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Topics in Chapter
Features of common stock Valuing common stock Preferred stock Stock market equilibrium Efficient markets hypothesis Implications of market efficiency for financial decisions
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ValueStock =
Cost of
equity (rs)
Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are agents of shareholders, their goal should be: Maximize stock price.
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Classified Stock
Classified stock has special provisions. Could classify existing stock as founders shares, with voting rights but dividend restrictions. New shares might be called Class A shares, with voting restrictions but full dividend rights.
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Tracking Stock
The dividends of tracking stock are tied to a particular division, rather than the company as a whole.
Investors can separately value the divisions. Its easier to compensate division managers with the tracking stock.
But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company.
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Free cash flow method (covered in Chapter 11) Using the multiples of comparable firms
P0 =
D1 (1 + rs)1
D2 (1 + rs)2
D3
++
(1 + rs)3
(1 + rs)
What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g.
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Dt = D0(1 + g)t
0.25
If g > r, P0 = !
Years (t)
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P0 =
(1 + rs)2
++
^
D0(1 + rs)
(1 + rs)
(1 + g)t
(1 + rs)t
> 1, and P0 =
Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%.
Projected Dividends
D0 = $2 and constant g = 6%
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2 2.2472
3 2.3820
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$2.12
0.07
= $30.29.
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D1 will have been paid, so expected dividends are D2, D3, D4 and so on.
D2 ^ $2.2472 P1 = = rs g 0.07 = $32.10
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Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13%. Total return = 13% = rs. For constant growth stock:
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2.00
^
2.00 = $15.38.
2.00
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Supernormal growth of 30% for Year 0 to Year 1, 25% for Year 1 to Year 2, 15% for Year 2 to Year 3, and then long-run constant g = 6%. Can no longer use constant growth model. However, growth becomes constant after 3 years.
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1
g = 25%
2
g = 15%
3
g = 6%
4 3.9618
2.6000 2.3009
3.2500
3.7375
2.5452
2.5903 39.2246 ^ 46.6610 = P0 $3.9618 ^ = $56.5971 P3 = 0.13 0.06
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During nonconstant growth, dividend yield and capital gains yield are not constant. If current growth is greater than g, current capital gains yield is greater than g. After t = 3, g = constant = 6%, so the capital gains yield = 6%. Because rs = 13%, after t = 3 dividend yield = 13% 6% = 7%.
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If most of a stocks value is due to long-term cash flows, why do so many managers focus on quarterly earnings? See next slide.
26
Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes managers have bonuses tied to quarterly earnings.
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rs = 13% g = 0%
2 2.00
g = 0%
3 2.00
g = 6%
4 2.12
^ = 2.12 P3
0.07
= 30.2857
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Dividend Yield = D1/P0 Dividend Yield = $2.00/$25.72 Dividend Yield = 7.8% CGY = 13.0% 7.8% = 5.2%.
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Now have constant growth, so: Capital gains yield = g = 6% Dividend yield = rs g Dividend yield = 13% 6% = 7%
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Analysts often use the P/E multiple (the price per share divided by the earnings per share). Example:
Estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.
33
Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example,
the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt.
V/EBITDA V/Customers
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The result is the firms total value. Subtract the firms debt to get the total value of its equity. Divide by the number of shares to calculate the price per share.
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Multiply the firms sales by the V/Sales multiple. Multiply the firms # of customers by the V/Customers ratio
It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range.
For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?
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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.
37
Vps
D1
rs g
g could change.
40
41
Small changes in expected g and rs cause large changes in stock prices. As new information arrives, investors continually update their estimates of g and rs. If stock prices arent volatile, then this means there isnt a good flow of information.
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In equilibrium, the intrinisic price must equal the actual price. If the actual price is lower than the fundamental value, then the stock is a bargain. Buy orders will exceed sell orders, the actual price will be bid up. The opposite occurs if the actual price is higher than the fundamental value.
(More)
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True Expected
Future Cash Flows
True
Risk
Perceived Expected
Future Cash Flows
Perceived
Risk
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P0
If the price is lower than the fundamental value, then the stock is a bargain. Buy orders will exceed sell orders, the price will be bid up until: D1/P0 + g = ^s = rs. r
46
Securities are normally in equilibrium and are fairly priced. One cannot beat the market except through good luck or inside information. EMH does not assume all investors are rational. EMH assumes that stock market prices track intrinsic values fairly closely.
(More)
47
EMH (continued)
If stock prices deviate from intrinsic values, investors will quickly take advantage of mispricing. Prices will be driven to new equilibrium level based on new information. It is possible to have irrational investors in a rational market.
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Weak-form EMH
Cant profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but technical analysis is still used.
49
Semistrong-form EMH
All publicly available information is reflected in stock prices, so it doesnt pay to pore over annual reports looking for undervalued stocks. Largely true.
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Strong-form EMH
All information, even inside information, is embedded in stock prices. Not trueinsiders can gain by trading on the basis of insider information, but thats illegal.
51
100,000 or so trained analystsMBAs, CFAs, and PhDswork for firms like Fidelity, Morgan, and Prudential. These analysts have similar access to data and megabucks to invest. Thus, news is reflected in P0 almost instantaneously.
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Market Efficiency
For most stocks, for most of the time, it is generally safe to assume that the market is reasonably efficient. However, periodically major shifts can and do occur, causing most stocks to move strongly up or down.
53
Many investors have given up trying to beat the market. This helps explain the growing popularity of index funds, which try to match overall market returns by buying a basket of stocks that make up a particular index.
54
Important implications for stock issues, repurchases, and tender offers. If the market prices stocks fairly, managerial decisions based on over- and undervaluation might not make sense. Managers have better information but they cannot use for their own advantage and cannot deliberately defraud investors.
55
Stock market bubbles of 2000 and 2008 suggest that something other than pure rationality in investing is alive and well. People anchor too closely on recent events when predicting future events.
When market is performing better than average, they tend to think it will continue to perform better than average.
Conclusions
Markets are rational to a large extent, but at time they are also subject to irrational behavior. One must do careful, rational analyses using the tools and techniques covered in the book. Recognize that actual prices can differ from intrinsic values, sometimes by large amounts and for long periods. Good news! Differences between actual prices and intrinsic values provide wonderful opportunities for those able to capitalize on them. 57