ch08 ppt brighamfm1ce

8/3/2019 Ch08 Ppt Brighamfm1ce

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PowerPoint Presentationprepared by

Traven ReedCanadore College


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CH8

Copyright 2011 by Nelson Education Ltd. All rights reserved. 8-3

Corporate Valuation andStock Risk


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Topics in Chapter

Features ofcommon stock

Determining common stock values

Efficient markets

Preferred stock


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Common Stock: Owners,Directors, and Managers

Represents ownership.

Ownership implies control.

Stockholders elect directors.

Directors hire management.

Managers are agents ofshareholders, they always solicitshareholders proxies and usuallysucceed.


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Control of the Firm

Shareholders often have the right (i.e.preemptive right) to purchase any

additional shares sold by the firm This preemptive right protects the control

of the present shareholders and alsoprevents dilution of their value

The preemptive right makes it moredifficult to raise equity capital from newlarge shareholders



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Types of Common Stock

Not all common shares are createdequally

Most firms have only one type ofcommon stock

A system of dual-class shares is

used to meet the special needs ofthe company



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Classified Stock

Classified stockhas specialprovisions.

Could classify existing stock asfounders shares, with voting rightsbut dividend restrictions.

New shares might be called ClassA shares, with voting restrictionsbut full dividend rights.


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Stock Market Reporting

In the past, tracking stock is through thebusiness section of a daily newspaper.

Today, wecan get quotes all during t

he dayfrom a wide variety of Internet sources (e.g.

Globeinvestor.com).

Comparing with once a day from thenewspaper prints, the 20-minute delay with

the Internet information is nothing. The quote provides the price a buyer would

have to pay (Ask) and the price someonecan sell the stock (Bid) for.


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Different Approaches forValuing Common Stock

Most stocks expected total return =dividend yield + capital gains yield

Intrinsic value of a stock is thepresent value of its expected futurecash flow stream

Dividend growth model Free cash flow approach

Using the multiples ofcomparable firms


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Stock Value = PV ofexpected future dividends

What is a constant growth stock?

One whose dividends are expectedto grow forever at a constant rate, g.

P0 =^

(1+rs)1 (1+rs)2 (1+rs)3 (1+rs)

D1 D2 D3 D

++ ++


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For a constant growth stock:

D1 = D0(1+g)1

D2 = D0(1+g)2

Dt = D0(1+g)t

If g is constant and less than rs, then:

P0 =^ D0(1+g)

rs - g=

D1rs - g

Use decimals, not % in the calculation


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Dividend and Earnings

Growth Growth in dividends occurs primarily as

a result of growth in EPS.

Earnings growth results from a numberof factors: (1) inflation, (2) reinvestedprofit, and (3) ROE.

Firms cannot increase stock price by justraising the current dividend.

There is a tradeoff between current

dividends and future dividends.



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Intrinsic Stock Value vs.Quarterly Earnings

If most of a stocks value is due to long-term cash flows, why do so many

managers focus on quarterly earnings? Sometimes changes in quarterly

earnings are a signal of future changesin cash flows. This would affect the

current stock price.

Sometimes managers have bonuses tiedto quarterly earnings.


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Dividend Growth and PV ofDividends: P

0= (PVof D

t)

$

0.25

Years (t)

Dt = D0(1 + g)t

PV of Dt =Dt

(1 + rS)t

If g > rs , P0 = !


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What happens if g > rs?

P0 =^

(1+rs)1 (1+rs)2 (1+rs)

D0(1+g)1 D0(1+g)

2 D0(1+rs)

+ ++

(1+g)t

(1+rs)t

If g > rIf g > rss, then, then P0 = ^

> 1, and

So g must be less than rs to use theconstant growth model.


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Projected Dividends

D0 = $2 and constant g = 6% = 0.06

D1 = D0(1+g) = 2(1.06) = $2.12

D2 = D1(1+g) = 2.12(1.06) =$2.2472

D3 = D2(1+g) = 2.2472(1.06) =$2.3820


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Expected Dividends and PVs(r

s= 13%, D

0= $2, g = 6%)

0 1

2.2472

2

2.3820

3g=6%

4

1.8761

1.75991.6508

13 %

2.12


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Intrinsic Stock Value:D

0= $2.00, r

s= 13%, g = 6%

Constant growth model:

= = $30.290.13 - 0.06

$2.12 $2.12

0.07

P0 =^ D0(1+g)

rs - g=

D1rs - g


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Expected value one yearfrom now:

D1 will have been paid, so expecteddividends are D2, D3, D4 and so on.

P1 =^ D2

rs - g=

$2.2427

0.07

= $32.10 = $30.29(1+0.06)


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Expected Dividend Yield andCapital Gains Yield (Year 1)

Dividend yield = = = 7.0%$2.12$30.29

D1P0

CG Yield = =P1 - P0^

P0$32.10 - $30.29

$30.29

= 6.0%


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Total Year-1 Return

Total return = Dividend yield +Capital gains yield.

Total return = 7% + 6% = 13%

Total return = 13% = rs For constant growth stock:

Capital gains yield = 6% = g


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Expected Rate of Return on

a Constant Growth

Stock

Then, rs = $2.12/$30.29 + 0.06= 0.07 + 0.06 = 13%

^

P0

=^ D1

rs - gto

D1

P0

rs

^

=+ g


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If g = 0, the dividend streamis a perpetuity

2.00 2.002.00

0 1 2 3rs=13%

P0 = = = $15.38PMT

r

$2.00

0.13^


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Supernormal (Non-constant)Growth Stock

Supernormal growth of 30% for 3years, and then long-run constant g

= 6%.

