Chapter 7 Valuing Stocks PDF

Chapter 7 Valuing Stocks Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 1 Stocks and the Stock Market (1 of 5)  Primary Market – Market for the sale of new securit...

Chapter 7 Valuing Stocks Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 1 Stocks and the Stock Market (1 of 5)  Primary Market – Market for the sale of new securities by corporations  Initial Public Offering (IPO) – First offering of stock to the general public  Primary Offering – The corporation sells shares in the firm Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 2 Stocks and the Stock Market (2 of 5)  Common Stock – Ownership shares in a publicly held corporation  Secondary Market – Market in which previously issued securities are traded among investors  Dividend – Periodic cash distribution from the firm to the shareholders  P/E Ratio – Ratio of stock price to earnings per share – The P/E ratio is important because it provides a measuring stick for comparing whether a stock is overvalued or undervalued. A high P/E ratio could mean that a stock's price is expensive relative to earnings and possibly overvalued Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 3 Stocks and the Stock Market (3 of 5)  Bid Price - represents the maximum price that a buyer is willing to pay for a share of stock or other security.  Ask Price – represents the minimum price that a seller is willing to take for that same security.  Bid-ask spread –the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.  Market order – An order to buy or sell shares at the best currently available market price.  Limit order – An order to buy or sell shares at a predetermined price, to be executed when the market price reaches the requested price. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 4 Stocks and the Stock Market (4 of 5) Example If an investor wishes to purchase 100 shares of FedEx with a bid price of $159.78 and an ask price of $159.99, how much could the investor expect to pay for the shares? What is the P/E Ratio and Dividend Yield? Payment P/E Ratio 100 × 159.99 = $15,999 160.39 = 42.25 3.80 Dividend Yield 1.00 =.65 % 160.39 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 5 Stocks and the Stock Market (5 of 5) Share price history for FedEx Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 6 Market Values, Book Values, and Liquidation Values (1 of 2)  The difference between a firm’s actual market value and its’ liquidation or book value is attributable to its “going-concern value” – Factors of “Going Concern Value” Extra earning power Intangible assets Value of future investments Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 7 Market Values, Book Values, and Liquidation Values (2 of 2)  Book Value – Net worth of the firm according to the balance sheet  Liquidation Value – Net proceeds that could be realized by selling the firm’s assets and paying off its creditors  Market Value Balance Sheet – Financial statement that uses market value of all assets and liabilities Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 8 Valuing Common Stocks (1 of 10)  Stock Valuation Methods – Valuation by comparables Ratios Multiples – Intrinsic Value Present value of future cash payoffs from a stock or other security – Dividend Discount Model Discounted cashflow model that states that today’s stock price equals the present value of all expected future dividends Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 9 Valuing Common Stocks (2 of 10) Div1 + 𝑃1 𝑉0 = 1+𝑟 V0 = The intrinsic value of the share Div1 = The expected dividend per share at the end of the year P1 = The predicted stock price in year 1 r = The discount rate for the stock’s expected cash flows Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 10 Valuing Common Stocks (3 of 10) Example What is the intrinsic value of a share of stock if expected dividends are $3/share and the expected price in 1 year is $81/share? Assume a discount rate of 12%. Div1 + 𝑃1 3 + 81 𝑉0 = = = $75 1+𝑟 1.12 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 11 Valuing Common Stocks (4 of 10)  Expected Return – The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR) Div1  P1  P0 Expected return  r  P0 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 12 Valuing Common Stocks (5 of 10) Example (continued) Using the prior example, what is the expected return assuming the stock price started the year at $75? 