SLIDE 1

Stocks and their Valuation is the last topic to be covered in AC 513's midterms period.
The issuance of stocks is one of the most common sources of financing for companies that
needs to raise funds. Thus, in the point of view of investors, they need to determine which
stock among the stocks offered in the market is a deemed as a desirable buy
SLIDE 2
A person who invests in stocks is called a stockholder. A stockholder is considered as one of
the owners of the company. As one of the owners, stockholders can control the company
through their votes in stockholders' meetings. If a stockholder is unable to be physically
present during meetings, he/she could assign a PROXY to vote on shareholder resolutions on
his/her behalf.
Stockholders are the ones who elect the Board of Directors, who in turn, decide who the
management team should be. Contrary to traditional belief, the goal of management is NOT
to maximize net income. It is in fact, to maximize stock price or shareholder wealth. The
primary responsibility of management is towards the shareholders - not BODs or anybody
else.
SLIDE 3
Some investors want to gain controlling interest in a corporation, and this could be done
through takeovers. Takeovers could be friendly or hostile.
Friendly takeovers occur when there is a meeting of the minds between the acquirer and
acquiree. In other words, this is a situation wherein the target company is informed that the
company is being acquired, and that they accept the terms and conditions set forth in the
acquisition.
A hostile takeover, on the other hand, occurs when the target company does not approve of,
and as a result, opposes and resists the acquisition.
Tender offer occurs when the acquiring company simply offers to buy the shares of existing
shareholders even without the approval of directors and management. After amassing
enough shares, they now have control of the target company.
A hostile takeover done through proxy fight occurs when the existing shareholders join
forces or they convince other shareholders to use their proxy votes to change the BODs of
the company. Once changed, these BODs would then approve of the acquisition.
One of the rights given to existing common shareholders is called the "Preemptive right".
Sometimes, management would issue large number of additional shares so that they can
purchase these themselves. When this happens, there would be dilution of shares of existing
shareholders. Thus, when new issues are being offered, these are first offered to existing
shareholders before they are offered to others to give the former the chance to maintain
their current shareholdings.
Eg: Company A has 10 million shares outstanding. Mr. A holds 1 million shares. Effectively,

Mr. A owns 10% of the company.

If Company A wishes to issue an additional 5 million shares, the new number of shares
outstanding would be 15 million shares. Without the preemptive right, the shares of Mr. A
becomes 6.67% instead of the original 10% - this is a dilution of his shares. With the
preemptive right, Mr. A should be offered the right to buy 10% of the additional 5 million
shares or 500,000 shares so that when he has a say whether he wants his shares diluted or
not
SLIDE 4
Classified stock - Companies can specifically designate stocks into classes. Each class
usually have different characteristics and voting rights. Class A stocks are usually more
superior to Class B stocks, but this is not true in all cases. There are even common stock
classes that do not have voting rights, as long as there is at least one class that has voting
rights.
Founders' shares - these are stocks given to the founders of the firm which holds sole voting
rights or usually have more voting rights than any class of common stock. However,
dividends are not given for a specified number of years in order to give the company a
number of years to grow and keep its net income as retained earnings.
Golden share - is usually a share granted to the government or any organization that funds
the business proposal of a particular company. This golden share can outvote all other
shares of the company because the fund provider has to protect its interest and make sure
that their funds are put into good use.
SLIDE 5
As said in an earlier slide, management's goal is to maximize shareholder wealth. While
management's duty is towards the shareholders, they should also take good care of other
stakeholders such as employees, customers, suppliers, and the public. This is because the
dissatisfaction of these other stakeholders can lead to a decrease in shareholder wealth.
However, management must also be wary of its constraints and limitations while working for
its shareholders.
Lik

SLIDE 6
Stocks can be bought either in the secondary market, primary market, or through initial
public offering or IPO.
A secondary market is a market where the stocks have already been bought and sold. The
price of the stock in the secondary market is determined by supply and demand.
A primary market is a market when the new issues of shares are bought and sold directly.
The market price is determined by the issuing company beforehand, and is not determined
by supply and demand.
All IPO markets are primary markets, but not all primary markets are IPO markets. Selling
stock through IPO means that it is the first sale of stock by a private company when it wants
to go public.

