Stocks And The Stock Market PDF

Stocks and the Stock Market 1 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. © McGraw...

Stocks and the Stock Market 1 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. © McGraw Hill, LLC 1  Stocks and the Stock Market 2 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. © McGraw Hill, LLC 2  Stocks and the Stock Market 3 Bid Price The prices at which investors are willing to buy shares. Ask Price The prices at which current shareholders are willing to sell their shares. Access the text alternative for slide images. © McGraw Hill, LLC 3  Stocks and the Stock Market 4 Example You wish to purchase 100 shares of FedEx (Bid price = $167.41, Ask Price = $167.43), how much would you expect to pay for the shares? What is the P/E Ratio and Dividend Yield of your purchase? © McGraw Hill, LLC 4  Stocks and the Stock Market 4 Example You wish to purchase 100 shares of FedEx (Bid price = $167.41, Ask Price = $167.43), how much would you expect to pay for the shares? What is the P/E Ratio and Dividend Yield of your purchase? Payment: 100 $167.43 $16,743 (Note: Your order to buy 100 shares would be crossed with the ask price.) $167.43 P/E Ratio: 34.17 $4.90 $2.60 Dividend Yield: .0155, or 1.55% $167.43 (Note: Figure 7.1 uses yesterday’s price to calculate dividend yield.) © McGraw Hill, LLC 5  Market Values, Book Values, and Liquidation Values 1 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. © McGraw Hill, LLC 6  Market Values, Book Values, and Liquidation Values 3 The difference between a firm’s actual market value and its’ liquidation or book value is attributable to its “going-concern value.” What factors determine “Going Concern Value.” © McGraw Hill, LLC 7  Market Values, Book Values, and Liquidation Values 3 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 (good recipe) Intangible assets Value of future investments (well positioned) © McGraw Hill, LLC 8  Valuing Common Stocks 1 Stock Valuation Methods. Valuation by comparables. Ratios. Multiples. Intrinsic Value: a way of describing the perceived or true value of an asset. Present value of future cash payoffs from a stock or other security. (Dividend Discount Model) © McGraw Hill, LLC 9  Valuing Common Stocks 3 Intrinsic Value Method 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. © McGraw Hill, LLC 10  Valuing Common Stocks 3 Is the Intrinsic Value Method a good way to estimate intrinsic value? © McGraw Hill, LLC 11  Valuing Common Stocks 4 Example What is the intrinsic value of a share of stock if expected dividends are $3 per share and the expected price in 1 year is $81 per share? Assume a discount rate of 12%. © McGraw Hill, LLC 12  Valuing Common Stocks 4 Example What is the intrinsic value of a share of stock if expected dividends are $3 per share and the expected price in 1 year is $81 per share? Assume a discount rate of 12%. Div1  P1 $3.00  81.00 V0   $75.00 1 r 1.12 © McGraw Hill, LLC 13  Valuing Common Stocks 9 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. © McGraw Hill, LLC 14  Valuing Common Stocks 10 Example Current dividend forecasts for XYZ Company are $3.00, $3.24, and $3.50 (next three years). 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? © McGraw Hill, LLC 15  Valuing Common Stocks 10 Example Current dividend forecasts for XYZ Company are $3.00, $3.24, and $3.50 (next three years). 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 © McGraw Hill, LLC 16  Valuing Common Stocks 11 Value for Different Time Horizons © McGraw Hill, LLC 17  Simplifying the Dividend Discount Model 1 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. © McGraw Hill, LLC 18  Simplifying the Dividend Discount Model 2 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. © McGraw Hill, LLC 19  Simplifying the Dividend Discount Model 3 Example What is the value of a stock that expects to pay a $0.86 dividend next year, and then increase the dividend at a rate of 4.75% per year, indefinitely? Assume a 7.0% expected return. © McGraw Hill, LLC 20  Simplifying the Dividend Discount Model 3 Example What is the value of a stock that expects to pay a $0.86 dividend next year, and then increase the dividend at a rate of 4.75% per year, indefinitely? Assume a 7.0% expected return. Div1 $0.86 P0   $38.22 r  g.07 .0475 © McGraw Hill, LLC 21  Simplifying the Dividend Discount Model 4 If a firm pays a lower dividend → 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 Assumes constant ROE and debt ratio. © McGraw Hill, LLC 22  Simplifying the Dividend Discount Model 5 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. © McGraw Hill, LLC 23  Simplifying the Dividend Discount Model 6 Example Aqua America has