Understanding Intrinsic Value: Stocks, Valuation, and Market Equilibrium, Slides of Financial Management

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CHAPTER 7 Stocks, Stock Valuation, and Stock Market Equilibrium docsity.com 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 docsity.com 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. docsity.com 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. docsity.com Different Approaches for Valuing Common Stock  Dividend growth model  Constant growth stocks  Nonconstant growth stocks  Free cash flow method (covered in Chapter 11)  Using the multiples of comparable firms docsity.com Dividend Growth and PV of Dividends: P0 = ∑(PV of Dt) $ 0.25 Years (t) Dt = D0(1 + g)t PV of Dt = Dt (1 + r)t If g > r, P0 = ∞ ! docsity.com What happens if g > rs? P0 = ^ (1 + rs)1 (1 + rs)2 (1 + rs)∞ D0(1 + g)1 D0(1 + g)2 D0(1 + rs)∞ + + … + (1 + g)t (1 + rs)t P0 = ∞ ^ > 1, and So g must be less than rs for the constant growth model to be applicable!! If g > rs, then docsity.com Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%. rs = rRF + (RPM)bFirm = 7% + (5%)(1.2) = 13%. Use the SML to calculate rs: docsity.com Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6% Constant growth model: = = = $30.29. 0.13 – 0.06 $2.12 $2.12 0.07 P0 = ^ D0(1 + g) rs – g = D1 rs – g docsity.com Expected value one year from now: P1 = ^ D2 rs – g = $2.2472 0.07 = $32.10  D1 will have been paid, so expected dividends are D2, D3, D4 and so on. docsity.com Expected Dividend Yield and Capital Gains Yield (Year 1) Dividend yield = = = 7.0%. $2.12 $30.29 D1 P0 CG Yield = = P1 – P0 ^ P0 $32.10 – $30.29 $30.29 = 6.0%. docsity.com If g = 0, the dividend stream is a perpetuity. 2.00 2.00 2.00 0 1 2 3 rs = 13% P0 = = = $15.38. PMT r $2.00 0.13 ^ docsity.com Supernormal Growth Stock  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. docsity.com Nonconstant growth followed by constant growth (D0 = $2): 0 2.3009 2.5452 2.5903 39.2246 1 2 3 4 rs = 13% 46.6610 = P0 g = 30% g = 25% g = 15% g = 6% 2.6000 3.2500 3.7375 3.9618 ^ P3 = ^ $3.9618 0.13 – 0.06 = $56.5971 docsity.com Is the stock price based on short-term growth? The current stock price is $46.66. The PV of dividends beyond Year 3 is: ^ P3 / (1+rs)3 = $39.22 (see slide 22) = 84.1%. $39.22 $46.66 The percentage of stock price due to “long-term” dividends is: docsity.com Intrinsic Stock Value vs. Quarterly Earnings  If most of a stock’s value is due to long-term cash flows, why do so many managers focus on quarterly earnings?  See next slide. docsity.com Intrinsic Stock Value vs. 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. docsity.com Dividend Yield and Capital Gains Yield (after t = 3)  Now have constant growth, so:  Capital gains yield = g = 6%  Dividend yield = rs – g  Dividend yield = 13% – 6% = 7% docsity.com If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P0 > 0: ^ = = = $9.89. $2.00(0.94) 0.13 – (-0.06) $1.88 0.19 P0 = ^ D0(1 + g) rs – g = D1 rs – g docsity.com Annual Dividend and Capital Gains Yields 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. docsity.com 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 firm’s total value.  Subtract the firm’s debt to get the total value of its equity.  Divide by the number of shares to calculate the price per share. docsity.com 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? docsity.com 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. docsity.com Consider the following situation. D1 = $2, rs = 10%, and g = 5%: P0 = D1/(rs – g) = $2/(0.10 – 0.05) = $40. What happens if rs or g changes? docsity.com Stock Prices vs. Changes in rs and 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 docsity.com 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. docsity.com rs = D1/P0 + g = rs = rRF + (rM – rRF)b. ^ In equilibrium, expected returns must equal required returns: docsity.com How is equilibrium established? If rs = + g > rs, then P0 is “too low.” 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 = rs = rs. ^ D1 ^ ^ P0 docsity.com 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.  EMH does not assume all investors are rational.  EMH assumes that stock market prices track intrinsic values fairly closely. (More…) docsity.com 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. docsity.com 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. docsity.com Markets are generally efficient because:  100,000 or so trained analysts—MBAs, CFAs, and PhDs—work 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. docsity.com Implications of Market Efficiency for Financial Decisions  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. docsity.com Rational Behavior vs. Animal Spirits, Herding, and Anchoring Bias  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.  Other investors emulate them, following like a herd of sheep. docsity.com 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. docsity.com