Chapter 8 - The Valuation and Characteristics of Stock

Common Stock

Corporations are owned by common

stockholders

Most large companies are “widely held’

– Ownership spread among many investors.

Investors don’t think of their role as owners

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 The Return on an
Investment in Common Stock
Income in a stock investment comes from:
– dividends
– gain or loss on the difference between the purchase and sale
price
If you buy a stock for price P0, hold it for one year, receive a dividend
of D1, then sell it for price P1, you return, k, would be:

D1+ (P1 -P0 )

k=
P0 A capital gain (loss) occurs
or if you sell the stock for a
k=
D1
+
(P1-P0 ) price greater (lower) than
P0 P0 you paid for it.
! "
#$# %
dividend yield capital gains yield

3
 The Return on an
Investment in Common Stock
Solve the previous equation for P0, the stock’s
price today:

kP0 = D1 + ( P1 - P0 )
P0 + kP0 = D1 + P1
(1 + k ) P0 = D1 + P1
D1 + P1
P0 =
(1 + k )

4
 The Return on an
Investment in Common Stock

The return on a stock investment is the

interest rate that equates the present value of
the investment’s expected future cash flows to
the amount invested today, the price, P0
Figure 8-1 Cash Flow Time Line for
Stock Valuation

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 The Nature of Cash Flows
from Stock Ownership
Comparison of Cash Flows from Stocks and Bonds

– For stockholders: – For bondholders:

Expected dividends and
future selling price are not
known with any precision
Similarity to bond cash flows
is superficial – both involve
a stream of small payments
followed by a larger payment
When selling, investor
receives money from
another investor
Interest payments are
guaranteed, constant
Maturity value is fixed
At maturity, the investor
receives face value from
the issuing company.

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 The Basis of Value

The basis for stock value is the present value

of expected cash inflows even though
dividends and stock prices are difficult to
forecast

P0 = D1 éëPVFk,1 ùû + D2 éëPVFk,2 ùû + ! + Dn éëPVFk,n ùû + Pn éëPVFk,n ùû

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Concept Connection Example 8-1 Valuation
of Stock Based on Projected Cash Flows

Joe Simmons is interested in the stock of Teltex Corp.

He feels it is going to have two very good years
because of a government contract, but may not do
well after that.
Joe thinks the stock will pay a dividend of $2 next year
and $3.50 the year after. By then he believes it will be
selling for $75 a share, at which price he'll sell
anything he buys now.
People who have invested in stocks like Teltex are
currently earning returns of 12%. What is the most
Joe should be willing to pay for a share of Teltex?
Concept Connection Example 8-1 Valuation
of Stock Based on Projected Cash Flows

Joe shouldn’t pay more than the present value of the

cash flows he expects: $2 at the end of one year and
$3.50 plus $75 at the end of two years.

P0 = $2 éëPVF12%,1 ùû + $3.50 éëPVF12%,2 ùû + $75 éëPVF12%,2 ùû

= $2[0.8929] + $3.50[0.7972] + $75.00[0.7972]
= $64.37

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 The Intrinsic (Calculated)
Value and Market Price
A stock’s intrinsic value is based on
assumptions about future cash flows made
from fundamental analysis of the firm and its
industry
Different investors with different cash flow
estimates will have different intrinsic values

11
 Growth Models of Common
Stock Valuation
Based on predicted growth rates since
forecasting exact future prices and dividends
is difficult

More likely to forecast a growth rate of

earnings rather than cash flows

12
 Developing Growth-Based Models

A stock’s value today is the sum of the present values

of the dividends received while the investor holds it
and the price for which it is eventually sold

D1 D2 Dn Pn
P0 = + +! + +
(1 + k ) (1 + k ) 2
(1 + k ) (1 + k )
n n

An Infinite Stream of Dividends

Many investors buy a stock, hold for awhile, then sell, as
represented in the above equation

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 Developing Growth-Based Models

A person who buys stock at time n will hold it until

period m and then sell it
– Their valuation will look like this:

Dn + 1 Dm Pm
Pn = +…+ +
(1 + k ) (1 + k )
m-n
(1 + k )
m-n

Repeating this process until infinity results in:

¥
Di
P0 = å
(1 + k )
i
i=1

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 The Constant Growth Model
If dividends are assumed to be growing at a constant rate forever
and the last dividend paid is, D0, then the model is:

D 0 (1 + g)i
¥
P0 = å
i=1 (1 + k ) i

This represents a series of fractions as follows

D0 (1 + g) D0 (1 + g ) D0 (1 + g )
2 3

P0 = + + + !¥
(1 + k ) (1 + k )
2
(1 + k )
3

If k>g, the fractions get smaller (approach zero) as exponents get larger

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 Constant Normal Growth
The Gordon Model
Constant growth model can be simplified to

k must be
D1 greater than
P0 = g.
k -g
The Gordon Model is a simple expression for forecasting
the price of a stock that’s expected to grow at a constant,
normal rate

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Concept Connection Example 8-3 Constant
Normal Growth - The Gordon Model
Atlas Motors is expected to grow at a constant rate of
6% a year into the indefinite future. It recently paid a
dividends of $2.25 a share. The rate of return on
stocks similar to Atlas is about 11%. What should a
share of Atlas Motors sell for today?

D1
P0 =
k-g
$2.25 (1.06)
=
.11 - .06
= $47.70

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 The Zero Growth Rate Case —
A Constant Dividend
If a stock is expected to pay a constant, non-growing
dividend, each dollar dividend is the same
Gordon model simplifies to:

D
P0 =
k
A zero growth stock is a perpetuity to the investor

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 The Expected Return

Recast Gordon model to focus on the return (k)

implied by the constant growth assumption

D1
k= +g
P0
The expected return reflects investors’ knowledge of a
company
If we know D0 (most recent dividend paid) and P0
(current actual stock price), investors’ expectations
are input via the growth rate assumption

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 Two Stage Growth

At times, a firm’s future growth may not be

expected to be constant
– A new product may lead to temporary high growth

The two-stage growth model values a stock that

is expected to grow at an unusual rate for a
limited time
– Use the Gordon model to value the constant portion
– Find the present value of the non-constant growth
periods

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Figure 8-2 Two Stage Growth Model

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 Concept Connection Example 8-5
Valuation Based on Two Stage Growth

Zylon Corporation’s stock is selling for $48 a share.

We’ve heard a rumor that the firm will make an

exciting new product announcement next week.

We’ve concluded that this new product will support an

overall company growth rate of 20% for about two
years.

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 Concept Connection Example 8-5
Valuation Based on Two Stage Growth

We feel growth will slow rapidly and level off at about

6%. The firm currently pays an annual dividend of
$2.00, which can be expected to grow with the
company.

The rate of return on stocks like Zylon is

approximately 10%.

Is Zylon a good buy at $48?

Concept Connection Example 8-5 Valuation
Based on Two Stage Growth

D1 = D0 (1+g1) = $2.00(1.20) = $2.40

D2 = D1 (1+g1) = $2.40(1.20) = $2.88

D3 = D2(1+g2) = $2.88(1.06) = $3.05

 Concept Connection Example 8-5
Valuation Based on Two Stage Growth
We’ll develop a schedule of expected dividend payments:

Expected
Year Dividend Growth
1 $2.40 20%
2 $2.88 20%
3 $3.05 6%

Next, we’ll use the Gordon model at the point in time

where the growth rate changes and constant growth
begins. That’s year 2, so:
D3 $3.05
P2 = = = $76.25
k - g2 .10 - .06

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 Concept Connection Example 8-5
Valuation Based on Two Stage Growth
Then we take the present value of D1, D2 and P2:

P0 = D1 éëPVFk, 1 ùû + D2 éëPVFk, 2 ùû + P2 éëPVFk, 2 ùû

= $2.40 éëPVF10, 1 ùû + $2.88 éëPVF10, 2 ùû + $76.25 éëPVF10, 2 ùû
= $2.40 [0.9091] + $2.88 [0.8264 ] + $76.25 [0.8264]
= $67.57

Compare $67.57 to the listed price of $48.00. If we

are correct in our assumptions, Zylon should be
worth about $20 more than it is selling for in the
market, so we should buy Zylon’s stock.

