Chapter 7

The Valuation and Characteristics of Stocks

COMMON STOCK OWNERSHIP

Stockholder Rights:

-  Dividend

-  Asset-ownership (Little role as "owner" in large public companies

Stock is just an investment)

- Voting

- Preemptive right- Allow stockholders to maintain their proportionate ownership

- Common-stock classes

Nonvoting stock

Voting stock

- Voting Rights

Majority Voting--(Statutory Voting)

One share = One Vote

In this case, often have no minority viewpoint representation on the Board of Directors

If own 100 shares have 100 votes for each issue voted upon.

Cumulative Voting

Cumulative voting ensures some minority group representation on the board. Minority stockholders can cast all votes for a single seat.

Each share of stock represents as many votes as there are directors to be elected.

If you have 7 directors to be elected (7 issues) and you own 100 shares then you have 700 votes which you can cast. Can cast all votes for one director (on one issue).

- Stock splits

- if management feels stock should sell at lower price to attract more purchasers it can effect a stock split

- seems that optimum price rage is $15-$60

- accounting treatment: par value is adjusted accordingly

( ie. 2-1 split: par value is reduced by one half and the # of shares doubled)

- Reverse Stock Split

- used to bring low-priced shares up to more desirable level

- Stock Dividends

- dividend to stockholders that consists of additional shares of stock instead of cash

- Stock-Repurchases

- company repurchase own stock (known as treasury stock)

Advantages:

(1) no fixed-dividend obligation

(2) decreased debt ratio

Disadvantages:

(1) high-cost of financing

(2) dilution of original owner's claim

RETURN ON AN INVESTMENT IN STOCK

One year holding period:

Stock Valuation


where

Ke: Market Capitalization Rate

D1: Expected dividend for t=1

P1: Expected price for t=1

Po: Current price

The return on any stock investment is the rate that makes the present value of future cash flows equal to the price paid today

Common Stock

(1) Cash flows:

-  dividends


capital gains

Dividend Capital

Yield Gain

(2) Growth

Sources to find expected growth rates:

Value Line Investment Survey

Institutional Brokers Estimate System

Zacks Earning Estimate

CASH FLOWS FROM COMMON STOCK OWNERSHIP

Analogous to bonds

A regular series followed by a return of invested funds

however

Far less precise and regular

Not contractually guaranteed

Years

0 1 2 3 n-1 n

D1 D2 D3 Dn-1 Dn

Pn

THE BASIS OF VALUE

Make some assumption about the behavior of future dividends and the eventual selling price. Then take the present value of future cash flows

P0 = D1[PVFk,1] + D2[PVFk,2] + . . . + Dn[PVFk,n] + Pn[PVFk,n]

Example: Joe Simmons is interested in the stock of Teltex Corp. He feels it will pay dividends of $2 and $3.50 in the next two years, after which its price will be $75. Similar stocks return 12%. What should Joe be willing to pay for Teltex?

Solution:

P0 = D1[PVFk,1] + D2[PVFk,2] + P2[PVFk,2]

= $2.00[PVF12,1] + $3.50[PVF12,2] + $75.00[PVF12,2]

= $2.00[.8929] + $3.50[.7972] + $75.00[.7972]

= $64.37

Buy if the price is below about $64

Fundamental Analysis

The Intrinsic (Calculated) Value and Market Price

Joe's research led to a forecast of future dividends and prices which led to a value of about $64.

If other investors don't agree their intrinsic values will be different.

Market price is a consensus of everyone's intrinsic values.

If Joe is right, he can make money.

GROWTH BASED MODELS OF STOCK VALUATION

We generally don't have the detailed information to forecast exact dividends and prices. However, we can usually forecast a growth rate.

Develop a model based on today and an assumed growth into the future.

