. . .
. .$75.
20 40 083
12 08000
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6- 20
Valuing Common Stocks
Example - continuedIf the company did not plowback some earnings,the stock price would remain at $41.67. With theplowback, the price rose to $75.00.
The difference between these two numbers (75.00-41.67=33.33) is called the Present Value ofGrowth Opportunities (PVGO).
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6- 21
Valuing Common Stocks
Present Value of Growth Opportunities(PVGO) - Net present value of a firm’sfuture investments.
Sustainable Growth Rate - Steady rate atwhich a firm can grow: plowback ratio Xreturn on equity.
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6- 22
No Free Lunches
Technical AnalystsForecast stock prices based on the watching the
fluctuations in historical prices (thus “wigglewigglewatcherswatchers”)
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6- 23
No Free Lunches
Scatter Plot of NYSE Composite Index over two successive weeks.
Where’s the pattern?
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6- 24
Random Walk Theory
The movement of stock prices from day today DO NOT reflect any pattern.Statistically speaking, the movement of
stock prices is random (skewed positive over thelong term).
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6- 25
Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
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6- 26
Random Walk Theory
S&P 500 Five Year Trend?or
5 yrs of the Coin Toss Game?
80
130
180
Month
Lev
el
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6- 27
Random Walk Theory
S&P 500 Five Year Trend?or
5 yrs of the Coin Toss Game?
80
130
180
230
Month
Lev
el
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6- 28
Random Walk Theory
LastMonth
ThisMonth
NextMonth
1,300
1,200
1,100
MarketIndex
Cyclesdisappear
onceidentified
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6- 29
Another Tool
Fundamental AnalystsResearch the value of stocks using NPV and other
measurements of cash flow
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6- 30
Efficient Market Theory
Weak Form EfficiencyMarket prices reflect all historical information
Semi-Strong Form EfficiencyMarket prices reflect all publicly available
information
Strong Form EfficiencyMarket prices reflect all information, both
public and private
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6- 31
Efficient Market Theory
-16-11-6-149
141924293439
Days Relative to annoncement date
Cu
mu
lati
veA
bn
orm
alR
etu
rn(%
)
Announcement Date
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6- 32
Behavioral Finance
Attitudes towards riskBeliefs about probabilities
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6- 33
www.rba.co.uk/sources/stocks.htm
www.euroland.com
finance.yahoo.com
www.briefing.com
www.thestreet.com
www.fool.com
moneycentral.msn.com/investor/home.asp
www.dividenddiscountmodel.com
www.valuepro.com
www.exinfm.com/free_spreadsheets.html
www.zacks.com
www.bestcalls.com
Web Resources
www.nyse.com
www.nasdaq.com
www.fibv.com
www.djindexes.com
www.spglobal.com
www.msci.com
www.barra.com
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