3  81  75 Expected return  r  .12 75 Expected return = 12% Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 13 Valuing Common Stocks (6 of 10) The formula can be broken into two parts: Dividend yield + Capital appreciation Div1 P1  P0 Expected return  r   P0 P0 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 14 Valuing Common Stocks (7 of 10) Example (continued) Using the prior example, what is the expected dividend yield and capital gain? 3 81  75 Expected return  r   .04 .08 .12 75 75 Expected dividend yield = 4% Expected capital gain = 8% Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 15 Valuing Common Stocks (8 of 10)  Dividend Discount Model – Discounted cash-flow model which states that today’s stock price equals the present value of all expected future dividends Div1 Div 2 Div t  Pt P0   ...  (1  r ) (1  r ) 1 2 (1  r ) t t - Time horizon for your investment Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 16 Valuing Common Stocks (9 of 10) Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return? 3.00 3.24 3.50  94.48 PV    (1 .12) (1 .12) 1 2 (1 .12)3 PV  $75.00 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 17 Simplifying the Dividend Discount Model (1 of 9) If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY Div1 EPS1 Perpetuity  P0  or r r Assumes all earnings are paid to shareholders Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 18 Simplifying the Dividend Discount Model (2 of 9)  Constant-Growth DDM – A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model) Div1 P0  rg Given any combination of variables in the equation, you can solve for the unknown variable Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 19 Simplifying the Dividend Discount Model (3 of 9) Example What is the value of a stock that expects to pay a $0.74 dividend next year, and then increase the dividend at a rate of 5% per year, indefinitely? Assume a 7.8% expected return. Div1 $0.74 P0    $26.43 r  g.078 .05 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 20 Simplifying the Dividend Discount Model (4 of 9) If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher  Payout Ratio – Fraction of earnings paid out as dividends  Plowback Ratio – Fraction of earnings retained by the firm  Sustainable Growth Rate – The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 21 Simplifying the Dividend Discount Model (5 of 9)  Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations 𝑔 = 𝑠𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑅𝑂𝐸 × 𝑝𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑖𝑜  Present Value of Growth Opportunities (PVGO) – Net present value of a firm’s future investments Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 22 Simplifying the Dividend Discount Model (6 of 9) Example Aqua America has an ROE of 12.5% and a book value per share of $9.86. It intends to plowback 40% of its earnings and the opportunity cost of capital is 7.8%. What is the stock price? EPS = $9.86 ×.125 = $1.233 Growth rate =.40 ×.125 =.05 or 5.0% Div1 = $1.233 ×.60 = $0.74 0.74 𝑃0 = = $26.43.078 −.05 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 23 Simplifying the Dividend Discount Model (7 of 9) Example (continued) If Aqua America decides not to reinvest any earnings, what is the value of the stock and what is the PVGO of the firm that is lost? EPS = $9.86 ×.125 = $1.233 1.233 𝑃0 = = $15.81.078 PVGO = 26.43 − 15.81 = $10.62 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 24 Simplifying the Dividend Discount Model (8 of 9) Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 20%. What is the value of the stock before and after the plowback decision? No Growth With Growth 5  g. 2 0.4 0. 08  P 0 $ 41. 67. 12 3   P $7 5. 00  0. 12. 08 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 25 Simplifying the Dividend Discount Model (9 of 9) Example (continued) If the company did not plowback some earnings, the stock price would remain at $41.67. With the plowback, the price rose to $75.00. The difference between these two numbers (75.00 - 41.67 = 33.33) is called the Present Value of Growth Opportunities (PVGO). Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 26 Valuing Non-Constant Growth (1 of 3)  Valuing Non-Constant Growth 1. Set investment horizon (year H) as future year after which you expect the company’s growth to settle down to a stable rate. Then calculate the present value of dividends from now to horizon year 2. Forecast stock price at horizon, and discount it to give it’s present value today. 3. Sum the total present value of dividends with present value of ending stock price(stock price at horizon) Div1 Div 2 Div H PH PV   ...   (1  r ) (1  r ) 1 2 (1  r ) H (1  r ) H Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 27  Valuing Non-Constant Growth (2 of 3) Example Given the following earnings and dividends, an 8.5% discount rate and a perpetual growth rate of 5%,which begins in year 6, what is the value of the stock? 2.85 3.14 3.45 3.79 4.17 PV15       13.50 (1  085) (1 .085) 1 2 (1 .085) (1 .085) 3 4 (1 .085) 5 4.17 × 1.05 4.38 PV5 = = = 125.14.085 −.05.085 −.05 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 28 Valuing Non-Constant Growth (3 of 3) Example (continued) Given the following earnings and dividends, an 8.5% discount rate and a perpetual growth rate of 5%,which begins in year 6, what is the value of the stock? 