CHAPTER 6 VALUING STOCKS 6.1 Stocks and the Stock Market ...
CHAPTER 6 VALUING STOCKS 6.1 Stocks and the Stock Market The owners of common stock of a firm are entitled to the firm’s residual cash flow (the remaining cash flow after employees and all other suppliers, lenders, and the government have been paid). They can also vote for the board of directors through one vote per share. Firms issues shares of common stock to the public when they need to raise money. They engage an investment dealer that provides investment banking services to help them price and sell these shares Sales of new stock of the firm occur in the primary market (market for the sale of new securities by corporations). > in an initial public offering (IPO), a company that has been privately owned sells stock to the public for the first time Seasoned offerings: when established firms raise money by issuing more shares and these new shares are also primary market issues Secondary market: market in which already-issued securities are traded among investors Stock Market Listings Dividend yield: a stock’s cash dividend divided by its current price (like current yield on a bond as it also ignores capital gains/losses) Price-earnings (PE) multiple: ratio of stock price to earnings per share Preferred stock: stock that takes priority over common stock in regards to dividends 6.2 Book Values, Liquidation Values, and Market Values Investors do not just buy and sell book value per share (because assets on a firm’s balance sheet are recorded at historical cost less and allowance for depreciation and don’t always represent current market value) Stock prices don’t equal liquidation value per share either (net proceeds that would be realized by selling the firm’s assets and paying off its creditors) The going concern value is the difference between a company’s accrual value and its book or liquidation value 1. Extra earning power: company may have the ability to earn more than an adequate rate of return on assets (value higher than book value) 2. Intangible Assets: many assets that accountants don’t put on the balance sheet (i.e. research and development, brand name etc..) 3. Value of future investments: investors believe the company will have the opportunity to make exceedingly profitable investments in the future, they will pay more for the stock today ** buy stock based on present and future earning value*** Market value balance sheet: financial statement that uses the market value of all assets and liabilities -> contains two classes of assets (1) already in pace, both tangible and intangible (2) opportunities to invest in attractive future ventures
6.3 Valuing Common Stocks The cash payoff to owners of common stocks comes in two forms (1) cash dividends, and (2) capital gains or losses Expected return= r= DIV1+P1-Po/ Po = expected dividend yield + expected capital gain DIV1= expected dividend per share Po= time zero, which is today P1= time 1, which is 1 year hence For many investors, both dividends and capital gains are taxable= look at after-tax rate of return for the best measure of the actual earnings on a stock After-tax rate of return= Div1- dividend tax/ Po + Capital gain- capital gains tax/Po The Dividend Discount Model Discounted cash flow model of today’s stock price that states that share value equals the present value of all expected future dividends Far-distant dividends will not have significant present values For one period investor. The valuation formula looks like this: Po= DIV1+p1/ 1+r Add on terms for each additional period Po= DIV1/1+r+ DIV2/ (1+r)2+…+ DIVh+ Ph/ (1+r)h The value of a stock is the present value of the dividends it will pay over the investor’s horizon plus the present value of the expected stock price at the end of that horizon Regardless of the investment horizon the stock value will always be the same. This is because the stock price at the horizon date is determined by expectations of dividends from that date forward. Therefore, as long as the investors are consistent in their assessment of the prospects of the firm, they will arrive at the same present value The principle holds for horizons of 1, 3, 10, 20 and 50 years or more 6.4 Simplifying the Divided Discount Model The Dividend Discount Model With No Growth Company that pays out all its earnings in dividends= cannot grow because it does not reinvest This model says that the no-growth shares should sell for the present value of a constant, perpetual stream of dividends (Po= DIV1/r) Since the company pays out all its earnings as dividends, dividends and earnings are the same, and we could just as well calculate stock value (Value of no-growth stock= Po= EPS1/r) EPS1 represents next year’s earnings per share of stock. We can loosely say that “stock price is the present value of future earning The Constant-Growth Dividend Discount Model Requires a forecast of dividends for every year into the future which poses a bit of a problem for stocks with lives that are potentially infinite= assume no-growth perpetuity that works for no-growth common shares and most preferred shares Note that each temr is proportionately smaller than the preceding one as long as the dividend growth rate is less than the discount rate. Because the present value of far-distant
dividends will always get closer to zero, the sum of all of these terms is finite despite the fact that an infinite number of dividends will be paid Po= DIV1/ r-g This equation is called the constant-growth dividend discount model A stock with a constant- growth dividend will also have a constant-growth stock price
