Transcript Chapter 7
Valuing Stocks
Chapter 7
Fin 325, Section 04 – Spring 2010
Washington State University
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Common Stock
Equity securities (stocks) represent ownership in a
corporation
Common stockholders are residual claimants
The market value of a firm’s common stock depends
on many factors including:
The company’s profitability (cash flows)
The company’s growth potential
Current market interest rates
Conditions in the overall stock market
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Stock Markets
Stock exchanges provide liquidity: the
ability for owners of common stock to
convert their shares into cash at any time
This liquidity, allowing buyers and
sellers the means to transact with each
other, gives people the confidence to buy
shares in the first place
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New York Stock Exchange
NYSE Trading Floor Overview:
http://www.youtube.com/watch?v=Q7FdaiPQuDg
NYSE Trading Floor Tour:
http://www.youtube.com/watch?v=TPUDPhpCecA
Largest U.S. stock exchange in terms of dollar
volume of trading
Located in New York City at the corner of Wall and
Broad streets
Home to nearly 2,700 listed firms
Trading Posts
Specialists
Brokers
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http://finance.yahoo.com/q?s=MCD
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To list its stock on the NYSE a company must
meet minimum requirements and pay listing
fees and annual fee to NYSE
Total number of stockholders
Level of trading volume
Corporate earnings
Firm size
What if a firm doesn’t meet these criteria, or
doesn’t want to pay the high NYSE fees?
If they want to list on an organized exchange, they
could list on the exchange down the street: the
American Stock Exchange
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The American Stock Exchange (AMEX)
The nation’s second largest floor-based stock
exchange
Also called the ‘curb’ exchange
Uses a specialist system like the NYSE
Also active in trading derivative securities and a
very popular security called an Exchange Traded
Fund (ETF)
What if a firm doesn’t need or want to be
traded on an organized, floor-based
exchange?
They can trade over-the-counter on NASDAQ
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The Nasdaq Stock Market
An electronic stock market without a physical
trading floor
Home of thousands of the smallest publiclytraded firms, as well as many high-tech giants
Microsoft, Apple, Intel, Google
Nasdaq lists around 3,000 domestic and
foreign companies
Second largest equity market in the world
behind the NYSE
Uses a market maker system rather than a
specialist system
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Tracking the Stock Market
How do we determine the overall direction
of the market?
We use stock indices
The three most-recognized indices are:
The Dow Jones Industrial Average (DJIA)
The Standard & Poor’s 500 Index (S&P500)
The Nasdaq Composite Index
Check Yahoo Finance: http://finance.yahoo.com/
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The Dow Jones Industrial Average (DJIA)
Invented in 1896, consisting of 12 companies
The only surviving company from the original twelve is
General Electric
Price-weighted index - computed by adding up
the stock prices and dividing by the number 12
The DJIA now consists of 30 large firms,
representing 30 percent of the total U.S. stock
value
Firms are occasionally added or deleted from the index
E.g. Altria Group and Honeywell were replaced by Chevron
and Bank of America on February 19, 2008
Dow 30 Components: http://money.cnn.com/data/dow30/
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The S&P 500
Was created in 1957
Intended to represent 10 sectors of the economy
Value-weighted index - uses market capitalization
to compute the index rather than stock prices
Represents roughly 80 percent of the overall stock
market value
Considered to be superior to the DJIA because of
the much wider coverage and the more useful way
it is calculated
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The Nasdaq Composite Index
Launched in 1971
Like the S&P 500 index, it uses a market
capitalization weighted average
Measures the market capitalization of all stocks
listed on the Nasdaq stock exchange
Because of the dominance of the large high-tech
firms on Nasdaq, this index is considered a
measure of the performance of the technology
sector
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Trading Stocks
Brokerage Accounts
Full-service Stockbrokers (Merrill Lynch)
Discount Brokerage (E-trade, Scottrade)
Buy and sell orders go through the brokerage
firm to a market maker or specialist
Bid/Ask spreads
Bid price = price at which the dealer will buy
Ask price = price at which the dealer will sell
The bid/ask spread is the profit for the
market maker
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Types of Orders
Market order
Broker buys or sells at best price available at the
moment
Limit order
Order to buy or sell at a specific price
Example: Suppose a share is currently selling for $75
Buy limit is at a price less than the current market
price. Place a limit order to buy at $72
Sell limit is at a price greater than the current
market price. Place a limit order to sell shares you
own at $79
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Basic Stock Valuation
Consider a two-year horizon:
D1
0
1
D2 + P2
2
The present value of the cash flows in years 1 and 2
is today’s stock value
D1 D2 P2
P0
2
1 i (1 i)
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In general, for any time horizon:
D1
D2
D n Pn
P0
...