Just remember that a public company can sell in the primary market its new issues of stocks,
but only private companies that are going public can issue stocks through IPOs.
Like

SLIDE 7
Stock price is the price that is published in stock exchanges and newspapers. It is
determined by supply and demand - hence it is determined by investors - on how they
perceive the returns through their perceived risks. We don't need to compute for stock price
because it is already determined.
It is essential though, that we know how to compute for the intrinsic value. The intrinsic
value is the true value of the stock. It is not determined by investors - rather, it is
determined by the issuing company - and such price is not published. The intrinsic value
represents true investor returns caused by true risk.
L

SLIDE 8
Since we would already know what the stock price is, intrinsic value is important to
determine whether the stock is undervalued or overvalued.
When intrinsic value > stock price, the stock is undervalued - hence it is a good buy.
When intrinsic value < stock price, the stock is overvalued - hence it is a good sell.
SLIDE 9
There are four different approaches to value common stock. However, as in our textbook,
the discussion will focus only on the first two approaches, namely: dividend growth model
and corporate value model.
I may be giving you a separate lecture as to the last 2 approaches in a separate album
subject to time constraint.
SLIDE 10
The first model: dividend growth model or discounted dividend model. This is the most
commonly used model of all.
According to the DGM, the value of a stock is the present value of the FUTURE dividends
expected to be generated by the stock.
We can immediately see the inherent limitation of the DGM. If a company does not give any
dividends, this model obviously cannot be used - for it doesn't mean that a company that
does not issue dividends has zero value.
Po stands for the Intrinsic Value at Period 0
D1 stands for dividends at Period 1
SLIDE 11

The DGM can be converged into the Gordon Growth Model when dividends are expected to
grow at a constant growth rate forever.

SLIDE 12
To use the Gordon Growth or Constant Growth Model two conditions must be met:
1. g must be constant
2. rs must be greater than g (stocks can only have a value of zero or positive)
If any of the two conditions are unmet, then the Gordon Growth Model should not be used to
compute for the intrinsic value of a stock.
g stands for growth.
rs stands for required return.
SLIDE 13
This slide shows that there is an inverse relationship between dividends and intrinsic value.
While dividends are increasing at g, the intrinsic value decreases as time lengthens because
the dividends are discounted at rs, and we know that rs must be greater than g.
SLIDE 14
rs = rrf + B (rm - rrf)
rs = 7% + 1.2 (12% - 7%)
rs = 13%
For the rest of the lecture, unless otherwise stated, we will assume rs = 13%.

SLIDE 15
As a review in your AC 501, when a company has net income, it has to choice of whether to
pay out dividends or to keep net income as retained earnings. RR (Retention ratio) refers to
the portion of net income that the company decides to retain and DPO (Dividend payout
ratio) refers to the portion of net income that the company decides to distribute to
shareholders. Therefore, RR + DPO = 1.
g = (1 - DPO) x NI/Equity
g = (1 - 40%) x 100,000/1,000,000
g = 6%
For the rest of the lecture, unless otherwise stated, we will assume g = 6%.
SLIDE 16-A
Assume rs = 13%, g is a constant 6%.

SLIDE 16-B
To find the dividend stream, multiply the previous dividend by (1+g)
To find the PV of dividend stream, divide each dividend stream by (1+rs)^n
SLIDE 17-B
Since the two conditions (rs > g and g is constant) are met, then the Gordon Growth Model
can be used to compute for the intrinsic value (Po) of the stock.
SLIDE 18-B
We can modify the Po = D1/(rs-g) equation to get P1, namely: P1 = D2/(rs-g). However, we
can also use an alternate equation P1 = Po (1+g). We must remember though, that this
could be used only if the two conditions are met.
These two equations will always give the same answer provided that (1) rs > g and (2) g is
constant.
SLIDE 19-A
As in the bonds and their valuation lecture, when we compute for CY, CGY, and TY;
Stocks and their valuation also has yield computations, as follows: DY (dividend yield), CGY
(capital gains yield) and rs (total return)
DY = D1/Po
CGY = (P1-Po)/Po
Total Return = DY + CGY
SLIDE 19-B
Using the equations, we get the answers 7% for dividend yield, 6% for capital gains yield,
and 13% for total return.
You might have noticed that these figures look familiar. We do have a general rule here. If
growth is constant:
DY is always equal to (rs - g)
CGY is always equal to g
Total return is always equal to rs
If you follow these rules, you will find out that you do save time and don't really need to do
computations.
SLIDE 20-A
Assume that rs is 13% and g is a constant 0%.
SLIDE 20-B