Estimating Expected Rates of Return Constant-growth dividend discount model (forecasts a constant growth rate, g, in both future dividends and stock prices= forecast capital gains=g per year) r= DIV1/Po +g = dividend yield+ growth rate Non Constant Growth Set the investment horizon (Year H) at the future year by which you expect the company’s growth to settle down. Calculate the present value of dividends from now to the horizon year. Forecast the stock price in that year and discount it also to present value. Then add it up to get the total present value of dividends plus the ending stock price Po= DIV1/1+r + DIV2/(1+r)2 +…+ DIVh/ (1+r)h+ Ph/ (1+r)h PV of stock price at horizon PV of dividend at horizon 6.5 Growth Stocks and Income Stocks Buy growth stocks in expectation of capital gains and interested in the future growth of earnings rather than in dividends Income stocks principally for cash dividends Payout ratio: fractions of earnings paid out as dividends Plowback ratio: fraction of earnings retained by the firm. Also called retention ratio Growth ate= return on equity X plowback ratio Sustainable growth ate: steady rate at which a firm can grow; return on equity plowback ratio; rate of growth an entity can sustain without raising more capital Without reinvesting any of its earnings, firm devalues its stock price (since stock price is determined by future investments, future growth expectations and intangible assets)>> stock price would just derive from the stream of earnings from the existing assets Plowing earnings back into new investments may result in growth in earnings and dividends, but it does not add to the current stock price if that money is expected to earn only the return that investors require. Plowing earnings back does add to value if investors believe that the reinvested earnings will earn a higher rate of return than investors require Present value of growth opportunities (PVGO): Net present value of a firm’s future investments The Price Earnings Ratio High P/E suggests that investors think that the firm has good growth opportunities. However, firms can have a high P/E ratio not because the price is high but because earnings
are temporarily depressed. A firm that earns nothing in a particular period will have an infinite P/E 6.6 There Are No Free Lunches on Bay Street Why is it so difficult to beat the market? Two main methods #1: Technical Analysis Some investors try by spotting and exploiting patters in stock prices. These investors are known as technical analysts (investors who attempt to identify undervalued stocks by searching for patterns in past stock prices) Can’t get rich looking for patterns because prices appear to wander randomly, virtually equally likely to offer a high or low return on any particular day, regardless of what have occurred on previous days This is called following a random walk (security prices change randomly, with no predictable trends or patterns) #2: Fundamental Analysis Investors who attempt to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects Inside information relevant information about a company known to its board of directors, management, and or employees, and other insiders but not to the public Insiders: members of the board of directors, management, employees and others with a close relationship to a company including lawyers, financial advisors and accountants Insider trading: illegal trading of securities, including stocks, bonds and options by insiders or those who are tipped by insiders on the basis of inside information Insider trading laws needed to help create a market where investors have confidence that they are not being taken advantage of by better informed market participants A Theory to Fit the Facts Stock market is an efficient market (market in which prices reflect all available information) Three different types of information and three degrees of efficiency 1. Weak-form efficiency: market prices rapidly reflect all information contained in the history of past prices 2. Semi-strong form efficiency: market prices rapidly reflect all publicly available information 3. Strong-form efficiency: market prices rapidly reflect all information that could in principle be used to determine true value 6.7 Market Anomalies and Behavioural Finance Market Anomalies: acceptations to the efficient markets theory 1. The Earnings Announcement Puzzle Behavioural Finance 1. Attitudes Towards risk 2. Beliefs about probabilities
6.3 Valuing Common Stocks The cash payoff to owners of common stocks comes in two forms (1) cash dividends, and (2) capital gains or losses Expected return= r= DIV1+P1-Po/ Po = expected dividend yield + expected capital gain DIV1= expected dividend per share Po= time zero, which is today P1= time 1, which is 1 year hence For many investors, both dividends and capital gains are taxable= look at after-tax rate of return for the best measure of the actual earnings on a stock After-tax rate of return= Div1- dividend tax/ Po + Capital gain- capital gains tax/Po The Dividend Discount Model Discounted cash flow model of today’s stock price that states that share value equals the present value of all expected future dividends Far-distant dividends will not have significant present values For one period investor. The valuation formula looks like this: Po= DIV1+p1/ 1+r Add on terms for each additional period Po= DIV1/1+r+ DIV2/ (1+r)2+…+ DIVh+ Ph/ (1+r)h The value of a stock is the present value of the dividends it will pay over the investor’s horizon plus the present value of the expected stock price at the end of that horizon Regardless of the investment horizon the stock value will always be the same. This is because the stock price at the horizon date is determined by expectations of dividends from that date forward. Therefore, as long as the investors are consistent in their assessment of the prospects of the firm, they will arrive at the same present value The principle holds for horizons of 1, 3, 10, 20 and 50 years or more 6.4 Simplifying the Divided Discount Model