Stocks & Stock Market

Primary Market - Place where the sale of new stock first occurs.

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

Stocks & Stock Market

Common Stock - Ownership shares in a publicly held corporation.

Secondary Market - market in which already issued securities are traded by investors.

Dividend - Periodic cash distribution from the firm to the shareholders.

P/E Ratio - Price per share divided by earnings per share.

Stocks & Stock Market

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NYSE

Nasdaq

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Stock Market

Valuing Common Stocks

Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the holding period return (HPR).

Expected Return

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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.

H - Time horizon for your investment.

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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?

Valuing Common Stocks

If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

Perpetuity PDiv

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EPS

r 0

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Assumes all earnings are paid to shareholders.

Valuing Common Stocks

Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).

Given any combination of variables in the equation, you can solve for the unknown variable.

PDiv

r g01

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.

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.

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?

Valuing Common Stocks

Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.

Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.

Net Present Value

Opportunity Cost of Capital - Expected rate of return given up by investing in a project.

Net Present Value - Present value of cash flows minus initial investments.

Net Present Value

Example

Q: Suppose we can invest £50 today & receive £60 later today. What is our increase in value?

Initial Investment

Added Value

£50

£10

A: Profit = - £50 + £60 = £10

Net Present Value

Example

Suppose we can invest £50 today and receive £60 in one year. What is our increase in value given a 10% expected return?

This is the definition of NPV

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Initial Investment

Added Value

£50

£4.55

Net Present Value

NPV = PV - required investment

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Net Present Value

Terminology

C = Cash Flow

t = time period of the investment

r = “opportunity cost of capital”

• The Cash Flow could be positive or negative at any time period.

Net Present Value

Net Present Value RuleNet Present Value Rule

Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost.

Therefore, they should accept all projects with a positive net present value.

Net Present Value

Example If the building is being offered for sale at a price of £350,000, would you buy the building and what is the added value generated by your purchase and management of the building?

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NPV

Other Investment Criteria

Internal Rate of Return (IRR) - Discount rate at which NPV = 0.

Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

Internal Rate of Return

Example

You can purchase a building for £350,000. The investment will generate £16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for £450,000. What is the IRR on this investment?

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IRR = 12.96%

NPV

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Cash Flow -100 205 -95

Has 2 IRR’s of –29.2 and 34.2

One IRR Problem

Another IRR problem

Project T=0 1 2 IRR

A -100 10 110 10%

B 100 -10 -110 10%

Do you accept both if cost of capital is 9%?

Final IRR problem

Project t=0 1 2 3 IRR

A -100 50 50 50 23.4%

B -1000 500 500 300 15.6%

These projects are mutually exclusive r=10%

Payback Method

Payback Period - Time until cash flows recover the initial investment of the project.

• The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period.

Capital Rationing

Capital Rationing - Limit set on the amount of funds available for investment.

Soft Rationing - Limits on available funds imposed by management.

Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market.

Maximize NPV subject to Capital– use Profitability Index?

ProfitabilityProject PV Investment NPV Index

L 4 3 1 1/3 = .33M 6 5 1 1/5 = .20N 10 7 3 3/7 = .43O 8 6 2 2/6 = .33P 5 4 1 1/4 = .25

This is super simplified!

Problems..

• You have 4 million and can’t borrow.

• Project A has a NPV of 1 million, but costs 1 million.

• Project B has a NPV of 3 million, but costs 4 million.

Profitability Index of A>B. However if one does A, they can’t do B.