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Copyright © 2001 by Harcourt, Inc. All rights reserved.
Represents ownership.
Ownership implies
control.
Stockholders elect
directors.
Directors elect
management.
Management’s goal:
Maximize stock price.
Facts about Common Stock
9 - 2
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Social/Ethical Question
Should management be equally
concerned about employees,
customers, suppliers, “the public,”
or just the stockholders?
In enterprise economy, work for
stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
9 - 3
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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.
What’s classified stock?
How might classified stock
be used?
9 - 4
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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.
9 - 5
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Average Initial Returns on
IPOs in Various Countries
Ma
lay
si
a
100%
75%
50%
25%
Br
az
il
Po
rtu
ga
l
Ja
pa
n
Sw
ed
en
Un
ite
d
St
at
es Ca
na
d
a
9 - 6
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Dividend growth model
Free cash flow method
Using the multiples of
comparable firms
Different Approaches for
Valuing Common Stock
9 - 7
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One whose dividends are expected to
grow forever at a constant rate, g.
Stock Value = PV of Dividends
What is a constant growth stock?
9 - 8
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For a Constant Growth Stock
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = Dt(1 + g)t
P0 = = .
If g is constant, then:
D0(1 + g)
ks - g
D1
ks - g
^
9 - 9
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$
Years (t)0
9 - 10
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What happens if g > ks?
If ks< g, get negative stock
price, which is nonsense.
We can’t use model unless
(1) ks> g and (2) g is
expected to be constant
forever.
9 - 11
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Assume beta = , kRF = 7%,
and kM = 12%. What is the
required rate of return on the
firm’s stock?
ks= kRF + (kM – kRF)bFirm
= 7% + (12% – 7%) ()
= 13%.
Use the SML to calculate ks:
9 - 12
Copyright © 2001 by Harcourt, Inc. All rights reserved.
D0 was $ and g is a
constant 6%. Find the
expected dividends for the
next 3 years, and their PVs.
ks = 13%.0 1
2
3g = 6%
D0 =
13%
9 - 13
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= =
What’s the stock’s market
value?
D0 = , ks = 13%, g = 6%.
Constant growth model:
P0 = =
D1
ks – g –
$
$
$.
9 - 14
Copyright © 2001 by Harcourt, Inc. All rights reserved.
D1 will have been paid, so
expected dividends are D2,
D3, D4 and so on. Thus,
Could also find P1 as
follows:
ks – g –
P1 = =
What is the stock’s market
value one year from now, P1?
^
^
^
D2 $^
= $.
P1 = P0() = $.
9 - 15
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Find the expected dividend
yield, capital gains yield, and
total return during the first
year.
Dividend yld = = =
Cap gains yld = =
Total return = % + % = %.
D
1P0
P1 –
P0P0
^
$
9
$
2
%.
$ – $
$
9= %.
9 - 16
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Rearrange model to rate of return form:
$ $ .P
D
k g
D
P
g
s
0
1 1
0
=
-
= + to k s
Then, ks = $ +
= + = 13%.
^
9 - 17
Copyright © 2001 by Harcourt, Inc. All rights reserved.
P0 = = = $.
What would P0 be if g = 0?
The dividend stream would be a
perpetuity.
0 1 2 3
13% ...
^ PMT
k
$
0
^
9 - 18
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Can no longer use
constant growth model.
However, growth becomes
constant after 3 years.
If we have supernormal
growth of 30% for 3 years,
then a long-run constant
g = 6%, what is P0? k is still
13%.
^
9 - 19
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Nonconstant growth followed by constant
growth:
0
1 2 3 4ks = 13%
= P0
g = 30% g = 30% g = 30% g = 6%
D0 =
$ .
. .
$
13 0 06
=
-
=
0
...
^
9 - 20
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What is the expected
dividend yield and capital
gains yield at t = 0?
At t = 4?
Div. yield0 = = %.
Cap. gain0 = % – % = %.
$
$
1
9 - 21
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During nonconstant
growth, D/P and capital
gains yield are not
constant, and capital gains
yield is less than g.
After t = 3, g = constant =
6% = capital gains yield; k =
13%; so D/P = 13% – 6% =
7%.
9 - 22
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Suppose g = 0 for t = 1 to 3,
and then g is a constant 6%.
What is P0?
0
1 2 3 4
ks=13%
g = 0% g = 0% g = 0% g = 6%
.
$P3
0 07 .
= =
^
...
9 - 23
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t = 3: Now have constant growth
with g = capital gains yield = 6% and
D/P = 7%.