Since growth is a constant 0%, the dividend streams remain constant at $2. The present
value of the dividend streams are computed by dividing each dividend stream by (1+rs)^n.
We can definitely use the Gordon Growth Model to determine the intrinsic value of the stock
since g is constant 0% and rs of 13% is greater than g of 0%. Thus, the intrinsic value of this
stock is $15.38.
SLIDE 21
As a general rule (so there are exceptions), supernormal growth occurs when the company
achieves a double digit growth rate. (Eg: 10% and above). We do not expect any company to
have a double digit growth rate that can sustain indefinitely.
SLIDE 22-B
We are aware that the stock will undergo 3 years of supernormal growth of 30% before
achieving a long-run or constant growth of 6%. We cannot use the GGM to compute the
intrinsic value of a stock since at that time g is not yet constant. However, the growth does
become constant at Year 3. So, it is only at year 3 can we use that equation.
In constructing your timeline, determine first how long the supernormal (or nonconstant)
growth will be, then just add one more period to accommodate when the growth becomes
constant. That is why you see in this timeline, we have 4 ticks.
The dividend streams for Years 1 to 3 will be based on the 30% supernormal growth while
the dividend stream for Year 4 will be based on the constant growth rate of 6%. Since we
know that we can use the equation to find P3, that is why we did so. P3 is equal to 66.5377.
To find the intrinsic value, we must discount all FUTURE dividend streams and the P3. The P3
should be discount at 1.13^3 since the D4 is already converted to P3. Then we will add all
the present values of the dividend streams and P3 to arrive at the INTRINSIC VALUE of
$54.11.
We DO NOT add the $2 Do because according to the DGM, we are supposed to determine
the PV of FUTURE dividends, NOT PRESENT dividends.
Again, do take heed of the common mistakes made by students when computing for the
intrinsic value of nonconstant stocks:
1. Some students would not extend the timeline to accommodate the time when growth
becomes constant. (We should accommodate)
2. Some students use n=4 in discounting the terminal value. (We should use n=3 as it is
already converted to P3)
3. Some students would add Do in solving for Po. (Do not include Do)
SLIDE 23-A
As in the bonds and their valuation lecture, when we compute for CY, CGY, and TY;
Stocks and their valuation also has yield computations, as follows: DY (dividend yield), CGY
(capital gains yield) and rs (total return)

DY = D1/Po
CGY = (P1-Po)/Po
Total Return = DY + CGY
SLIDE 23-B
Since we have already computed D1 and Po, we can easily substitute the figures to compute
for dividend yield. D1 is 2.6 while Po is 54.11. Therefore, the dividend yield is 4.8050%.
The computation for capital gains yield is a little more complicated for nonconstant stocks
though, because we cannot use P1 = Po(1+g) just yet. That is why it is essential to do
manual computation to derive P1. As what we have done to get Po, we make a timeline good
for four ticks, and then we find the present value of the dividend streams AT YEAR 1 this
time (Not Year 0). We DO NOT ADD Do and D1 because at n=1. Do and D1 are NOT
considered as future dividends. Adding the PVs at Year 1 of D2, D3, and P3, we will arrive at
P1 = $58.54.
We can then get the CGY using the equation. (58.54 - 54.11) / 54.11 = 8.1870%
Then to derive at the Total Returns, we simply add DY and CGY which will equate to 13%
(there is some rounding off error which we can of course ignore).
If you notice, the total returns look familiar. Yes. even if growth is not yet constant, your total
returns will ALWAYS equal to your rs.
So actually, you only don't have to endure the hassle of computing for P1 ... actually, all you
had to do was to deduct DY from TY to get CGY if you are running out of time. Of course if
you want to prove that your answer is correct, you are welcome to compute for P1.
And to recap the general rules regarding constant and nonconstant stocks:
Constant growth:
DY = rs - g
CGY = g
Total return = rs
Nonconstant growth
Total return = rs
SLIDE 24-A
As in the bonds and their valuation lecture, when we compute for CY, CGY, and TY;
Stocks and their valuation also has yield computations, as follows: DY (dividend yield), CGY
(capital gains yield) and rs (total return)
For the second year:
DY = D2/P1

