5-1

CHAPTER 5
Stocks and Their Valuation

 Features of common stock

 Determining common stock
values
 Efficient markets
 Preferred stock
 5-2

Common Stock: Owners, Directors,

and Managers
 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.
 5-3

What’s classified stock? How might

classified stock be used?

 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.
 5-4
What is 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.
 5-5

When is a stock sale an initial public

offering (IPO)?

 A firm “goes public” through an IPO

when the stock is first offered to the
public.
 Prior to an IPO, shares are typically
owned by the firm’s managers, key
employees, and, in many situations,
venture capital providers.
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What is a seasoned equity offering

(SEO)?

 A seasoned equity offering occurs

when a company with public stock
issues additional shares.
 After an IPO or SEO, the stock trades
in the secondary market, such as the
NYSE or Nasdaq.
 5-7

Different Approaches for Valuing

Common Stock

 Dividend growth model

 Using the multiples of comparable
firms
 Free cash flow method (covered in
Chapter 10)
 5-8

Stock Value = PV of Dividends

D1 D2 D3 D
Pˆ0     ...
 1  rs   1  rs   1  rs 
1 2 3
 1  rs  

What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.
 5-9

For a constant growth stock,

D1  D 0 1  g
1

D 2  D 0 1  g
2

D t  D t 1  g
t

If g is constant, then:
ˆ D0  1  g  D1
P0  
rs  g rs  g
 5 - 10
$
D t  D 0 1  g
t

0.25 Dt
PVDt 
1  r  t

P0   PVD t If g > r, P0  !

0 Years (t)
 5 - 11

What happens if g > rs?

D1
Pˆ0  requires rs  g .
rs  g
 If rs< g, get negative stock price,
which is nonsense.
 We can’t use model unless (1) g  rs
and (2) g is expected to be constant
forever. Because g must be a long-
term growth rate, it cannot be  rs.
 5 - 12

Assume beta = 1.2, rRF = 7%, and RPM =

5%. What is the required rate of return
on the firm’s stock?

Use the SML to calculate rs:

rs = rRF + (RPM)bFirm
= 7% + (5%) (1.2)
= 13%.
 5 - 13

D0 was $2.00 and g is a constant 6%.

Find the expected dividends for the
next 3 years, and their PVs. rs = 13%.

0 g=6% 1 2 3 4

D0=2.00 2.12 2.2472 2.3820

1.8761 13%
1.7599
1.6508
 5 - 14
What’s the stock’s market value?
D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:

ˆ D0  1  g  D1
P0  
rs  g rs  g

$2.12 $2.12
= = $30.29.
0.13 - 0.06 0.07
 5 - 15

What is the stock’s market value one

^
year from now, P 1?

 D1 will have been paid, so expected

dividends are D2, D3, D4 and so on.
Thus, D
2
P1 = rs - g

= $2.2427 = $32.10
0.07
 5 - 16

Find the expected dividend yield and

capital gains yield during the first year.

D1 $2.12
Dividend yield = = = 7.0%.
P0 $30.29

^
P1 - P 0 $32.10 - $30.29
CG Yield = =
P0 $30.29
= 6.0%.
 5 - 17

Find the total return during the

first year.

 Total return = Dividend yield +

Capital gains yield.
 Total return = 7% + 6% = 13%.
 Total return = 13% = rs.
 For constant growth stock:
Capital gains yield = 6% = g.
 5 - 18

Rearrange model to rate of return form:

ˆ D 
D1
P0  1
to r s   g.
rs  g P0

^
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.
 5 - 19

What would P0 be if g = 0?

The dividend stream would be a

perpetuity.
0 r =13% 1 2 3
s

2.00 2.00 2.00

^ PMT $2.00
P0 = = = $15.38.
r 0.13
 5 - 20

If we have supernormal growth of

30% for 3 years, then a long-run
^
constant g = 6%, what is P0? r is
still 13%.

 Can no longer use constant growth

model.
 However, growth becomes constant
after 3 years.
 5 - 21

Nonconstant growth followed by constant

growth:
0 r =13% 1 2 3 4
s

g = 30% g = 30% g = 30% g = 6%

D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
$4.6576
P̂3   $66.5371
46.1135 0.13  0.06
^
54.1067 = P0
 5 - 22

What is the expected dividend yield and

capital gains yield at t = 0? At t = 4?

At t = 0:
D1 $2.60
Dividend yield = = = 4.8%.
P0 $54.11

CG Yield = 13.0% - 4.8% = 8.2%.

(More…)
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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 t
t = 4 capital gains gains yield = 6%.
 Because rs = 13%, the t = 4 dividend
yield = 13% - 6% = 7%.
 5 - 24

Is the stock price based on

short-term growth?
 The current stock price is $54.11.
 The PV of dividends beyond year 3 is
^
$46.11 (P3 discounted back to t = 0).
 The percentage of stock price due to
“long-term” dividends is:
$46.11
$54.11 = 85.2%.
 5 - 25

If most of a stock’s value is due to long-

term cash flows, why do so many
managers focus on quarterly earnings?