$
$
What is D/P and capital gains
yield at
t = 0 and at t = 3?
t = 0:
D1
P0
= = %.
CGY = 13% – % = %.
9 - 24
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If g = -6%, would anyone buy
the stock? If so, at what
price?
Firm still has earnings and still pays
dividends, so P0 > 0:
( )
$P
D
k g
D g
k gs s
0
1 0 1=
-
=
+
-
$() $
– ()
= = = $.
9 - 25
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What is the annual D/P and
capital gains yield?
Capital gains yield = g = %,
Dividend yield= % – (%) = 19%.
D/P and cap. gains yield are constant,
with high dividend yield (19%) offsetting
negative capital gains yield.
9 - 26
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Free Cash Flow Method
The free cash flow method suggests
that the value of the entire firm
equals the present value of the firm’s
free cash flows (calculated on an
after-tax basis).
Recall that the free cash flow in any
given year can be calculated as:
NOPAT – Net capital investment.
9 - 27
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Once the value of the firm is
estimated, an estimate of the
stock price can be found as
follows:
MV of common stock
(market capitalization) =
MV of firm – MV of debt
and preferred stock.
P = MV of common stock/#
of shares.
Using the Free Cash Flow
Method
^
9 - 28
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Free cash flow method is
often preferred to the
dividend growth model--
particularly for the large
number of companies that
don’t pay a dividend, or for
whom it is hard to forecast
dividends.
Issues Regarding the Free
Cash Flow Method
(More...)
9 - 29
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Similar to the dividend
growth model, the free
cash flow method
generally assumes that at
some point in time, the
growth rate in free cash
flow will become constant.
Terminal value represents
the value of the firm at the
point in which growth
becomes constant.
FCF Method Issues
Continued
9 - 30
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FCF estimates for the next 3
years are
-$5, $10, and $20 million,
after which the FCF is
expected to grow at 6%. The
overall firm cost of capital is
10%.
0
1 2 3 4
k = 10%
g = 6%
-5 10 20
...
*TV3 represents the terminal value of
the firm, at t = 3.
530 = = *TV3
9 - 31
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If the firm has $40 million in
debt and has 10 million
shares of stock, what is the
price per share?
Value of equity = Total value – Value of debt
= $ – $40
= $ million.
Price per share = Value of equity/# of shares
= $
= $.
9 - 32
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Analysts often use the following multiples
to value stocks:
P/E
P/CF
P/Sales
P/Customer
Example: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.
Using the Multiples of
Comparable Firms to
Estimate Stock Price
9 - 33
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In equilibrium, stock prices are stable.
There is no general tendency for
people to buy versus to sell.
In equilibrium, expected returns must
equal required returns:
What is market equilibrium?
ks = D1/P0 + g = ks = kRF + (kM – kRF)b.
^
9 - 34
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ks = D1/P0 + g = ks = kRF + (kM – kRF)b.
^
Expected returns are obtained by
estimating dividends and expected
capital gains (which can be found
using any of the three common stock
valuation approaches).
Required returns are obtained from
the CAPM.
9 - 35
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How is equilibrium
established?
If ks = + g > ks, then
P0 is “too low” (a bargain).
Buy orders > sell orders;
P0 bid up; D1/P0 falls until
D1/P0 + g = ks = ks.
^
^
D1
P0
9 - 36
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Why do stock prices
change?
1. ki could change:
ki = kRF + (kM – kRF )bi.
kRF = k* + IP.
2. g could change due to
economic or firm situation.
P0 =
^ D1
ki – g
9 - 37
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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 better
information.
9 - 38
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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.
9 - 39
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2. Semistrong-form EMH:
All publicly available
information is reflected in
stock prices, so doesn’t pay to
pore over annual reports
looking for undervalued
stocks. Largely true, but
superior analysts can still
profit by finding and using new
information.
9 - 40
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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.
9 - 41
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Markets are generally
efficient because:
1. 15,000 or so trained analysts; MBAs,
CFAs, Technical PhDs.
2. Work for firms like Merrill, Morgan,
Prudential, which have a lot of money.
3. Have similar access to data.
4. Thus, news is reflected in P0 almost
instantaneously.
9 - 42
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Preferred Stock
Hybrid security.
Similar to bonds in that
preferred stockholders
receive a fixed dividend that
must be paid before
dividends can be paid on
common stock.
However, unlike interest
payments on bonds,
companies can omit dividend
payments on preferred stock
without fear of pushing the
firm into bankruptcy.