CGY = (P2-P1)/P1
Total Return = DY + CGY
SLIDE 24-B
Since we have already computed D2 and P1, we can easily substitute the figures to compute
for dividend yield. D2 is 3.38 while P1 is 58.54. Therefore, the dividend yield is 5.7738%
Using the short-cut method like what I have related to you in the previous slides, since total
return will always be equal to rs no matter what, the Total return will automatically be 13%,
and the CGY = Total return - DY = 13% - 5.7738% = 7.2262%.
However if you want to use the long method to compute for CGY, that is perfectly fine. At
n=2, the growth has not yet become constant. So, we cannot use P2 = P1(1+g) just yet.
That is why it is essential to do manual computation to derive P2. As what we have done to
get P1, we make a timeline good for four ticks, and then we find the present value of the
dividend streams AT YEAR 2. We DO NOT ADD Do, D1, and D2 because at n=2. Do, D1, and
D2 are NOT considered as future dividends. Adding the PVs at Year 2 of D3 and P3, we will
arrive at P2 = $62.77.
We can then get the CGY using the equation. (62.77 - 58.54)/58.54 = 7.2258%. This is the
same result as CGY using the short-cut method. The very minute difference of 0.0004% is
due to rounding off error.
Then to derive at the Total Returns, we simply add DY and CGY which will equate to 13%
(there is some rounding off error which we can of course ignore).
And to recap the general rules regarding constant and nonconstant stocks:
Constant growth:
DY = rs - g
CGY = g
Total return = rs
Nonconstant growth
Total return = rs
SLIDE 25-A
As in the bonds and their valuation lecture, when we compute for CY, CGY, and TY;
Stocks and their valuation also has yield computations, as follows: DY (dividend yield), CGY
(capital gains yield) and rs (total return)
For the third year:
DY = D3/P2
CGY = (P3-P2)/P2
Total Return = DY + CGY

SLIDE 25-B
Using the short-cut method, remember that at n=3, growth has already become constant.
Therefore, we can automatically answer this problem even without making any
computations using the rule: DY = rs - g; CGY = g, and Total return = rs. Therefore, DY = 7%,
CGY = 6%, and Total return = 13%.
Using the long method:
Since we have already computed D3 and P2, we can easily substitute the figures to compute
for dividend yield. D3 is 4.394 while P2 is 62.77. Therefore, the dividend yield is 7%.
P3 or the terminal value is already known as 66.5377. Thus, to compute for CGY, that would
be (P3-P2)/P2 = (66.54 - 62.77) / 62.77 = 6%.
Then to derive at the Total Returns, we simply add DY and CGY which will equate to 13%
And to recap the general rules regarding constant and nonconstant stocks:
Constant growth:
DY = rs - g
CGY = g
Total return = rs
Nonconstant growth
Total return = rs
SLIDE 26-A
This problem deals with nonconstant growth stock for 3 years before achieving constant
growth of 6%. While this example is not that of a supernormal growth stock, the
computational process involved is the same.
SLIDE 26-B
We are aware that the stock will undergo 3 years of zero growth before achieving a long-run
or constant growth of 6%. We cannot use the GGM to compute the intrinsic value of a stock
since at that time g is not yet constant. However, the growth does become constant at Year
3. So, it is only at year 3 can we use that equation.
In constructing your timeline, determine first how long the supernormal (or nonconstant)
growth will be, then just add one more period to accommodate when the growth becomes
constant. That is why you see in this timeline, we have 4 ticks.
The dividend streams for Years 1 to 3 will be based on zero growth while the dividend stream
for Year 4 will be based on the constant growth rate of 6%. Since we know that we can use
the equation to find P3, that is why we did so. P3 is equal to 30.2857.
To find the intrinsic value, we must discount all FUTURE dividend streams and the P3. The P3
should be discount at 1.13^3 since the D4 is already converted to P3. Then we will add all
the present values of the dividend streams and P3 to arrive at the INTRINSIC VALUE of

$25.71
We DO NOT add the $2 Do because according to the DGM, we are supposed to determine
the PV of FUTURE dividends, NOT PRESENT dividends.
Again, do take heed of the common mistakes made by students when computing for the
intrinsic value of nonconstant stocks:
1. Some students would not extend the timeline to accommodate the time when growth
becomes constant. (We should accommodate)
2. Some students use n=4 in discounting the terminal value. (We should use n=3 as it is
already converted to P3)
3. Some students would add Do in solving for Po. (Do not include Do)
SLIDE 27-A
Let us now solve the 3 yields for the first year and fourth year.
SLIDE 27-B
We will use the short-cut method to compute for the three yields.
For the first year:
Dividend yield = D1/Po. We already know the values for D1 and Po. Substitute this and you
will get DY of 7.7791%.
We already know that total returns = rs. Thus, if total returns is 13%, CGY is 13% - 7.7791%
= 5.2209%.
For the fourth year, growth is already constant. Therefore, DY = 7%, CGY = 6%, and total
returns = 13%.
SLIDE 28
There are only two conditions that need to be met so that we can use the GGM. (1) rs > g
and (2) g is constant. Even if this example when growth is negative, it is still constant and
less than rs of 13%. Therefore, we can use the GGM to compute for the Po or Intrinsic Value.
D1 = Do (1+g) = 2 x (1 + -6%) = 2 x 0.94 = 1.88
Po = D1/(rs-g) = 1.88/(13% - - 6%) = 9.89
The intrinsic value of this stock is 9.89.
Although only a very few people would want to buy stocks that results in constant negative
growth, theory states that as long as the stock has a value, there will be some investors who
may be willing to buy that stock.
SLIDE 29
Since growth is constant, we can follow the rule:
DY = rs - g
CGY = g

