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Chapter 5
Valuing Stocks
Answers to Concept Review Questions
1. Why are common stockholders viewed as residual owners? What rights do they get in
exchange for taking more risk than creditors and preferred shareholders take?
Common stockholders are residual owners because they are entitled to receive cash only
after all other creditors and preferred shareholders have been paid. Because common
stockholders receive their compensation from the residual or whatever is left over
after everyone else has been paid, their claim is especially risky. As compensation for
taking that risk, common stockholders can earn much higher returns than can creditors
and preferred stockholders, and common stockholders also have the right to vote on
important corporate matters.
2. Most large J apanese corporations hold their annual shareholders meeting on the same day
and require voting in person. What does this practice say about the importance and clout
of individual shareholders in J apanese corporate governance?
Since it is clearly impossible for a person who owns stock in more than one company to
be present at more than one annual meeting, these practices indicate that individual
shareholders have very little decision-making power in Japanese corporations.
3. What is the difference between a primary market and a secondary market? Differentiate
between the organized exchanges and the over-the-counter market.
The primary market refers to when a firm first issues a particular security. The secondary
market is where the daily back and forth trading of that security takes place. Organized
exchanges are physical locations where investors come together to trade, while the OTC
market is a decentralized market of interconnected traders and dealers.
4. What do firms and their investment bankers hope to learn on the road show?
The purpose of the road show is to obtain a preliminary assessment of how much demand
there will be for the firms stock at different possible prices. This helps the banker set the
offering price.
5. How are underwriters compensated?
Underwriters earn the underwriting spread which typically equals about seven percent of
the money raised in a an equity IPO and about 0.5 percent in a large debt offering.)
26 Chapter 5/Valuing Stocks
6. When you buy a stock in the secondary market, does the firm that issued the stock
receive cash?
No. In a secondary market transaction, cash simply flows from the investor buying the
shares to the investor selling the shares. The firm is not a party to the transaction. Firms
receive money when they sell shares in the primary market.
7. List several differences between the NYSE and the Nasdaq.
The most obvious difference is that the NYSE is a physical market located in New York
City, while the Nasdaq is an electronic market with no single central location. The NYSE
usually has higher trading volume (in terms of dollars traded) and the value of securities
traded there is greater than the value of stocks on the Nasdaq.
8. Why is it appropriate to use the perpetuity formula from Chapter 3 to estimate the value
of preferred stock?
This formula applies to a level stream of cash flows that never ends. Preferred shares
generally pay a fixed dividend, and they do not have a specific maturity date.
9. When a shareholder sells shares of common stock, what is being sold? What gives a share
of common stock value?
What is being sold is the right to receive all future cash payments paid by the company to
stockholders. It is the prospect of receiving cash payments over time that gives common
shares their value.)
10. Using a dividend forecast of $2.15, a required return of 9 percent, and a growth rate of
3.8 percent, we obtained a price for Peoples Energy Corp. of $41.35. What would
happen to this price if the markets required return on Peoples Energy stock increased?
The price would fall because the market would be discounting the firms cash flows at a
higher rate. This is the same inverse relationship between discount rates and security
prices that we learned about in Chapter 4 for bonds.
11. How can the free cash flow approach to valuing an enterprise be used to resolve the
valuation challenge presented by firms that do not pay dividends? Compare and contrast
this model to the dividend valuation model.
The FCF model does not require any assumption about when a firm will distribute cash
dividends to investors. Instead, the model examines the cash flow generated by a firm,
making adjustments for cash flow that must be reinvested to generate growth
opportunities. Like the dividend growth model, the FCF approach tries to measure how
much cash a firm can distribute to shareholders over time.)
12. Why might the use of book value and liquidation value to value the firm be characterized
as viewing the firm as dead rather than alive? Explain why those views are inconsistent
with the discounted cash flow valuation models.
Book value measures the costs of a firms assets, net of accumulated depreciation.
Subtract off the historic value of the firms liabilities and you have the book value of the
Chapter 5/Valuing Stocks 27
firms equity. Liquidation value measures how much cash a firm could raise from a one-
time sale of its assets (again, subtracting off what is needed to pay creditors). Neither of
these measures is forward looking as is the discounted cash flow approach. If the firm is
a going concern, then a forward-looking approach is preferred because it can potentially
capture the value of future growth opportunities.
13. Why is it dangerous to conclude that a firm with a high P/E ratio will probably grow
faster than a firm with a lower P/E ratio?
The P/E ratio might be high simply because E is unusually small in a particular quarter
or year. Also, the P/E ratio can be influenced by how risky the firm is. If we have two
firms with identical expected growth rates and identical current earnings, the firm that is
less risky may have a higher P/E ratio because investors discount its future earnings at a
lower rate than they use to discount the earnings of the riskier firm. Finally, we have
noted in several places in this chapter that growth rates are notoriously difficult to
predict.
Answers to Self Test Questions
ST5-1. Omega Healthcare Investors (ticker symbol, OHI) pays a dividend on its Series B
preferred stock of $0.539 per quarter. If the price of Series B preferred stock is $25 per
share, what quarterly rate of return does the market require on this stock, and what is the
effective annual required return?
The preferred stock valuation formula says that the price equals the dividend divided by
the required rate of return. Therefore, using the quarterly dividend and the quarterly
required rate, we have
$25 =$0.539/r
r =0.02156
This means that the effective annual required rate on the stock equals (1.02156)
4
-
1=0.089 or 8.9%.
28 Chapter 5/Valuing Stocks
ST5-2. The restaurant chain Applebees International Inc. (ticker symbol, APPB) announced an
increase of their quarterly dividend from $0.06 to $0.07 per share in December 2003.
This continued a long string of dividend increases. Applebees was one of few companies
that had managed to increase its dividend at a double-digit clip for more than a decade.
Suppose you want to use the dividend growth model to value Applebees stock. You
believe that dividends will keep growing at 10 percent per year indefinitely, and you
think the markets required return on this stock is 11 percent. Lets simplify by assuming
that Applebees pays dividends annually and that the next dividend is expected to be
$0.31 per share. The dividend will arrive in exactly one year. What would you pay for
Applebees stock right now? Suppose you buy the stock today, hold it just long enough to
receive the next dividend, and then sell it. What rate of return will you earn on that
investment?
To calculate the price of the stock now, we simply divided next years expected dividend,
$0.31, by the difference between the required rate of return and the dividend growth rate.
This yields a price of $0.31(0.11-0.10) = $31.00. Next, we have to calculate the
expected price a year from now after the $0.31 dividend has been paid. To do that, we
need an estimate of the dividend two years in the future. If next years dividend is $0.31,
then the following years dividend should be 10 percent more or $0.341 per share. This
means that the price of Applebees stock, just after the $0.31 dividend is paid should be
$0.341(0.11-0.10) = $34.10. Now calculate your rate of return. You purchase the stock
for $31. One year later you receive a dividend of $0.31 and you immediately sell the
stock for $34.10, generating a capital gain of $3.10. Your total return is therefore
($34.10 + $0.31 - $31.00)$31.00 = 0.11 or 11%. That shouldnt be a surprise because
this is exactly the markets required return on the stock.