CHAPTER 9 Stocks and Their ValuationFacts about Common StockSocial/Ethical QuestionWhat’s classified stock? How might classified stock be used?When is a stock sale an initial public offering (IPO)?Average Initial Returns on IPOs in Various CountriesDifferent Approaches for Valuing Common StockPowerPoint PresentationFor a Constant Growth StockSlide 10What happens if g > ks?Assume beta = 1.2, kRF = 7%, and kM = 12%. What is the required rate of return on the firm’s stock?D0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. ks = 13%.What’s the stock’s market value? D0 = 2.00, ks = 13%, g = 6%.What is the stock’s market value one year from now, P1?Find the expected dividend yield, capital gains yield, and total return during the first year.Slide 17What would P0 be if g = 0?If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P0? k is still 13%.Slide 20What is the expected dividend yield and capital gains yield at t = 0? At t = 4?Slide 22Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P0?What is D/P and capital gains yield at t = 0 and at t = 3?If g = -6%, would anyone buy the stock? If so, at what price?What is the annual D/P and capital gains yield?Free Cash Flow MethodUsing the Free Cash Flow MethodIssues Regarding the Free Cash Flow MethodFCF Method Issues ContinuedFCF estimates for the next 3 years are -$5, $10, and $20 million, after which the FCF is expected to grow at 6%. The overall firm cost of capital is 10%.If the firm has $40 million in debt and has 10 million shares of stock, what is the price per share?Using the Multiples of Comparable Firms to Estimate Stock PriceWhat is market equilibrium?Slide 35How is equilibrium established?Why do stock prices change?What’s the Efficient Market Hypothesis?Slide 39Slide 40Slide 41Markets are generally efficient because:Preferred StockWhat’s the expected return of preferred stock with Vp = $50 and annual dividend = $5?9 - 1Copyright © 2001 by Harcourt, Inc. All rights reserved.CHAPTER 9Stocks and Their ValuationFeatures of common stockDetermining common stock valuesEfficient marketsPreferred stock9 - 2Copyright © 2001 by Harcourt, Inc. All rights reserved.Represents ownership.Ownership implies control.Stockholders elect directors.Directors elect management.Management’s goal: Maximize stock price.Facts about Common Stock9 - 3Copyright © 2001 by Harcourt, Inc. All rights reserved.Social/Ethical QuestionShould management be equally concerned about employees, customers, suppliers, “the public,” or just the stockholders?In enterprise economy, work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition.9 - 4Copyright © 2001 by Harcourt, Inc. All rights reserved.Classified stock has special provisions.Could classify existing stock as founders’ shares, with voting rights but dividend restrictions.New shares might be called “Class A” shares, with voting restrictions but full dividend rights.What’s classified stock? How might classified stock be used?9 - 5Copyright © 2001 by Harcourt, Inc. All rights reserved.When is a stock sale an initial public offering (IPO)?A firm “goes public” through an IPO when the stock is first offered to the public.9 - 6Copyright © 2001 by Harcourt, Inc. All rights reserved.Average Initial Returns on IPOs in Various CountriesMalaysia100%75%50%25%BrazilPortugalJapanSwedenUnited StatesCanada9 - 7Copyright © 2001 by Harcourt, Inc. All rights reserved.Dividend growth modelFree cash flow methodUsing the multiples of comparable firmsDifferent Approaches for Valuing Common Stock9 - 8Copyright © 2001 by Harcourt, Inc. All rights reserved.       PDkDkDkDks s s s01122331 1 1 1 . . .One whose dividends are expected togrow forever at a constant rate, g.Stock Value = PV of DividendsWhat is a constant growth stock?9 - 9Copyright © 2001 by Harcourt, Inc. All rights reserved.For a Constant Growth StockD1 = D0(1 + g)1D2 = D0(1 + g)2Dt = Dt(1 + g)tP0 = = .If g is constant, then:D0(1 + g)ks - gD1ks - g^9 - 10Copyright © 2001 by Harcourt, Inc. All rights reserved. t0tg1DD  tttk1DPVD!P k,>g If0t0PVDP $0.25Years (t)09 - 11Copyright © 2001 by Harcourt, Inc. All rights reserved.What happens if g > ks?If ks< g, get negative stock price, which is nonsense.We can’t use model unless (1) ks> g and (2) g is expected to be constant forever..PDk ggs01 requires ks9 - 12Copyright © 2001 by Harcourt, Inc. All rights reserved.Assume beta = 1.2, kRF = 7%, and kM = 12%. What is the required rate of return on the firm’s stock?ks= kRF + (kM – kRF)bFirm = 7% + (12% – 7%) (1.2) = 13%.Use the SML to calculate ks:9 - 13Copyright © 2001 by Harcourt, Inc. All rights reserved.D0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. ks = 13%.0 12.24722.3823g = 6%1.87611.7599D0 = 2.001.650913%2.129 - 14Copyright © 2001 by Harcourt, Inc. All rights reserved.= =What’s the stock’s market value? D0 = 2.00, ks = 13%, g = 6%.Constant growth model:P0 = = D1ks – g 0.13 – 0.06 $2.12$2.120.07$30.29.9 - 15Copyright © 2001 by Harcourt, Inc. All rights reserved.D1 will have been paid, so expected dividends are D2, D3, D4 and so on. Thus,Could also find P1 as follows:ks – g 0.13 – 0.06 P1 = = What is the stock’s market value one year from now, P1?^^^D2 $2.247^= $32.10.P1 = P0(1.06) = $32.10.9 - 16Copyright © 2001 by Harcourt, Inc. All rights reserved.Find the expected dividend yield, capital gains yield, and total return during the first year.Dividend yld = = =Cap gains yld = = Total return = 7.0% + 6.0% = 13.0%.D1P0P1 – P0P0^$30.29$2.12 7.0%.$32.10 – $30.29$30.29= 6.0%.9 - 17Copyright © 2001 by Harcourt, Inc. All rights reserved.Rearrange model to rate of return form: .PDk gDPgs01 10  to ksThen, ks= $2.12/$30.29 + 0.06= 0.07 + 0.06 = 13%.^9 - 18Copyright © 2001 by Harcourt, Inc. All rights reserved.P0 = = = $15.38.What would P0 be if g = 0?The dividend stream would be a perpetuity.2.00 2.002.000 1 2 313%...^PMTk$2.000.13^9 - 19Copyright © 2001 by Harcourt, Inc. All