125.14 𝑃0 = 13.50 + 5 = $96.72 1.085 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 29  No Free Lunches (1 of 2)  Technical Analysts – Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices – Forecast stock prices based on watching the fluctuations in historical prices (thus “wiggle watchers”) Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 30  Another Tool  Fundamental Analysts – Investors who attempt to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects – Research the value of stocks using NPV and other measurements of cash flow Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 31  Efficient Markets Market in which security prices are current and fair to all traders. Transactions costs are minimal. There are two forms of efficiency: 1. Operational efficiency and 2. Informational efficiency Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 32  Operational Efficiency Speed and accuracy with which trades are processed. Ease with which the investing public can access the best available prices.  The NYSE’s Super DOT computer system, NASDAQ’s SOES Match buyers and sellers very efficiently and at the best available price. Therefore definitely very operationally efficient markets. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 33  Informational Efficiency  Speed and accuracy with which information is reflected in the available prices for trading.  Securities would always trade at their fair or equilibrium value. These three forms make up what is known as the efficient market hypothesis (EMH). Weak-form efficient markets : Current prices reflect past prices and trading volume. Technical analysis –not useful. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 34  Informational Efficiency  Semi-strong-form efficient markets:  Current prices reflect price and volume information and all available relevant public information as well.  Publicly available news or financial statement information not very useful.  Strong-form efficient markets: Current prices reflect price and volume history of the stock, all publicly available information, and even all private information. All information is already embedded in the price--no advantage to using insider information to routinely outperform the market.  Most academic research supports semi-strong form of efficient markets. Public information is fully reflected in markets within minutes. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 35  MCQs Test your Knowledge Stocks differ from bonds because A. Bond cash flows are known while stock cash flows are uncertain. B. Firms pay bond cash flows prior to paying taxes while stock cash flows are after tax. C. The ending par value of a bond is known at purchase while the ending value of a share of stock is unknown at purchase. D. All of the above. 7- 36  MCQs Test your Knowledge You want to invest in a stock that pays $6.00 annual cash dividends for the next five years. At the end of the five years, you will sell the stock for $30.00. If you want to earn 10% on this investment, what is a fair price A. $41.37 B. $40.37 C. $22.75 D. $18.63 7- 37  MCQs Test your Knowledge ________ has to do with the speed and accuracy of processing a buy or sell order at the best available price. A. Market efficiency B. Mechanical efficiency C. Informational efficiency D. Operational efficiency Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 38  MCQs Test your Knowledge Most academic research supports markets as ________ efficient. A. weak form B. semi-strong form C. strong form D. not at all 7- 39  Stock Pricing Exercise 1 - Pfender Guitars has a current annual cash dividend policy of $4.00. The price of the stock is set to yield an 8% return. What is the price of this stock if the dividend will be paid i. for 15 years and then a liquidating or final dividend of $25.00? ii. forever with no liquidating dividend? Solution Price = $4.00 × (1 – 1/(1.08)^15 / 0.08) + $25.00 × 1/(1.08)^15 = $4.00 × 8.5595 + $25 × 0.3152 = $34.24 + $7.88 = $42.12 PV = PMT/r Price = $4.00 / 0.08 = $50.00 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 40  Stock Pricing Exercise 2- King Waterbeds has an annual cash dividend policy that raises the dividend each year by 4%. Last year’s dividend was $0.40 per share. What is the price of this stock if an investor wants a 13% return? Solution: Div 0   1 g  Price  0 r  g  Price = $0.40 × (1.04) / (0.13 – 0.04) = $0.4160 / 0.09 = $4.62 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 41  Stock Pricing Exercise 3 - Sia Dance Studios has an annual cash dividend policy that raises the dividend each year by 2%. Last