Download Investments: An Introduction Sixth Edition

Ch7 & 8
The Valuation of
Common Stock
 Acquiring
ownership in a
corporation
 Formed
by a state: A corporation
is an artificial legal economic unit
established (i.e., chartered) by a
stat
 Certificate of incorporation:
A document creating a corporation.
 Charter
– A document specifying
the relationship between a firm
and the state in which it is
incorporated
 Bylaws - specifies the relationship
with stockholders
 Director:
A
person who is elected by
stockholders to determine the
goals and policies of the firm.
Preemptive
rights
Rights
offering
Right of
stockholder
Voting
authority
Cumulative
voting
 Voting
authority to elect a board
of directors
 Cumulative voting: The alternative
system, cumulative voting, gives
minority stockholders a means to
obtain representation on the
firm’s board.
 Preemptive
rights: The right of
current stockholders to maintain
their proportionate ownership in
the firm.
 Rights offering: Sale of new
securities to existing
stockholders.
 Dividends/earnings
 Stability
of the payout ratio
 Stability
of dividend payments
Dividends
Stock
Dividends
Cash
Dividends
Distribution
from earnings
Regular quarterly dividends
Extra dividends
Irregular dividends
Dividends paid in property
Date
of record
Stock trading ex dividend
Ex-dividend date
Distribution date
 The
retention ratio:
earnings retained/earnings
or
1 - payout ratio
Date of record: The day on which
an investor must own shares in
order to receive the dividend
payment.
Stock trading ex dividend:
Stock that trades exclusive of any
dividend payment.
 Ex-dividend
date is two trading
days prior to the date of record
 Distribution
date: The date on
which a dividend is paid to
stockholders.
 Some
firms pay stock dividends in
addition to or in lieu of cash
dividends.
 Stock dividends are a form
recapitalization and do not affect
the assets or liabilities of the
 firm.
 Does
not affect
ownership
 Does not affect
 Does not affect
 Does not affect
proportionate
assets
liabilities
total equity
Dilution
of existing shares:
A
reduction in earnings per share due to the
issuing of new securities.
Price
adjusts for a stock dividend
A 10% stock dividend
Causes a $20 stock price to fall
to $18.18 ($20/1.1)
 Does
not affect
ownership
 Does not affect
 Does not affect
 Does not affect
proportionate
assets
liabilities
total equity
Does
affect the stock's price
A 2 for 1 stock split
Causes a $80 stock price to
decline to $40 ($80/2)
 Cash
dividends used to purchase
additional shares
 Additional cash contributions may
be allowed
 Expenses often paid by the firm
 Are automatic; an easy means to
save
 Corporations
with cash may
reduce the number of existing
shares through buy back
programs
 The decrease in outstanding
shares may
◦ Increase earnings per share
◦ Increase the price of the stock
 Stockholders
their shares
 Sales
do not have to sell
are
◦ Realized capital gains
◦ Subject to capital gains taxation




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.
The dividends is % of the par value
25
Vps = $50 =
$5
^r
ps =
$50
$5
^r
ps
= 0.10 = 10.0%
26
 Corporate
 Company
liquidations are rare
◦ Ceases operations
◦ Pays off its liabilities
◦ Distributes its remaining assets
to stockholders
 THE
LOGICAL PROCESS OF
SECURITIES VALUATION
1.
Evaluate
the
economic
environment Including estimates of
economic growth, employment,
inflation, and the geopolitical
environment
in
which
firms
operate.
2. Evaluate regulatory issues and
the impact of government policy
and intervention.
3. Analyst then moves to the various
sectors of the economy.

Within each industry the analyst needs
to be aware of the degree of
competition,
cost
structures,
the
pricing environment, and anticipated
growth. Such background is necessary
prior to analyzing an individual firm.


4. The securities analyst progresses to
consider specific firms.
Ultimately the purpose of the analysis is
to determine if the firm’s securities
(i.e., its stocks and bonds) are
undervalued and should be purchased
for inclusion in an individual’s or
investment company’s portfolio.

Investors purchase stock with the
anticipation of a total return consisting of a
dividend yield and a capital gain.
R(E) = E(D) /P + E(g)

If a firm’s $0.93 dividend is expected to
grow at 7 percent to $1.00 and the price of
the stock is $25, the anticipated annual
return on an investment in the stock is:
 An
estimate of the firm's dividend
growth rate is used in the
dividend-growth model
 Estimates often based on
accounting data
 Historical earnings or dividend
payments
 Increased
growth should increase
a stock’s price
 Increased
growth at the expense
of dividends may reduce a stock’s
price
 Growth
or income
 Question
of what is the best use
of the funds - retention versus
distribution
 Dividends:
Regular, extra, and
irregular.
 Payout: The ratio of dividends to
earnings.
 Retention ratio: The ratio of
earnings not distributed to
earnings.
 Difference
in short and long-term
capital gains taxation favor capital
gains
 Transaction
costs (e.g.,
commissions) favor dividend
income
Dividends'
Capital gain
Higher taxation
Low taxation
Short term
Long term
No commission for selling and
buying
Pay commission for selling and
buying