an ROE of 12.5% and a book value per share of $11.10. It intends to plowback 38% of its earnings and the opportunity cost of capital is 7.0%. What is the stock price? © McGraw Hill, LLC 24  Simplifying the Dividend Discount Model 6 Example Aqua America has an ROE of 12.5% and a book value per share of $11.10. It intends to plowback 38% of its earnings and the opportunity cost of capital is 7.0%. What is the stock price? EPS = $11.10 ×.125 = $1.39 Growth rate =.38 ×.125 =.0475 or 4.75% Div1 $1.39 .62 $0.86 $0.86 P0  $38.23.07 .0475 © McGraw Hill, LLC 25  Simplifying the Dividend Discount Model 7 Example 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? © McGraw Hill, LLC 26  Simplifying the Dividend Discount Model 7 Example 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 = $11.10 ×.125 = $1.3875 1.3875 P0  $19.82.070 PVGO 38.23  19.82 $18.41 © McGraw Hill, LLC 27  Simplifying the Dividend Discount Model 8 Example A company forecasts a $5.00 dividend next year, which represents 100% of its earnings. This provides investors with a 12% expected return. Suppose it decides to plowback 40% of the earnings at the firm’s current ROE of 20%. What is the value of the stock before and after the plowback decision? © McGraw Hill, LLC 28  Simplifying the Dividend Discount Model 8 Example A company forecasts a $5.00 dividend next year, which represents 100% of its earnings. This provides investors with a 12% expected return. Suppose it decides to plowback 40% of the earnings at the firm’s current ROE of 20%. What is the value of the stock before and after the plowback decision? No Growth With Growth $5.00 g .20 .40 .08 P0  $41.67.12 $5.00 (1 .40) P0  $75.00.12 .08 © McGraw Hill, LLC 29  Simplifying the Dividend Discount Model 9 Example 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 ($75.00 - 41.67 = $33.33) is called the Present Value of Growth Opportunities (PVGO). © McGraw Hill, LLC 30  Valuing Non-Constant Growth 1 Valuing Non-Constant Growth. Div1 Div 2 Div H PH PV      (1  r ) (1  r ) 1 2 (1  r )H (1  r )H © McGraw Hill, LLC 31  Valuing Non-Constant Growth 2 Example What is the value of a stock with the following dividends, an 8.5% discount rate, and a growth rate of 6% (beginning in year 6)? Year 1 2 3 4 5 Dividends $2.16 2.38 2.61 2.87 3.16 © McGraw Hill, LLC 32  Valuing Non-Constant Growth 2 Example What is the value of a stock with the following dividends, an 8.5% discount rate, and a growth rate of 6% (beginning in year 6)? Year 1 2 3 4 5 Dividends $2.16 2.38 2.61 2.87 3.16 $2.16 2.38 2.61 2.87 3.16 PVDividends 1-5      $10.23 1.085 1.085 1.085 1.085 1 2 3 4 1.085 5 P5 $3.16 1.06 $133.98 PVPrice in Year 5    $89.11 (1  r )5 (.085 .06) 1.085 5 1.085 5 PVStock $10.24  $89.11 $99.33 © McGraw Hill, LLC 33  Valuing Common Stocks 5 Expected Return The percentage yield that an investor forecasts from a specific investment over a set time period. Sometimes called the holding period return (H PR). Div1  P1  P0 Expected return r  P0 © McGraw Hill, LLC 34  Valuing Common Stocks 6 Example Using the prior example, what is the expected return assuming the stock price started the year at $75? © McGraw Hill, LLC 35  Valuing Common Stocks 6 Example Using the prior example, what is the expected return assuming the stock price started the year at $75? $3.00  81.00  75.00 Expected return r  .12 $75.00 Expected return = 12% © McGraw Hill, LLC 36  Valuing Common Stocks 7 The formula can be broken into two parts: Dividend yield + Capital appreciation Div1 P1  P0 Expected return r   P0 P0 © McGraw Hill, LLC 37  Valuing Common Stocks 8 Example Using the prior example, what is the expected dividend yield and capital gain? © McGraw Hill, LLC 38  Valuing Common Stocks 8 Example 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% © McGraw Hill, LLC 39  No Free Lunches 1 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. © McGraw Hill, LLC 40  Random Walk Theory 1 Security prices change randomly, with no predictable trends or patterns. Statistically speaking, the movement of stock prices is random. Skewed positive over the long term. © McGraw Hill, LLC 41  Random Walk Theory 3 Scatter plots of NYSE Composite Index over successive time periods. Where’s the pattern? © McGraw Hill, LLC 42  Another Tool 1 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. © McGraw Hill, LLC 43  Efficient Market Theory 1 Efficient Market. Market in which prices reflect all available information. Weak Form Efficiency. Market prices reflect all historical information. Semi-Strong Form Efficiency. Market prices reflect all publicly available information. Strong Form Efficiency. Market prices reflect all information, both public and private. © McGraw Hill, LLC 44