Can no longer use constant growthmodel.

However, growth becomes constantafter 3 years.


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Nonconstant growth followedby constant growth (D

0

= $2):

0

2.3009

2.6470

3.0453

46.1135

1 2 3 4rs=13%

54.1067 = P0

g = 30% g = 30% g = 30% g = 6%2.60 3.38 4.394 4.6576

^ P3 =^ $4.6576

0.13 0.06= $66.5371


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Dividend Growth Rates


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Suppose g = 0 for t = 1 to 3, andthen g is a constant 6%

0

1.7699

1.56631.386120.9895

1 2 3 4rs=13%

25.7118

g = 0% g = 0% g = 0% g = 6%

2.00 2.00 2.00 2.12

2.12P3

0.0730.2857! !


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If g = -6%, would anyone buythe stock? If so, at what price?

Firm still has earnings and still pays

dividends, so P0 > 0:^

= = = $9.89$2.00(0.94)

0.13 - (-0.06)

$1.88

0.19

P0 =^ D0(1+g)

rs - g

=D1

rs

- g


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Stock Valuation:

FCF Approach

Firm value is the present value ofits future expected free cash flows

(FCF) discounted at the WACC.

Since PV (FCF) is the present valueof a growing annuity, we have


gWACC

gFCFV

!

)1(


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Using Stock Price Multiplesto Estimate Stock Price

Analysts often use the P/E multiple(the price per share divided by the

earnings per share). Example:

Estimate the average P/E ratio ofcomparable firms. This is the P/E

multiple. Multiply this average P/E ratio by the

expected earnings of the company toestimate its stock price.


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Using Entity Multiples

The entity value (V) is: the market value of equity (# shares of stock

multiplied by the price per share)

plus the value of debt. Pick a measure, such as EBITDA, Sales,

Customers, Eyeballs, etc. Calculate the average entity ratio for a

sample ofcomparable firms. Forexample, V/EBITDA V/Customers


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Using Entity Multiples (contd)

Find the entity value of the firm inquestion. For example, Multiply the firms sales by the V/Sales

multiple. Multiply the firms # ofcustomers by the

V/Customers ratio

The result is the total value of the firm.

Subtract the firms debt to get t

he totalvalue of equity.

Divide by the number of shares to getthe price per share.


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Problems with MarketMultiple Methods

It is often hard to find comparable firms.

The average ratio for the sample of

comparable firms often has a widerange.

For example, the average P/E ratio might be20, but the range could be from 10 to 50.

How do you know whether your firm shouldbe compared to the low, average, orhighperformers?


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Preferred Stock

Hybrid security.

Similar to bonds in that preferred

stockholders receive a fixed dividendwhich must be paid before dividendscan be paid on common stock.

However, unlike bonds, preferredstock dividends can be omittedwithout fear of pushing the firm intobankruptcy.



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Preferred Stock Valuation

Similar to the valuation of perpetualbonds

A preferred stock pays a quarterlydividend of $1.25 ($5 per year) with

a required return of10%. Its valueis


PS

PS

PSr

D

V !

50$1.0

5$

1.0

)25.1($4!!!!

PS

PS

PS

r

DV


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Expected return: given Vps = $50and annual dividend = $5

Vps = $50 = $5

rps^

rps$5

$50

^= = 0.10 = 10.0%


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Stock Price Volatility forchanges in rS and g

Are volatile stock prices consistent withrationing pricing?

Small changes in expected g and rscause large changes in stock prices.

As new information arrives, investorscontinually update their estimates of g

and rs. If stock prices are not volatile, then thismeans there is not a good flow ofinformation.


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Stock Market Equilibrium

In equilibrium, stock prices arestable. There is no general

tendency for people to buy versusto sell.

The expected price, P, must equalthe actual price, P. In other words,the fundamental value must be thesame as the price.


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rs = D1/P0 + g = rs = rRF + (rM - rRF)b^

In equilibrium, expected returnsmust equal required returns:


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If rs

= + g > rs, then P

0is too low.

If the price is lower than the fundamentalvalue, then the stock is a bargain. Buy

orders will exceed sell orders, the pricewill be bid up until:

D1/P0 + g = rs = rs

^

^

D1P0

^

How is equilibriumestablished?


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Efficient Market Hypothesis

Securities are normally in equilibriumand are fairly priced.

Investors cannot beat the marketexcept through good luck or insideinformation.

The prices of securities fully reflectavailable information. They will adjustimmediately to any new development.


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Weak-form EMH

Investors buying bonds and stockscannot profit by looking at past

trends. A recent decline is noreason to think stocks will go up (ordown) in the future. Evidence

supports weak-form EMH, buttechnical analysis is still used.


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Semistrong-form EMH

All publicly available information isreflected in stock prices, so it does

not pay to pore over annual reportslooking for undervalued stocks.Largely true.


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Strong-form EMH

All information, even insideinformation, is embedded in stock

prices. Not true--insiders can gainby trading on the basis of insiderinformation, but that is illegal!


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Copyright 2011 by Nelson Education Ltd. All rights reserved. 8 46

Markets are generallyefficient because:

100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for

firms like Fidelity, Merrill, Morgan,and Prudential.

These analysts have similar access

to data and megabucks to invest. Thus, news is reflected in P0 almost

instantaneously.

ch08 ppt brighamfm1ce

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