year’s dividend was $3.00 per share. The company will be in business for forty years with no liquidating dividend. What is the price of this stock if an investor wants a 15% return? Solution: Div  1 g  n  1  1 g   +    Pricen Price  0 0 r  g    1 r   1 r n   Div  1 g  n  1 g   Price  0  1     0 r  g    1 r       Price = $3.00 × (1.02) / (0.15 – 0.02) × [1 – ((1.02) / (1.15))^40] = $3.06 / 0.13 × [1 - 0.0082] = $23.54 × [0.9918] = $23.35 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 42 Stock Pricing 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 $0.60 $0.55 $0.61 $0.67 $0.73 $0.81 $0.89 $0.98 $1.08 $1.80 Exercise 4 Quick MAX Enterprises is expecting that its last paid dividend of $1.80 will grow at its historical compound growth rate from here on. Using the past 10 years of dividend history and a required rate of return of 15%, calculate the price of Quick Max common stock. Solution We must estimate g from the dividend history of the firm… Required rate of return = 15% Compound growth rate “g” = (FV/PV)1/n -1 Where FV = $1. 80; PV = 0.60; n = 9 (number of dividend changes) g = (1.80/0.60)1/9 – 1 = 12.98% Div1 = Div0(1+g)= $1.80 x (1.1298)= $2.034 P0 = Div1/(r-g) = $2.034 / (0.15 - 0.1298) = $100.68 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 43  Stock Pricing Exercise 5 The Zeco Company is expected to pay a dividend of $1.00 at the end of current year. Thereafter, the dividends are expected to grow at the rate of 20% per year for 1 years, and then rise to 25% for 1 year, before settling at the industry average growth rate of 10% indefinitely. If you require a return of 15% to invest in a stock of this risk level, how much would you be justified in paying for this stock? D1=$1.00; g1=20%; g2=25%; gc=15%; r=16% Step 1. Calculate the annual dividends expected in Years 1-3, using the appropriate growth rates. D1 = $1.00; D2 = $1.00 x (1.20) = $1.20; D3= $1.20 x (1.25) = $1.50 Step 2. Calculate the price at the start of the constant growth phase using the Gordon model. P3 = D3 x (1+g)/(r-g) = $1.50 x (1.10)/(0.15 - 0.10) = $33 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 44 Stock Pricing Step 3. Discount the annual dividends in Years 1-3 and the price at the end of Year 4, back to Year 0 using the required rate of return as the discount rate, and add them up to solve for the current price. P0 = $1.00/(1.15) + $1.20/(1.15)2 + $1.50/(1.15)3 + $33.00/(1.15)3 P0 = $0.869 + $0.9074 + $0.986 + $21.698 P0 = $24.46 Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 45  Food for Thought Q-What are the differences between authorized, issued, and outstanding shares? Authorized shares are the number of shares a company can sell and is set by the charter of the company. Issued shares are the authorized shares that have been sold or distributed and are available for trading. Not all issued shares are available for public trading. The shares not available for sale and purchase are the outstanding shares. Treasury stock, for example, represents stock that although issued are being held by the company and therefore not available for trading. Q- What is the role of the investment banker in the primary sale of common stock? The investment banker is the partner to the company in the sale of common stock in the primary market. The investment banker serves as the distributor of information to potential buyers, the expert to the company on pricing and timing of the sale, and the marketer of the shares. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 46  Food for Thought Q- What are the potential repercussions if the investment banker does not perform the due diligence task? Failure to perform due diligence leaves the investment banker liable for potential lawsuits by those who bought the newly issued shares. Q- What is a bid price, and what is an ask price? The bid price is the price offered by a willing buyer for the stock. The ask price is the price requested by a willing seller of the stock. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 47  Food for Thought Q-What is the difference between preferred stock and common stock? Preferred stock is a form of financing where the owner receives a pre-set dividend based on the par value of the preferred stock. Common stock’s dividends are set by the board and will change over time. Preferred stock must receive its dividends prior to dividends sent to common stock holders. Hence, preferred stock represents a preferential claim on dividends. Q-How is operational efficiency different from informational efficiency? Operational efficiency deals with the speed and accuracy of processing a buy or sell order. Information efficiency is how quickly and accurately information is reflected in the current price of a stock. Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 7- 48