7-1

CHAPTER 7
Stocks and Their Valuation

Features of common stock

Determining common stock
values
Efficient markets
Preferred stock

7-2

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.

7-3

Whats 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.

What is tracking stock?

7-4

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.

7-5

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 firms managers, key
employees, and, in many situations,
venture capital providers.

7-6

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.

7-7

Different Approaches for Valuing

Common Stock

Dividend growth model

Using the multiples of comparable
firms
Free cash flow method (covered in
Chapter 15)

7-8

Stock Value = PV of Dividends

P0

D3
D1
D2
D

...
1
2
3

1 rs 1 rs 1 rs
1 rs

What is a constant growth stock?

One whose dividends are expected to
grow forever at a constant rate, g.

7-9

For a constant growth stock,

D1 D 0 1 g
2
D 2 D 0 1 g
t
D t D t 1 g
1

If g is constant, then:

D0 1 g
D1

P0

rs g
rs g

7 - 10

D t D 0 1 g

0.25

Dt
PVDt
1 r t

P0 PVD t

If g > r, P0 !
Years (t)

7 - 11

What happens if g > rs?

P0

D1
requires rs g .
rs g

If rs< g, get negative stock price,

which is nonsense.
We cant use model unless (1) g rs
and (2) g is expected to be constant
forever. Because g must be a longterm growth rate, it cannot be rs.

7 - 12

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

5%. What is the required rate of return
on the firms stock?
Use the SML to calculate rs:
rs = rRF + (RPM)bFirm
= 7% + (5%) (1.2)
= 13%.

7 - 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%

D0=2.00 2.12
1.8761 13%
1.7599
1.6508

2
2.2472

3
2.3820

7 - 14

Whats the stocks market value?

D0 = 2.00, rs = 13%, g = 6%.
Constant growth model:

D0 1 g
D1

P0

rs g
rs g
$2.12
$2.12
=
=
$30.29.
0.13 - 0.06
0.07

7 - 15

What is the stocks market value one

^
year from now, P
1?
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on.
Thus,
D2
P1 = rs - g

= $2.2427 = $32.10
0.07

7 - 16

Find the expected dividend yield and

capital gains yield during the first year.

D1
$2.12
Dividend yield =
=
= 7.0%.
P0
$30.29
^
$32.10 - $30.29
P1 - P0
CG Yield =
=
$30.29
P0
= 6.0%.

7 - 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.

7 - 18

Rearrange model to rate of return form:

D
D1
1

P0
to r s
g.
rs g
P0

Then, rs = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.

7 - 19

What would P0 be if g = 0?
The dividend stream would be a
perpetuity.
0 r =13%
s

2.00

2.00

2.00

PMT $2.00
P0 =
=
= $15.38.
r
0.13
^

7 - 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.

7 - 21

Nonconstant growth followed by constant

growth:
0 r =13%
s
g = 30%

D0 = 2.00

2
g = 30%

2.60

3.38

3
g = 30%

4.394

4
g = 6%

4.6576

2.3009
2.6470
3.0453
46.1135
54.1067

^
= P0

$4.6576

P3
$66.5371
0.13 0.06

7 - 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%.
$54.11
P0
CG Yield = 13.0% - 4.8% = 8.2%.
(More)

7 - 23

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%.

7 - 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%.

7 - 25

If most of a stocks value is due to longterm 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.

7 - 26

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

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

rs=13%
g = 0%

1.7699
1.5663
1.3861
20.9895
25.7118

g = 0%

g = 0%

2.00

2.00

4
g = 6%

2.00

...

2.12

P 2.12 30.2857
3
0.07

7 - 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%.

7 - 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:

P D0 1 g D1
0
rs g
rs g
$2.00(0.94) $1.88
=
=
= $9.89.
0.13 - (-0.06) 0.19

7 - 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.

7 - 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.

7 - 31

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

7 - 32

Using Entity Multiples (Continued)

Find the entity value of the firm in question.
For example,
Multiply the firms sales by the V/Sales
multiple.
Multiply the firms # of customers by the
V/Customers ratio
The result is the total value of the firm.
Subtract the firms debt to get the total value
of equity.
Divide by the number of shares to get the
price per share.

7 - 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?

7 - 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.

7 - 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
9%
10%
11%

4%
40.00
33.33
28.57

5%
50.00
40.00
33.33

6%
66.67
50.00
40.00

7 - 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 arent volatile, then
this means there isnt a good flow of
information.

7 - 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)

7 - 38

In equilibrium, expected returns must

equal required returns:
^

rs = D1/P0 + g = rs = rRF + (rM - rRF)b.

7 - 39

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 .

7 - 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.

7 - 41

Whats 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)

7 - 42

1. 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.

7 - 43

2. 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.

7 - 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 thats
illegal.

7 - 45

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.

7 - 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.

7 - 47

Whats the expected return on

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

r ps

$5

r ps

$5

0.10 10.0%.
$50