Transcript Chapter 11
The stock market • The stock market receives considerable attention from investors. Great fortunes can be made, but also big losses... • This is the focus of chapter 11 – a look at the equity side of investing. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-1 The stock market • We examine the markets where stocks trade, and then review the underlying theories for stock valuation. We learn that stock valuations is quite difficult. Topics include: – Investing in Stocks – Computing the Price of Common Stock – Errors in Valuation Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2 The stock market • Net worth (also called equity capital) is the difference between a firm’s assets (what it owns) and its liabilities (what it owes). • The more net worth a firm has, the less likely it is to default. • When firms seeking credit have high net worth, lenders are more willing to make loans: “Only the people who don’t need money can borrow it!” Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-3 Investing in Stocks 1. Represents ownership in a firm 2. Earn a return in two ways 4. Right to vote for directors and on certain issues 5. Two types – Price of the stock rises over time – Dividends are paid to the stockholder – Common stock 3. Stockholders have claim on all assets Copyright © 2009 Pearson Prentice Hall. All rights reserved. • • – Right to vote Receive dividends Preferred stock • • Receive a fixed dividend Do not usually vote 11-4 Buying Foreign Stocks • Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S. • American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-5 Buying Foreign Stocks • These receipts can be traded domestically, usually on the NASDAQ. • Trade in ADRs is conducted entirely in U.S. dollars, and the bank converts stock dividends into U.S. currency. • ADR allows foreign firms to trade in the United States without the firms having to meet the disclosure rules required by the SEC. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-6 The Securities and Exchange Commission • The primary mission of the SEC is “…to protect investors and maintain the integrity of the securities markets.” • The SEC brings around 500 actions against individuals and firms each year toward this effort… Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-7 Computing the Price of Common Stock Valuing common stock is, in theory, no different from valuing debt securities: determine the future cash flows and discount them to the present at an appropriate discount rate. We will review four different methods for valuing stock, each with its advantages and drawbacks. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-8 Computing the Price of Common Stock: The One-Period Valuation Model • Simplest model, just taking the expected dividend and price over the next year. • Price = Div1 P1 (1 ke ) (1 ke ) • The discount factor used to discount the cash flows is the required return on investments in equity Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-9 Computing the Price of Common Stock: The One-Period Valuation Model What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate Answer: Price = 0.16 60 53.71 (1 0.12) (1 0.12) Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-10 Computing the Price of Common Stock: The Generalized Dividend Valuation Model • The one-period dividend valuation model can be extended to any number of periods (if Pn is far in the future, it will not affect the price). Divt t • Price = ( 1 k ) t 1 e • Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-11 Computing the Price of Common Stock: The Gordon Growth Model • Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is, Div(t+1) = Divt x (1 + g) • Price = Divt D1 t ( ke g ) t 1 (1 ke ) Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-12 Computing the Price of Common Stock: The Gordon Growth Model The model is useful, with the following assumptions: • Dividends do, indeed, grow at a constant rate forever • The growth rate of dividends, g, is less than the required return on the equity, ke. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-13 Computing the Price of Common Stock: The Price Earnings Valuation Model • The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for $1.00 of earnings from the firms (P/E). • Firms in the same industry are expected to have similar PE ratios in the long run. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-14 Computing the Price of Common Stock: The Price Earnings Valuation Model • The value of a firm’s stock can be found by multiplying the average industry PE times the expected earnings per share. • Price = P E E • A skilled analyst will adjust the PE ratio up or down to reflect unique characteristics of a firm when estimating its stock price. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-15 Computing the Price of Common Stock: The Price Earnings Valuation Method If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share? Answer: Price = 16 x $1.13 = $18.08 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-16 Errors in Valuations Although the pricing models are useful, market participants frequently encounter problems in using them. • Problems with Estimating Growth • Problems with Estimating Risk • Problems with Forecasting Dividends • … can have a significant impact in the pricing models Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-17 Errors in Valuations Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-18 Errors in Valuations Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-19 IPOs • Two common statistics in IPOs are “underpricing” and “money left on the table”. • Underpricing is defined as percentage change between the offering price and the first day closing price. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-20 IPOs • Money left on the table is the difference between the first day closing price and the offering price, multiplied by the number of shares offered. • In August of 2004, Google went public. The shares originally sold for $85 / share, and closed at over $100 on the first day. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-21