Total return = rs
DY = 13% - - 6% = 19%
CGY = -6%
Total return = 13%
SLIDE 30-A
For this exercise, even if the problem will not tell you D1 = 2.20, you must know how to
discern whether the dividend referred to is Do or D1. In this case, it is essential for us to
review English terms properly.
When the problem says: The company is expected to pay; the company will pay... this deals
with the FUTURE. Hence we know that the dividends referred to are D1.
However, when the problem says: The company has paid; The last dividend paid... this deals
with the PAST. Hence we know that the dividends referred to are Do.
SLIDE 30-B
The problem asks for P3. Notice that we are missing the growth rate as well as the rs. We
first solve the rs as we have all the data needed to make the computation. The rs is
computed as 11.28%.
To compute for the growth rate, we use the GGM formula and derive it using algebra. Growth
is computed to be 2.48%.
To find P3, there are two methods we can use. The first method simply multiplies Po by
(1+g)^3. This results to P3 of $26.91.
Using method 2, we modify the GGM formula to accommodate P3. Thus, P3 = D4/(rs-g).
Since D1 is 2.20, we mulitply it by (1+g)^3 to find P3. The P3 is computed as $26.91 - same
as when you use the first method to compute for P3.
SLIDE 31-A
There is an major erratum for this exercise. In the sixth line, "dividend should grow rapidly at
a rate of 0% per year"
Please change that to "dividend should grow rapidly at a rate of 50% per year"
SLIDE 31-B
The supernormal growth rate of 50% is good for two years after which there an 8% constant
growth rate is expected after Year 5. That is why we extend one tick up to Year 6. We
compute for P5 using te GGM because as of this point, rs > g and g is constant.
We then discount all the future dividend streams and the P3 to their values at Year 0. The
intrinsic value is then computed to be $23.77.
SLIDE 32
The second method used to compute for the intrinsic value of a stock is called the Corporate
Value Model. This is also knows as the free cash flow methods. This method, although not
the most popular, it is the most reliable to be used because it considers the firm as a whole

before arriving at the equity value. Besides, this model can be used whether or not the
company pays out dividends or not.
As of this point, you are not expected to to compute for your own free cash flows as cash
flow estimation and risk analysis are supposed to be lectured in the finals period. However
for precaution purposes, we will solve one problem later on that requires you to compute for
free cash flows.
SLIDE 33
To use the corporate value model, the first step is to find the present value of the firm's
FUTURE free cash flows. While dividends are discounted using rs, the free cash flows are
discounted using WACC. This is because dividends is part of equity and rs is the required
return of the stock (which is also part of equity). On the other hand, WACC (weighted
average cost of capital) is the weighted average of the cost of debt, preferred and common
stock (If you add debt, preferred and common equity, you come up with assets). Since free
cash flows (cash is also an asset), it is befitting that free cash flows should be discounted
using WACC and not rs.
The sum of the PVs is called the Market Value of the Firm. Our goal is to find the intrinsic
value of the stock. So, we have to deduct the market values of debt and preferred equity
from market value of the firm to get the market value of common stock.
The intrinsic value of the stock is computed as the MV of common stock divided by the
number of common stock outstanding.
SLIDE 34
The corporate value model is preferred for companies that do not pay at all or do not pay
regular dividends. The process of computing for the Market value of the firm at Year 0 is
similar to the computation used by the dividend growth model.
The terminal value or horizon value is the value of the firm at the time when growth is
constant.
SLIDE 35-B
We will create a timeline and accommodate one tick for the time that growth becomes
constant. As discussed previously, free cash flows should be discounted using WACC. Thus to
get the terminal or horizon value, we modify the GGM of P3 = D4 / (rs-g) to TV or HV =
FCF4 / (WACC - g). The terminal or horizon value is 530 million.
We then discount all the future cash flows and the terminal value using the WACC. We then
add all the present values and come up with the sum which we call the market value of the
firm.
This is not yet the intrinsic value. We still have a few more steps to do in the following slide.
SLIDE 36-A
In this slide, we are given the values of debt and the number of common stock outstanding.
This is enough for us to compute the intrinsic value of the stock.
SLIDE 36-B