Need to change focus:

Thinking from a Finite Number of Dividends and a Price,

to an Infinite Stream of Dividends

P0 = D1[PVFk,1] + D2[PVFk,2] + . . . + Dn[PVFk,n] + Pn[PVFk,n]

or

Imagine the buyer in period n as having a model in mind for Pn stretching farther into the future to period m and ending with Pm

Replace Pn with that model pushing the selling price farther into the future.

Keep doing this until sale is infinitely distant and its PV = 0

Result is value based on only the PV of an infinite stream of dividends

A Market Based Argument

The only thing a company can return to equity investors is all of its dividends.

The investing community as a whole has nothing else on which to base value.

Working With Growth Rates

Growth rates work just like interest rates. If g = 6% $100 grows at rate g:

$100 x .06 = $6,

$100(1+g) = $100 x 1.06 = $106

Growing dividends beginning with the last one, D0:

D1 = D0 + gD0

= D0 (1+g)

D2 = D1 (1+g)

D2 = D0 (1+g)2

In general:

Di = D0 (1 + g)i

Multiply by (1+g) repeatedly for successive values

of a growing dividend

The Constant (Normal) Growth Model
The Gordon Model

n  Assume a constant growth in dividends

–  Dividends expected to grow at a constant rate, g, over time

- g: growth rate

- ke: required return

- Ke > g

–  D1 is the expected dividend at end of the first period

–  D1 =D0 (1+g)

n  Implications of constant growth

–  Stock prices grow at the same rate as the dividends

–  Stock total returns grow at the required rate of return

»  Growth rate in price plus growth rate in dividends equals k, the required rate of return

–  A lower required return or a higher expected growth in dividends raises prices

Example 7-3: Atlas Motors will grow at 6% indefinitely. It recently paid a dividend of $2.25 a share. Similar stocks return about 11%. What should Atlas sell for?

Solution: D0 = $2.25, k = .11, g = .06

The Zero Growth Case - A Constant Dividend

A perpetuity

THE EXPECTED RETURN

Solve the Gordon model for k

An estimate of the return at price P0 assuming the growth rate is g

Compare with one year return

g = capital gains yield



TWO STAGE GROWTH

n  Multiple growth rates: two or more expected growth rates in dividends

–  Ultimately, growth rate must equal that of the economy as a whole

–  Assume growth at a rapid rate for n periods followed by steady growth

n  Multiple growth rates

–  First present value covers the period of super-normal (or sub-normal) growth

–  Second present value covers the period of stable growth

»  Expected price uses constant-growth model as of the end of super- (sub-) normal period
»  Value at n must be discounted to time period zero

Two Period Growth Model:

m = length of time firm grows at g1

g2 < k

g1: growth rate for period 1

g2 : growth rate for period 2

ke: required return

Example: required rate of return =18% Current dividend is 2.00 dividends are expected to grow at 12% for first 6 years then at 6%

Present value of First 6-Years' Dividends:

Year
t / Dividend
Dt / P.V. Interest Factor
PVIF18.t = 1/(1 + .18)t / Present Value
Dt x PVIF18.t
1 / $ 2.240 / .874 / $ 1.897
2 / 2.509 / .718 / 1.801
3 / 2.810 / .609 / 1.711
4 / 3.147 / .516 / 1.624
5 / 3.525 / .437 / 1.540
6 / 3.948 / .370 / 1.461
PV (First 6-Years' Dividends / $10.034

Value of Stock at End of Year 6:

P6 = D7/(Ke - g2) where g2 = .06

D7 = D6(1 + g2) = 3.948(1 + .06) = $4.185

P6 = 4.185/(.18 - .06) = $34.875

Present Value of P6

PV(P6) = P6/(1 + ke)6 = $34.875/(1 + .18)6

= $34.875 x .370 = $12.904

Value of Common Stock (Po)

Po = PV(First 6-Year's Dividends) + PV(P6)

= 10.034 + 12.904 = $22.94

Two period growth model:

N = No. of years growing at g1

PRACTICAL LIMITATIONS OF PRICING MODELS

Although problems solve to the penny, our answers are not that accurate.