2
n
1 i (1 i)
(1 i)
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Dividend Discount Models
We can extend the equation above for an
infinite stream of dividends and no future
selling price
The stock’s value to the investor is the present
value of all future dividends
D3
D1
D2
P0
...
2
3
1 i (1 i)
(1 i)
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To use this model in practice, analysts make
a simplifying assumption to make the model
workable: constant perpetual growth
This model is often called the Gordon growth model
D0 (1 g )
D1
Constantgrowth model P0
ig
ig
There are two important assumptions implicit in this
model: constant growth g and i>g
If I is less than g, then the stock price is negative which is
nonsense
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Example: ACME stock recently paid a $4.00
dividend. The dividend is expected to grow
at 9% per year indefinitely. What would we
be willing to pay if our required return on
ACME stock is 14%?
P0 =
D1
i-g
=
4.36
= $87.20
.14 - .09
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Preferred Stock
Preferred stock is a hybrid security
Like common stock it has no fixed maturity
It is technically part of equity capital
Like debt , preferred dividends are fixed
Preferred dividends are cumulative
If a company misses preferred stock dividends,
they must make them up before they can pay
dividends to common stockholders
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Preferred stock is owned primarily by other
companies rather than individuals
Corporations can exempt 70 percent of dividend
income from taxes
Preferred stockholders do not have voting
rights
Preferred stock pays a constant dividend
It is a special case of the constant perpetual growth
model in which g=0
The formula collapses into the formula for the
present value of a perpetuity
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Coca-Cola’s dividend is $1.36 per share at a time
when the market price of its stock is $63.50. What
would the value of Coke’s stock be if the dividends
were not expected to grow (i.e. g=0)? The
company’s cost of capital is 11.5%.
P0 = 1.36/.115 = $11.83
The difference between $63.50 and $11.83 represents
the market value of the firm’s expected growth
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Expected Return
We can rearrange the constant growth formula to
solve for i, the expected return on the stock
ExpectedReturn i
D1
g Dividend yield Capitalgain
P0
Expected return comes from two sources
Dividend yield
Expected appreciation of the stock price, or capital
gain
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Additional Valuation Methods
Variable Growth Techniques
For high-growth firms, we can’t use the constant
growth formula because we know that the firm can’t
sustain the high growth forever
These firms may have two different growth rates
Growth during the supernormal growth period
Steady growth after the firm matures
We can use a multistage growth formula for these
firms, but we can also use discounted cash flows in
combination with the constant growth model
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Example:
Suppose a firm just paid a dividend of $5 per
share. We expect the firm to grow at a rate of
10% for three years, after which it will grow at
4% forever. The required return is 9%.
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D1 = 5(1+.10) = 5.50
D2 = 5.50(1.10) = 6.05
D3 = 6.05(1.10) = 6.655
D4 = 6.655(1.04) = 6.92
Now we can calculate the present value of all
of the dividends in periods 4 to ∞, where the growth is
constant forever
P3 = D4/(i-g)
= 6.92/(.09-.04)
= 138.42
Now we have all the cash flows, and we can find P0
P0 = 5.50/1.091 + 6.05/1.092 + (6.655 + 138.42)/1.093
= $122.17
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The P/E Model
The models we have used so far involve
computing a stock’s intrinsic value using
discounted cash flows to the investor
Another approach is to assess a stock’s
relative value
The price-earnings (P/E) ratio represents the
most common valuation yardstick in the
investment industry
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The P/E ratio is simply the current price of the
stock divided by the last four quarters of
earnings per share:
Current stock price
P/E
Per share earningsfor last 12 months
The P/E ratio is used as an indication of
expected growth of a company
Larger growth rates lead to larger P/E ratios
High P/E stocks are called growth stocks, whereas low
P/E stocks are called value stocks
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Estimating Future Stock Prices
Multiplying the P/E ratio by expected
earnings results in an expected stock price
n
P
Pn (
) x E0 x (1 g )
E
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Example: The P/E ratio for Caterpillar is
12.98. The company earned $5.05 per share
and paid a $1.10 dividend last year. Analysts
estimate that the company will grow at an
average annual rate of 12.8% over the next 5
years. Calculate the expected price of
Caterpillar’s stock price in 5 years.
P5 = (P/E) x E0 x (1 + g)5
= 12.98 x $5.05 x (1.128)5
= $119.70
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