The market value of equity is computed as market value of the firm less market value of
debt and market value of preferred stock. There is no amount for preferred stock so we
assume that preferred stock value is zero.
The market value of equity is computed as 416,942,148.80 - 40,000,000, which equates to
376,942,148.80.
Thus the intrinsic value of the stock is 376,942,148.80 divided by 10 million shares. We
come up with an intrinsic value of $37.69 per share.
SLIDE 37-B
Requirement 1:
The first requirement asks for the PV of free cash flows projected during the next four years.
We simply discount these given cash flows by (1+WACC)^n and add all of these. We will
arrive at $24,112,308.36.
Requirement 2:
The second requirement asks for the terminal or the horizon value. As seen in the timeline,
we extend one year to accommodate the point at which growth becomes constant at 7%. At
Year 5, we expect free cash flows to be $16,050,000. Getting the terminal value would be
16,050,000 divided by (WACC - constant g). Doing so results in a terminal or horizon value of
$321,000,000.
Requirement 3:
The third requirement asks for the total or the market value of the firm today. We should
discount all the future free cash flows and the terminal value by (1+WACC)^n to determine
their present values. Adding all of these result to the market value of the firm worth
$228,113,611.60.
Requirement 4:
The fourth and last requirement asks for the estimate of Barrett's price per share. This is in
effect looking for the intrinsic value of the stock. From requirement 3 above, we have
already determined the market value of the firm to be $228,113,611.60. From this amount,
we deduct the value of debt and preferred stock that adds up to $60 million so that we will
arrive at the market value of equity. The market value of equity is computed as
$168,113,611.60. Divide this amount by the number of common stocks outstanding, the
intrinsic value of the stock is $16.81 per share.
SLIDE 38-A
As mentioned in a previous slide, you are not yet expected to solve this kind of problem that
requires you to compute for the free cash flows. However, it is possible that you might
encounter this kind of problem in the midterm exam so I would like to discuss this with you.
Notice that you are given the required return on equity of 14% and WACC of 10%. Since we
are discounting cash flows, we should use WACC and ignore the required return on equity
which is just included to confuse you.
SLIDE 38-B
To compute for free cash flows, it is after-tax OI (or EBIT(1-T) or net operating profit after tax)
+ depreciation - capital expenditures - change in net operating working capital. The free

cash flows is thus computed as $400,000,000.

Since the growth is already deemed to be growing at a constant growth rate of 6% from the
start, the value of the firm is immediately computed as 400,000,000 divided by (WACC - g).
Hence, the value of the firm is $10,000,000,000.
To get the market value of equity, we deduct the market value of debt and preferred equity
from the firm's value. We thus end up with MV of equity worth $7,000,000,000.
Thus, the intrinsic value of the firm is 7,000,000,000 divided by 200,000,000 shares of
common stock outstanding = $35/share.
SLIDE 39
In the long run and in the absence of other information, we would assume that the market is
in equilibrium. In this situation, demand does not outweigh supply (or vice versa).
We already know that when market is in equilibrium, the expected returns must equal to the
required returns.
SLIDE 40
From our discussion of risk and return (Topic 1), we know that expected returns are
computed using probabilities and estimated returns for each state of economy. In the
context of stocks, we obtain expected returns by estimating dividends and expected capital
gains.
For required returns, we are able to compute it by using the CAPM equation.
SLIDE 41
We cannot expect that the market is always in equilibrium. Sometimes the expected return
will exceed the required return. This means that the stock is a good buy which results to
more buy orders than sell orders. However we cannot expect this phenomenon to sustain in
the long run because the market would always correct itself. More buy orders would bring
the price up until demand = supply.
SLIDE 42
Factors that can affect stock price include changes in the required return and growth rate.
Required return may be changed due to any changes effect by its components, namely the
nominal risk free rate, beta, or market risk premium.
The growth rate may also change due to internal (controllable) and external
(uncontrollable/market/economic) conditions
SLIDE 43
We will very briefly discuss about preferred stock. Preferred stock cannot be classified as a
debt security, nor could it be classified as an equity security. Because it has characteristics
of both debt and equity securities, we call it a "Hybrid Security".
Like debt securities that require the payment of fixed interests, preferred stockholders
(cumulative) are entitled to fixed dividends that should be paid before any dividends can be
paid to common shareholders. However, if the company wishes to defer payment of

preferred stocks (dividends in arrears or arrearages), it is allowed do so in subsequent