The Dividend Discount Model With No Growth Company that pays out all its earnings in dividends= cannot grow because it does not reinvest This model says that the no-growth shares should sell for the present value of a constant, perpetual stream of dividends (Po= DIV1/r) Since the company pays out all its earnings as dividends, dividends and earnings are the same, and we could just as well calculate stock value (Value of no-growth stock= Po= EPS1/r) EPS1 represents next year’s earnings per share of stock. We can loosely say that “stock price is the present value of future earning The Constant-Growth Dividend Discount Model Requires a forecast of dividends for every year into the future which poses a bit of a problem for stocks with lives that are potentially infinite= assume no-growth perpetuity that works for no-growth common shares and most preferred shares Note that each temr is proportionately smaller than the preceding one as long as the dividend growth rate is less than the discount rate. Because the present value of far-distant
dividends will always get closer to zero, the sum of all of these terms is finite despite the fact that an infinite number of dividends will be paid Po= DIV1/ r-g This equation is called the constant-growth dividend discount model A stock with a constant- growth dividend will also have a constant-growth stock price
Estimating Expected Rates of Return Constant-growth dividend discount model (forecasts a constant growth rate, g, in both future dividends and stock prices= forecast capital gains=g per year) r= DIV1/Po +g = dividend yield+ growth rate Non Constant Growth Set the investment horizon (Year H) at the future year by which you expect the company’s growth to settle down. Calculate the present value of dividends from now to the horizon year. Forecast the stock price in that year and discount it also to present value. Then add it up to get the total present value of dividends plus the ending stock price Po= DIV1/1+r + DIV2/(1+r)2 +…+ DIVh/ (1+r)h+ Ph/ (1+r)h PV of stock price at horizon PV of dividend at horizon 6.5 Growth Stocks and Income Stocks Buy growth stocks in expectation of capital gains and interested in the future growth of earnings rather than in dividends Income stocks principally for cash dividends Payout ratio: fractions of earnings paid out as dividends Plowback ratio: fraction of earnings retained by the firm. Also called retention ratio Growth ate= return on equity X plowback ratio Sustainable growth ate: steady rate at which a firm can grow; return on equity plowback ratio; rate of growth an entity can sustain without raising more capital Without reinvesting any of its earnings, firm devalues its stock price (since stock price is determined by future investments, future growth expectations and intangible assets)>> stock price would just derive from the stream of earnings from the existing assets Plowing earnings back into new investments may result in growth in earnings and dividends, but it does not add to the current stock price if that money is expected to earn only the return that investors require. Plowing earnings back does add to value if investors believe that the reinvested earnings will earn a higher rate of return than investors require Present value of growth opportunities (PVGO): Net present value of a firm’s future investments The Price Earnings Ratio High P/E suggests that investors think that the firm has good growth opportunities. However, firms can have a high P/E ratio not because the price is high but because earnings
are temporarily depressed. A firm that earns nothing in a particular period will have an infinite P/E 6.6 There Are No Free Lunches on Bay Street Why is it so difficult to beat the market? Two main methods #1: Technical Analysis Some investors try by spotting and exploiting patters in stock prices. These investors are known as technical analysts (investors who attempt to identify undervalued stocks by searching for patterns in past stock prices) Can’t get rich looking for patterns because prices appear to wander randomly, virtually equally likely to offer a high or low return on any particular day, regardless of what have occurred on previous days This is called following a random walk (security prices change randomly, with no predictable trends or patterns) #2: Fundamental Analysis Investors who attempt to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects Inside information relevant information about a company known to its board of directors, management, and or employees, and other insiders but not to the public Insiders: members of the board of directors, management, employees and others with a close relationship to a company including lawyers, financial advisors and accountants Insider trading: illegal trading of securities, including stocks, bonds and options by insiders or those who are tipped by insiders on the basis of inside information Insider trading laws needed to help create a market where investors have confidence that they are not being taken advantage of by better informed market participants A Theory to Fit the Facts Stock market is an efficient market (market in which prices reflect all available information) Three different types of information and three degrees of efficiency 1. Weak-form efficiency: market prices rapidly reflect all information contained in the history of past prices 2. Semi-strong form efficiency: market prices rapidly reflect all publicly available information 3. Strong-form efficiency: market prices rapidly reflect all information that could in principle be used to determine true value 6.7 Market Anomalies and Behavioural Finance Market Anomalies: acceptations to the efficient markets theory 1. The Earnings Announcement Puzzle Behavioural Finance 1. Attitudes Towards risk 2. Beliefs about probabilities
