Topics CoveredTerminology of StocksValue of a StockSimple ModelsExpected ReturnValuing Common StocksSlide 7Slide 8Slide 9Proportionate Dividend ValueNo Growth Perpetuity ModelGordon Growth ModelSlide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Valuing Non-Dividend StocksValuing Irregular Growth StocksMispricing of Stocks?Fundamental AnalysisTechnical AnalysisPrice/Earnings RatioPatterns in Prices?Random Walk TheorySlide 29Slide 30Slide 31Slide 32Efficient Market TheorySlide 34Anomalies to Market Efficiency/Behavioral FinanceBehavioral FinanceCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 1Topics 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 FinanceCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 2Terminology of StocksPublic 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 IPOCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 3Value of a StockBook 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).Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 4Simple Models1. 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).Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 5Expected ReturnExpected 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).0011Return ActualPPPDivrCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 6Valuing Common StocksThe formula can be broken into two parts.Dividend Yield + Capital Appreciation 00101Return ActualPPPPDivrCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 7Valuing Common StocksDividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.H - Time horizon for your investment.PDivrDivrDiv PrH HH011221 1 1 ( ) ( )...( )Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 8Valuing Common StocksExampleCurrent 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?Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 9Valuing Common StocksExampleCurrent 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?PVPV3 001 123 241 12350 94 481 12001 2 3.( . ).( . ). .( . )$75.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 10Proportionate Dividend Value01020304050607080Value per share, dollars1 2 3 10 20 30 50 100Investment Horizon, YearsPV (Terminal Value)PV (Dividends)Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 11No Growth Perpetuity ModelIf 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)Perpetuity PDivrorEPSr 01 1Assumes all earnings are paid to shareholders.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 12Gordon Growth ModelConstant Growth Model (Gordon Growth Model) - A version of the dividend growth model in which dividends grow at a constant rate = gPDivr g01Given any combination of variables in the equation, you can solve for the unknown variable.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 13Valuing Common StocksExampleWhat 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.PDivr g010012 0800$3.. .$75.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 14Valuing Common StocksExample- continuedIf the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?$100$3...001209ggAnswerThe market is assuming the dividend will grow at 9% per year, indefinitely.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 15Valuing 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 dividendsPlowback Ratio - Fraction of earnings retained by the firm.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin6- 16Valuing Common StocksGrowth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.g = return on equity X plowback ratioCopyright © 2007 by The