periods. In contrast, the company cannot defer interest payments in bonds (unless we are
dealing with income bonds).
Like stocks, if preferred dividends are not pay, investors cannot compel the company to pay
them. In contrast, when issuers fail to make interest payment, the issuer is deemed in
default and the investor can demand payment and sequester its assets if the bond is a
mortgage bond.
SLIDE 44
The intrinsic value of a preferred stock is computed as: Vp = D/rp as opposed to that of
common stock: Po=D1/(rs-g).
The dividends of preferred stock are fixed, that's why there is no growth involved. D is
always the same, and in the denominator, we don't deduct growth since growth is zero.
For this problem, it is asking about rp or the expected return of the preferred stock. Since Vp
is 50 and D is 5, the rp is 10%.
SLIDE 45
Efficient market hypothesis is a theory developed by Eugene Fama. This hypothesis assumes
that all investors are intelligent and well-informed. This results to the current stock prices
already reflecting all available information at any given time and in a liquid market. As a
result, it would be impossible to earn abnormal profits. If one were to earn abnormal profits,
then it is a game of chance rather than one of skill.
There are three levels of market efficiency. The weak form, semistrong form, and strong
form.
It is important to know that there are three kinds of information that determines whether the
market is weak, semistrong, or strong form efficient. These are:
1. Past information (can be studied through technical analysis)
2. Publicly available information (can be studied through fundamental analysis)
3. Private or insider information
SLIDE 46
The weak form efficiency states that stock prices already reflect past information. Therefore,
one cannot earn abnormal profits through the study of past information or technical analysis.
One can earn abnormal profits only through the study of publicly available information, the
knowledge of private or insider information, and/or when one has incredibly good luck.
Although the weak form efficiency is true, there are still some investors and stock analysts
who still analyze stocks using technical analysis.
SLIDE 47
The semistrong form efficiency states that stock prices already reflect past and publicly
available information. Therefore, one cannot earn abnormal profits through the study of past
information (technical analysis) and publicly available information (fundamental analysis)/
One can earn abnormal profits through the knowledge of private or insider information

and/or when one has incredibly good luck.

Although the semistrong form efficiency is largely true, there are still some investors and
stock analysts who perform fundamental analysis and still earn abnormal profits.
SLIDE 48
The strong form efficiency states that stock prices already reflect past, publicly available,
and insider information. Therefore, one can never earn abnormal profits unless he/she has
incredibly good luck.
Thee strong form efficiency is largely untrue because when one has knowledge of insider
information, he/she has an advantage over others because of information asymmetry. This
advantage can very easily translate into abnormal profits. However, one must be wary that
insider trading is illegal.
SLIDE 48.5 (Supplementary)
This slide summarizes the three levels of market efficiency, what the stock price reflects,
how each form can and cannot earn abnormal profits.
SLIDE 49
As a conclusion, the stock market is highly efficient in the weak form, reasonably efficient in
the semistrong form, and not effiicent in the strong form.
An investor can also use behavioral finance to understand why investors do what they do.
This understanding may allow the investor to know when is the right time to buy stocks or
when is the right time to sell the stocks if he/she can reasonably predict what other
investors are going to do.
SLIDE 50
Now we move on to other exercises that could help you in the upcoming midterm exam.
SLIDE 51-A
This exercise is asking for the intrinsic value of the stock today.
SLIDE 51-B
First, we determine what the rs is. Using the data given, we determine that it is 10.3%. Since
the growth becomes constant after Year 8, we extend the timeline to Year 9. Then we find
the present value of the future dividend streams as well as P8. Adding all the present value
of these, we get the intrinsic value of $20.65 per share.
SLIDE 52-A
This exercise is asking for P3.
SLIDE 52-B
Even if growth is negative, since rs > g and g is constant, we can use the GGM to solve first
for Po. Po is computed as 11.875.
To get P3, we multiply Po by (1+g)^3 and thus P3 is $10.18.
SLIDE 53-A

This exercise is asking for P8.

