6 1 Topics Covered Stocks and the Stock Market Book Values Liquidation Values and Market Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks Market Efficiency i e no free lunches on Wall Street Market Anomalies and Behavioral Finance McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 2 Terminology of Stocks Public Common Stock Ownership shares in a publicly held corporation Primary Market Place where the sale of new stock first occurs Secondary Market market in which already issued securities are traded by investors Initial Public Offering IPO First offering of stock to the general public Seasoned Issue Sale of new shares by a firm that has already been through an IPO McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 3 Value of a Stock Book Value Net worth of the firm according to the balance sheet under GAAP Market Value Balance Sheet Financial statement that uses market value of assets and liabilities Liquidation Value Net proceeds that would be realized by selling the firm s assets and paying off its creditors i e S H get what s left over McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 4 Simple Models 1 Stock Price discounted future stream of dividends paid to Shareholders where dividend periodic cash distribution from the firm to the shareholders 2 Stock Price discounted future value of corporation where future value is determined using expected cash flows or other estimate of value McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 5 Expected Return Expected Return The percentage yield that an investor forecasts from a specific investment over a set period of time Actual Return The percentage yield that an investor actually earns also called the Holding Period Return or HPR Div1 P1 P0 Actual Return r P0 McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 6 Valuing Common Stocks The formula can be broken into two parts Dividend Yield Capital Appreciation Div1 P1 P0 Actual Return r P0 P0 McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 7 Valuing Common Stocks Dividend Discount Model Computation of today s stock price which states that share value equals the present value of all expected future dividends Div1 Div2 Div H PH P0 1 2 H 1 r 1 r 1 r H Time horizon for your investment McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 8 Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of 3 3 24 and 3 50 over the next three years respectively At the end of three years you anticipate selling your stock at a market price of 94 48 What is the price of the stock given a 12 expected return McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 9 Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of 3 3 24 and 3 50 over the next three years respectively At the end of three years you anticipate selling your stock at a market price of 94 48 What is the price of the stock given a 12 expected return 3 00 3 24 350 94 48 PV 1 2 3 1 12 1 12 1 12 PV 75 00 McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 10 Proportionate Dividend Value Value per share dollars 80 70 60 50 40 PV Terminal Value PV Dividends 30 20 10 0 1 2 3 10 20 30 50 100 Investment Horizon Years McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 11 No Growth Perpetuity Model If we forecast no growth and plan to hold out stock indefinitely we will then value the stock as a perpetuity NOTE First payment is dividend in time period 1 not 0 Div1 EPS1 Perpetuity P0 or r r Assumes all earnings are paid to shareholders McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 12 Gordon Growth Model Constant Growth Model Gordon Growth Model A version of the dividend growth model in which dividends grow at a constant rate g Div1 P0 r g Given any combination of variables in the equation you can solve for the unknown variable McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 13 Valuing Common Stocks Example What is the value of a stock that expects to pay a 3 00 dividend next year and then increase the dividend at a rate of 8 per year indefinitely Assume a 12 expected return Div1 3 00 P0 75 00 r g 12 08 McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 14 Valuing Common Stocks Example continued If the same stock is selling for 100 in the stock market what might the market be assuming about the growth in dividends 3 00 100 12 g g 09 McGraw Hill Irwin Answer The market is assuming the dividend will grow at 9 per year indefinitely Copyright 2007 by The McGraw Hill Companies Inc All rights 6 15 Valuing Common Stocks If a firm elects to pay a lower dividend and reinvest the funds the stock price may increase because future dividends may be higher Payout Ratio Fraction of earnings paid out as dividends Plowback Ratio Fraction of earnings retained by the firm McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 16 Valuing Common Stocks Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations g return on equity X plowback ratio McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 17 Valuing Common Stocks Example Our company forecasts to pay a 5 00 dividend next year which represents 100 of its earnings This will provide investors with a 12 expected return Instead we decide to plow back 40 of the earnings at the firm s current return on equity of 20 What is the value of the stock before and after the plowback decision McGraw Hill Irwin Copyright 2007 by The McGraw Hill Companies Inc All rights 6 18 Valuing Common Stocks Example Our company forecasts to pay a 5 00 dividend next year which represents 100 of its earnings This will provide investors with a 12 expected return Instead we decide to blow back 40 of the earnings at the firm s current return on equity of 20 What is the value of the stock before and after the plowback decision No Growth With Growth 5 P0 41 67 12 McGraw Hill Irwin g 20 40 08 3 P0 75 00 12 08 Copyright 2007 by The McGraw Hill Companies Inc All rights 6 19 Valuing Common Stocks Example continued If the company did not plowback some earnings the stock