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 Practical Limitations of
Pricing Models
Stock valuation models give estimated results
since the inputs are approximations of reality

Actual growth rate can be VERY different from

predicted growth rates

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 Practical Limitations of
Pricing Models
Comparison to Bond Stocks That Don’t Pay
Valuation Dividends
Bond valuation is Have value because of
precise because the expectation that they will
inputs are precise. someday pay them.
Future cash flows are Some firms don’t pay
guaranteed in amount dividends even if they are
and time, unless firm profitable
defaults. – Firms are growing and
using profits to finance
the growth

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Valuing New Stocks Investment Banking and
The Initial Public Offering (IPO)

IPOs are the first public sales of a new

company stocks
 IPO Process

Investment Banking
Syndication
Registration
Underwriting
Best Efforts
 Promoting and Pricing the IPO

Quiet Period
Book Building and the Road Show
Ends before the IPO date
 Prices After the IPO

The Investment Bank in the Middle

Underpricing and IPO Pops
A little Big Pop History
POP Strategies
Market Stabilization
 Insights – Practical Finance

Facebook’s IPO

Most anticipated IPO in history

NASDAQ trading issues
Fourth largest IPO in history
Some Institutional Characteristics of
Common Stock

Corporate Organization and Control

– Controlled by Board of Directors

elected by stockholders
– Board appoints top management who appoint
middle/lower management
– Board consists of top managers and outside
directors (may include major stockholders)
– In widely held corporations, top management in
“control”

34
Some Institutional Characteristics of
Common Stock

Preemptive Rights
– Allows stockholders to maintain a
proportionate share of ownership
– If firm issues new shares, existing
shareholders can purchase pro rata share
of new issue

35
 Voting Rights and Issues

Each share of common stock has one

vote
– Vote for directors and other issues at the
annual stockholders’ meeting
– Vote usually cast by proxy

36
 Majority and Cumulative Voting

Majority Voting Cumulative Voting

gives the larger group gives minority interest a
control of the company chance at some
representation on the
board

Shares With Different Voting Rights

Different classes of stock can be issued different
rights
Some stock may be issued with limited or no
voting rights

37
 Stockholders’ Claim on
Income And Assets
Stockholders have a residual claim on income
and assets
What is not paid out as dividends is retained
for reinvestment in the business (retained
earnings)
Common stockholders are last in line, they
bear more risk than other investors

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 Preferred Stock

A hybrid security with characteristics of

common stock and bonds
– Pays a constant dividend forever
– Specifies the initial selling price and the
dividend
– No provision for the return of capital to the
investor

39
 Valuation of Preferred Stock

Since securities are worth the present value of

their future cash flows, preferred stock is worth
the present value of the indefinite stream of
dividends.

D
P
p
p
=
k

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Concept Connection Example 8-6
Pricing Preferred Stock

Roman Industries’ $6 preferred originally sold for

$50. Interest rates on similar issues are now 9%.
What should Roman’s preferred sell for today?

Just substitute the new market interest rate into the

preferred stock valuation model to determine
today’s price:

$6
P0 = = $66.67
.09
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 Characteristics of Preferred Stock

Cumulative Feature - can’t pay common dividends

unless cumulative preferred dividends are current
Never returns principal
Stockholders cannot force bankruptcy
Receives preferential treatment over common stock in
bankruptcy
No voting rights
Dividend payments not tax deductible to the firm

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 Securities Analysis

The art and science of selecting investments

Fundamental analysis looks at a company’s

business to forecast value
Technical analysis bases value on the pattern
of past prices and volume
The Efficient Market Hypothesis (EMH) -
financial markets are efficient since new
information is instantly disseminated

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 Options and Warrants
Options and warrants make it possible to
invest in stocks without holding shares
Options Warrants
Gives the holder the Similar but less common
temporary right to buy
or sell an asset at a
fixed price
Speculate on price
changes without
holding the asset

44
 Stock Options
Stock options speculate on stock price
movements
Trade in financial markets
Call option — option to buy
Put option — option to sell
Options are Derivative Securities
– Derive value from prices of underlying
securities
– Provide leverage – amplifying returns

45
 Call Option

Basic Call Option

– Gives owner (the holder) the right to buy
stock at a fixed price (the exercise or strike
price) for a specified time period
– Once expired, it can’t be exercised
– Option price < price of the underlying stock

46
Figure 8-3 Basic Call Option
Concepts

47
 Call Options

The more volatile the stock’s price, the

more attractive the option
– Stock’s price more likely to exceed the
strike price before the option expires

The longer the time until expiration the

more attractive the option
– The stock’s price is more likely to exceed
the strike price before the option expires

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 The Call Option Writer

The option writer originates the contract

The original writer must stand ready to
deliver on the contract regardless of how
many times the option is sold
Call writer hopes stock price will remain
stable or not rise

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 Intrinsic Value

Intrinsic value of a call is the difference

between the underlying stock’s current
price and the option’s strike price

If out-of-the-money, intrinsic value is zero

Option always sells for intrinsic value or

above
– Time premium - difference between option’s
intrinsic value and price

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Figure 8-4 The Value of a Call Option

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