Results can never be any more accurate than the inputs.

Projected growth rates and the interest rate can both be off by a lot.

An additional problem arises because of the difference in estimates in the denominator. Result blows up when the difference is small.

Bond valuation is exact because cash flows are contractually specified and very likely to occur. Market yields are also precise.

Stock valuation is comparatively fuzzy.

Stocks That Don't Pay Dividends

Have value because they are expected to pay them someday

(Even if management says it won't)

No Dividend Model

CORPORATE ORGANIZATION AND CONTROL

Corporations are controlled by Boards of Directors whose members are elected by stockholders.

The board appoints senior management which runs the company.

Major strategic decisions are considered by the board.

A few really big issues, like mergers, are voted on by the stockholders.

Boards generally are made up of top managers and outside directors.

Board members may be major stockholders, but don't have to be.

If stock ownership is widely distributed with no single party having a large share, top managers have control with little accountability to stockholders.

PREFERRED STOCK

•  Has a mix of the characteristics of common stock and bonds

•  Referred to as a hybrid

Features

-  Par price

Preferred is generally issued at prices of $25, $50, and $100

Pays a constant dividend forever (norm)

- Adjustable rate-preferred stock

Cumulative feature

Preferred dividends can be passed but must be caught up before common dividends can be paid. Designed to enhance safety for investors

- Participation in “extra” dividends

- Maturity

-  Call feature

-  Convertible

- Voting rights-none

Advantages of Preferred Stock Financing

(1) Preferred dividend payments are potentially flexible.

(2) Increase a firm's degree of financial leverage.

(3) 70% exclusion of dividend received from other companies from federal income.

Disadvantages

(1) High after-tax cost as compared with L-T debt.

E.g.: If the interest rate is 10%, preferred shares sold at $100 would offer a dividend of $10. Refer to as a $10 preferred issue rather than as a 10% preferred issue. Think of the 10% rate as similar to the coupon rate on a bond, and the $100 initial selling price as similar to a bond's face value

VALUATION OF PREFERRED STOCK

Valued as a perpetuity

Example 7-6:

Roman Industries' $6 preferred originally sold for $50. The rate on similar issues is now 9%. For what should Roman's preferred sell?

Solution:

P=6/.09 = 66.67

Notice current price is above the original issue price because interest rates have fallen from ($6/$50=) 12% to 9%.

Comparing Preferred Stock with Common Stock and Bonds

•  Payments to investors - Constant, like bonds

•  Maturity and return of principal - No maturity, like stock

•  Assurance of Payment - Cumulative feature - Between

•  Priority in bankruptcy - Between

•  Voting rights - None, like stock

•  Tax deductibility of payments - Not deductible, like stock

•  The Order of Risk - Between

SECURITIES ANALYSIS

Valuation is a part of Securities Analysis

Fundamental Analysis

Discover as much as possible about a firm and its industry

Use that knowledge to project future cash flows

Calculate intrinsic value

Compare with market price

Invest if market price is below intrinsic value

Technical Analysis

Historical patterns of price and volume repeat over time

Chart prices and volumes to predict changes

Technicians are also called chartists

The Efficient Market Hypothesis (EMH)

Financial markets are efficient in that new information is disseminated very quickly and prices adjust immediately.

Hence technical analysis is useless because all available information is already in the price of stocks.

Fundamental analysis also won't help an investor consistently beat the market because an army of professional analysts will have figured everything out first.

STOCK MARKET EFFICIENCY

Weak-form: security prices reflect all market-related data from past.

Semistrong: security prices reflect all past information but also all public information.

Strong: prices reflect all information including private or insider info.

Tests

Weak-form: look for non-random patterns in sec. prices.

Semistrong: Event studies benchmark to test for abnormal returns

^

CAPM: rj = rf + β(rm - rf)

abnormal return:

^

rj - rj = e

^

rj: actual rj: estimated

e: is difference

Question: is e significantly different from zero

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