 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.
 5 - 26

Suppose g = 0 for t = 1 to 3, and then g

is a constant 6%. What is P ^ ?
0

0 1 2 3 4
rs=13%
...
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861 2.12
20.9895 P3 
  30.2857
25.7118 0.07
 5 - 27

What is dividend yield and capital

gains yield at t = 0 and at t = 3?

D1 2.00
t = 0: P  $25.72 7.8%.
0

CGY = 13.0% - 7.8% = 5.2%.

t = 3: Now have constant growth

with g = capital gains yield = 6% and
dividend yield = 7%.
 5 - 28

If g = -6%, would anyone buy the

stock? If so, at what price?

Firm still has earnings and still pays

^
dividends, so P0 > 0:

ˆP  D0  1  g   D1
0
rs  g rs  g

$2.00(0.94) $1.88
= = = $9.89.
0.13 - (-0.06) 0.19
 5 - 29

What are the annual dividend

and capital gains yield?

Capital gains yield = g = -6.0%.

Dividend yield = 13.0% - (-6.0%)

= 19.0%.

Both yields are constant over time, with

the high dividend yield (19%) offsetting
the negative capital gains yield.
 5 - 30
Using the Stock Price Multiples to
Estimate Stock Price
 Analysts often use the P/E multiple (the price
per share divided by the earnings per share)
or the P/CF multiple (price per share divided
by cash flow per share, which is the earnings
per share plus the dividends per share) to
value stocks.
 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.
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Using Entity Multiples

 The entity value (V) is:
 the market value of equity (# shares of
stock multiplied by the price per share)
 plus the value of debt.
 Pick a measure, such as EBITDA, Sales,
Customers, Eyeballs, etc.
 Calculate the average entity ratio for a
sample of comparable firms. For example,
 V/EBITDA
 V/Customers
 5 - 32

Using Entity Multiples (Continued)

 Find the entity value of the firm in question.
For example,
 Multiply the firm’s sales by the V/Sales
multiple.
 Multiply the firm’s # of customers by the
V/Customers ratio
 The result is the total value of the firm.
 Subtract the firm’s debt to get the total value
of equity.
 Divide by the number of shares to get the
price per share.
 5 - 33
Problems with Market Multiple Methods

 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?
 5 - 34

Why are stock prices volatile?

^ D
P  r 1g
0 s

 rs = rRF + (RPM)bi could change.

 Inflation expectations
 Risk aversion
 Company risk

 g could change.
 5 - 35
Stock value vs. changes in rs and g

D1 = $2, rs = 10%, and g = 5%:

P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40.

What if rs or g change?
g g g
rs 4% 5% 6%
9% 40.00 50.00 66.67
10% 33.33 40.00 50.00
11% 28.57 33.33 40.00
 5 - 36
Are volatile stock prices consistent
with rational pricing?

 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 aren’t volatile, then
this means there isn’t a good flow of
information.
 5 - 37

What is market equilibrium?

In equilibrium, stock prices are stable.

There is no general tendency for
people to buy versus to sell.
^
The expected price, P, must equal the
actual price, P. In other words, the
fundamental value must be the same as
the price.
(More…)
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In equilibrium, expected returns must

equal required returns:

^
rs = D1/P0 + g = rs = rRF + (rM - rRF)b.
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How is equilibrium established?

^
^ D
If rs = 1 + g > rs, then P0 is “too low.”
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, and D1/P0 falls until
D /P + g = r = r .
 5 - 40

Why do stock prices change?

^ D1
P0 
ri  g
 ri = rRF + (rM - rRF )bi could change.
 Inflation expectations
 Risk aversion
 Company risk

 g could change.
 5 - 41

What’s the Efficient Market

Hypothesis (EMH)?

Securities are normally in

equilibrium and are “fairly priced.”
One cannot “beat the market”
except through good luck or inside
information.

(More…)
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1. Weak-form EMH:
Can’t 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.
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2. Semistrong-form EMH:
All publicly available
information is reflected in
stock prices, so it doesn’t pay
to pore over annual reports
looking for undervalued
stocks. Largely true.
 5 - 44

3. Strong-form EMH:
All information, even inside
information, is embedded in
stock prices. Not true--insiders
can gain by trading on the basis
of insider information, but that’s
illegal.
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Markets are generally efficient

because:

1. 100,000 or so trained analysts--MBAs,

CFAs, and PhDs--work for firms like
Fidelity, Merrill, Morgan, and
Prudential.
2. These analysts have similar access to
data and megabucks to invest.
3. Thus, news is reflected in P0 almost
instantaneously.
 5 - 46

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.
 5 - 47

What’s the expected return on

preferred stock with Vps = $50 and
annual dividend = $5?

$5
V ps  $50  
r ps


$5
r ps   0.10  10.0%.
$50