SLIDE 53-B
First we need to determine what the rs is. Using the CAPM, we know that it is 10%.
2.50 is considered to be D1 because the company "expects to pay" so it deals with the
future. Using the GGM, we arrive at a Po of 62.50. To get P8 we simply multiply 62.5 by
(1.06)^8. Thus, P8 is $99.62.
SLIDE 54-A
This exercise is asking the total market value (not the intrinsic value) of the firm's common
equity.
SLIDE 54-B
First we need to determine the rs. Using CAPM, we determine that the rs is 13%.
Next, we need to know what is Do so that we will be able to compute for Po. What we are
given in this exercise is the amount of retained earnings, which is 1.4 million. The exercise
further states that the payout ratio is 30%. That means that 70% of net income is retained.
Dividing 1.4 million by 70%, we derive a 2 million net income. Therefore, the dividends is
600,000.
To get Do, we divide the total dividends by 1 million shares. Hence we get $0.60 per share.
We now construct the timeline extending up to the fourth year. We then find the present
value of the future dividend streams and the P3 by dividing it by 1.13^n. Adding all of these
PVs, we arrive at Po = 9.17250111.
Therefore, the total market value of the firm's common equity is the intrinsic value
multiplied by the number of shares. 9.17250111 x 1 million = $9,172,501.11.
SLIDE 55-A
This exercise is asking for Po/E1 ratio.
SLIDE 55-B
First we compute for rs using CAPM and it is determined to be 16%.
Next we need to find what is Po. $1.50 is considered as Do because it is "the most recent
dividend" meaning it has happened in the past. So we need to multiply it by 1.1 to arrive at
D1. Po is computed to be 27.50.
Next, we should compute for E1. E1 stands for Earnings at Year 1. We are also told that
retention ratio is 70%. Therefore the dividend payout ratio is 30%. We also know that D1 is
1.65. So divide 1.65 by 30%, we arrive at E1 of 5.50
Po/E1 is then 27.50/5.50 = 5

SLIDE 56-A
This problem asks for CGY and DY.
SLIDE 56-B
Since growth is constant, we can follow the rule:
DY = rs - g
CGY = g
Total return = rs
Since growth is given, we can immediately say that CGY is 7%.
However, since we don't have rs, we have to compute DY manually using the formula DY =
D1/Po. 3.42 is considered Do because it's the "last dividend paid" (past). So we need to
multiply it by 1.07 to get D1. The dividend yield for this exercise is 11.3119%.
SLIDE 1
Stocks and their Valuation is the last topic to be covered in AC 513's midterms period.
The issuance of stocks is one of the most common sources of financing for companies that
needs to raise funds. Thus, in the point of view of investors, they need to determine which
stock among the stocks offered in the market is a deemed as a desirable buy.
SLIDE 2
A person who invests in stocks is called a stockholder. A stockholder is considered as one of
the owners of the company. As one of the owners, stockholders can control the company
through their votes in stockholders' meetings. If a stockholder is unable to be physically
present during meetings, he/she could assign a PROXY to vote on shareholder resolutions on
his/her behalf.
Stockholders are the ones who elect the Board of Directors, who in turn, decide who the
management team should be. Contrary to traditional belief, the goal of management is NOT
to maximize net income. It is in fact, to maximize stock price or shareholder wealth. The
primary responsibility of management is towards the shareholders - not BODs or anybody
else.
SLIDE 3
Some investors want to gain controlling interest in a corporation, and this could be done
through takeovers. Takeovers could be friendly or hostile.
Friendly takeovers occur when there is a meeting of the minds between the acquirer and
acquiree. In other words, this is a situation wherein the target company is informed that the
company is being acquired, and that they accept the terms and conditions set forth in the
acquisition.
A hostile takeover, on the other hand, occurs when the target company does not approve of,
and as a result, opposes and resists the acquisition.

Tender offer occurs when the acquiring company simply offers to buy the shares of existing
shareholders even without the approval of directors and management. After amassing
enough shares, they now have control of the target company.
A hostile takeover done through proxy fight occurs when the existing shareholders join
forces or they convince other shareholders to use their proxy votes to change the BODs of
the company. Once changed, these BODs would then approve of the acquisition.
One of the rights given to existing common shareholders is called the "Preemptive right".
Sometimes, management would issue large number of additional shares so that they can
purchase these themselves. When this happens, there would be dilution of shares of existing
shareholders. Thus, when new issues are being offered, these are first offered to existing
shareholders before they are offered to others to give the former the chance to maintain
their current shareholdings.
Eg: Company A has 10 million shares outstanding. Mr. A holds 1 million shares. Effectively,
Mr. A owns 10% of the company.
If Company A wishes to issue an additional 5 million shares, the new number of shares
outstanding would be 15 million shares. Without the preemptive right, the shares of Mr. A
becomes 6.67% instead of the original 10% - this is a dilution of his shares. With the
preemptive right, Mr. A should be offered the right to buy 10% of the additional 5 million
shares or 500,000 shares so that when he has a say whether he wants his shares diluted or
not.
SLIDE 5
As said in an earlier slide, management's goal is to maximize shareholder wealth. While
management's duty is towards the shareholders, they should also take good care of other
stakeholders such as employees, customers, suppliers, and the public. This is because the
dissatisfaction of these other stakeholders can lead to a decrease in shareholder wealth.
However, management must also be wary of its constraints and limitations while working for
its shareholders.