Dividend growth model
◦ Constant growth stocks
◦ Nonconstant growth stocks


Free cash flow method.
Using the multiples of comparable firms
40
^
D1
P0 =
(1 + ks)1
+
D2
(1 + ks)2
+
D3
+…+
(1 + ks)3
D∞
(1 +ks)∞
What is a constant growth stock?
One whose dividends are expected to grow
forever at a constant rate, g.
41
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
If g is constant and less than rs, then:
^P =
0
D0(1 + g)
ks – g
D1
=
ks – g
42
$
0.25
Dt = D0(1 + g)t
PV of Dt
=
Dt
(1 + r)t
If g > r, P0 = ∞ !
Years (t)
43
Valuation is
 V=D/k
 If
a stock pays a dividend of $1
and the investor’s required rate of
return is 12 percent, then the
valuation is = 1/12%= 8.33$
Valuation is
V=D0 (1+g)/(k - g) 
Constant growth model:
^
P0 =
=
D0(1 + g)
ks – g
$2.12
=
0.13 – 0.06
D1
=
ks – g
= $30.29.
46
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on.
^
P1 =
D2
ks – g
=
$2.2472

= $32.10
0.07
47
 Value
depends on the
◦ the required return
◦ the dividend
◦ the growth in the dividend
the
required
return
value
the growth
in the
dividend
the
dividend
 Depends
on
◦ the risk-free rate (rf)
◦ the return on the market (rm)
◦ the stock's beta
the stock's
beta
The
Required
Return (k)
the return
on the
market (rm)
the riskfree rate (rf)
 P/E
ratio is a price-earnings
multiple times earnings
 P=(m)(EPS)
 if
the analyst determines that the
appropriate P/E is 10 and the
firm’s per-share earnings are
$4.50, the value of the stock is 45
 Different
definitions of earnings
 Differences
 Question
multiple
in estimated earnings
of the appropriate
 Conceptually
P/E ratios
 Same
the same as using
weaknesses apply
 Standardizes
growth
the P/E ratio for
P/E
Earnings growth
 Low
PEG ratios (below 1.0)
suggest undervaluation
 Emphasis
on firm’s ability to
generate cash
 May
be applied when firm does
not pay a dividend
 May
be applied if firm operates at
a loss
 Value
investing employs all of the
alternative methods



Hard to beat the market on a riskadjusted basis consistently
Earning a higher return is not
necessarily outperforming the market
Considering risk is also important
 Large
number of competing
participants
 Information
is readily available
 Transaction
costs are small
 Another
term for efficient markets
 Does
not imply security prices are
randomly determined
 Implies
day-to-day price changes
are random
 Successive
prices changes are
independent
 Today's price does not forecast
tomorrow's price
 Current price embodies all known
information
 New
information must be random
IF NOT
 An
opportunity to earn an excess
return would exist
Undervaluation
 drives prices
up
 returns decline
Overvaluation
 drives prices
down
 returns
increase
 Prices
change quickly to new
information
 By
the time most investors know
the information the price change
has already occurred
 The
forms of the efficient market
hypothesis:
◦ the weak form
◦ the semi-strong form
◦ the strong form
 Even
if financial markets are
efficient, that does not answer the
question "How efficient?”
 Studying
past price and volume
data will not lead to superior
investment results
 While the weak form suggests that
using price data will not produce
superior results, using financial
analysis may produce superior
returns
 Studying
economic and
accounting data will not lead to
superior investment returns
 Studying
inside information may
lend to superior returns
Using inside information will not
lead to superior investment
returns

The Strong
Form
The SemiStrong Form
The Weak Form
 Empirical
support
results generally
◦ the weak form
◦ the semi-strong form
 Possible
exceptions to the
efficient market hypothesis, called
anomalies, appear to exist
 Low
P/E stocks
 The small firm effect
 The January effect
 The neglected firm effect
 The
day-of-the-week effect
 The
Value Line effect
 The
overreaction effect
 Drifts
in security prices
 Empirical
evidence of the
existence of an anomaly, however,
does not mean the individual can
take advantage of the anomaly
 The anomaly can still exist and
the market be effectively efficient
from the individual investor's
perspective
 Security
prices embody known
information
 The playing field is level
 Specifying financial goals may be
more important than seeking
undervalued stocks
 Other
markets may not be
efficient
 Importance
of reducing
transactions costs: the argument
for a buy-and-hold strategy