title: module 5 - valuing stocks speaker: rebecca stull ...c123).pdf · 7-3 valuing stocks this...

Title: Module 5 - Valuing Stocks Speaker: Rebecca Stull Created by: Gene Lai

online.wsu.edu

MODULE 5

VALUING STOCKS

Revised by Gene Lai

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Valuing Stocks

This module introduces valuations techniques

for equity (stocks).

The Dividend Discount Model provides an

excellent measure of a stock’s intrinsic value.

Outline

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

No more free lunches on Wall Street

Behavioral Finance and Dot.coms

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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

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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. 7-6


Book Value - Net worth of the firm according to

the balance sheet.

Liquidation Value - Net proceeds that would be

realized by selling the firm’s assets and

paying off its creditors.

Market Value Balance Sheet - Financial

statement that uses market value of assets and

liabilities. 7-7

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Primary vs. Secondary Markets:

Example Shannon sells 100 shares of Google stock from her portfolio for $500

per share to help pay for her son Domenic’s college education.

How much does Google receive from the sale of its shares?

Does this transaction occur on the primary or secondary

market?

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Basic Terminology: Example You are considering investing in a firm whose shares are currently

selling for $50 per share with 1,000,000 shares outstanding. Expected

dividends are $2/share and earnings are $6/share.

What is the firm’s Market Cap? P/E Ratio? Dividend Yield?

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Bid Price/Ask Price

Bid Price: The prices at which investors are willing to buy

shares.

Ask Price: The prices at which current shareholders are

willing to sell their shares.

Example:

If an investor wishes to purchase 100 shares of Apple with a bid

price of $253.40 and an ask price of $253.48, how much could

the investor expect to pay for the shares?

Answer: $253.48


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).

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Expected Return

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Expected Return: Example What should be the price of a stock in one year if it sells for $40

today, has an expected dividend per share of $3, and an expected

return of 12%?


The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

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Required Rates of Return

Estimating Expected Required Rates of Return:

Example: What rate of return should an investor expect on a share

of stock with a $2 expected dividend and 8% growth rate that sells

today for $60?

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Price and Intrinsic Value

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Price and Intrinsic Value

What is the intrinsic value of a share of stock if

expected dividends are $2/share and the expected price

in 1 year is $35/share? Assume a discount rate of 10%.


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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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?

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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?

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The Dividend Discount Model

Consider three cases:

1. No growth

2. Constant Growth

3. Nonconstant Growth


Case 1. No growth

If we forecast no growth, and plan to hold out stock

indefinitely, we will then value the stock as a

PERPETUITY.

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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.

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Example (cont.)

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The Dividend Discount Model Case 2: Constant Growth


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.

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Example- continued

If the same stock is selling for $100 in the stock

market, what might the market be assuming about

the growth in dividends? Answer

The market is

assuming the dividend

will grow at 9% per

year, indefinitely.

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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.

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Growth can be derived from applying the

return on equity to the percentage of earnings

plowed back into operations.

g = return on equity X plowback ratio

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Sustainable Growth Rate

If a firm earns a constant return on its equity and plows back a

constant proportion of earnings, then the growth rate g is:

Example: Suppose a firm that pays out 35% of earnings as dividends and

expects its return on equity to be 10%. What is the expected growth rate?

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Valuing Growth Stocks

Present Value of Growth Opportunities (PVGO) –

Where:

EPS = Earnings per share

PVGO = Present Value of Growth Opportunities


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?

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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 plowback 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?

No Growth With Growth

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Example - continued

If the company did not plowback some earnings,

the stock price would remain at $41.67. With the

plowback, the price rose to $75.00.

The difference between these two numbers (75.00-

41.67=33.33) is called the Present Value of

Growth Opportunities (PVGO).

It should be noted that PVGO is positive because

ROE (20%) is greater than Expected Return

=RRR (12%).

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Case 3: non-constant growth

We have discussed no growth case and

constant growth case. Next, we will talk

about non-constant growth case.

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Steps to calculate stock price in case 3: non-

constant growth

Step 1: Estimate cash flows (Dividends and

future price). Future price can be estimated

because of normal growth assumption.

If non-constant growth is 3 year then we need to

find price at time 3.

Step 2: Discount future cash flows

Step 3: Sum all PV of cash flows

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Case 3: non-constant growth

Note that to find P3, you need Div 4.

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Example

r =RRR= 9%, number of year (super growth) = 3,

Super Growth rate= 20%. After 3 year, the firm

grow at a constant rate, normal growth rate = 4%

DIV0 = 1.92 P0 = ?

DIV1 = 1.92(1.2) = 2.304

DIV2 = 1.92(1.2)2 = 2.765

DIV3 = 1.92(1.2)3 = 3.318

DIV4 = 1.92(1.2)3 * 1.04 = 3.45

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Example (cont.)

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There are No Free Lunch on Wall Street

It is not easy to beat the market or earn

abnormal return

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Performance of Money Manager

Average Annual Return on 1493 Mutual Funds and the

Market Index

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Random Walk Theory

The movement of stock prices from day to

day DO NOT reflect any pattern.

Statistically speaking, the movement of stock

prices is random (skewed positive over the long term).

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Random Walk (Weekly Evidence)

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No Free Lunches

Technical Analysts

Forecast stock prices based on the watching the

fluctuations in historical prices (thus “wiggle

watchers”)

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Random Walk Theory

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

Heads

Heads

Tails

Tails

Tails

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Random Walk Theory

S&P 500 Five Year Trend?

or

5 yrs of the Coin Toss Game?

80

130

180

Month

Level

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Random Walk Theory

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Random Walk Theory

The second one is S&P 500

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WHAT IS EFFICIENT MARKET

Definition of “efficient”

Information is widely and cheaply

available to investors and that all

relevant and ascertainable information is

already reflected in security prices.

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Efficient Market Theory

There are three types of efficient market

hypotheses:

Weak form

Semi-strong form

Strong form

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Weak Form Efficiency Hypothesis

Market prices reflect all historical information

Technical analysis is useless

You cannot earn abnormal profit using historical information when the capital market is weak form efficient

Empirical studies show the capital market is weak form efficient

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Technical Analysis

Technical analysts try to achieve superior returns by

spotting and exploiting patterns in stock prices.

Problem with this approach:

Prices follow a “random walk”


Last

Month

This

Month

Next

Month

1,300

1,200

1,100

Market

Index

Cycles

disappear

once

identified

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Semi-Strong Form Efficiency Hypothesis

Fundamental analysis is useless

Empirical studies show that mutual funds do not necessarily outperform stock market indexes

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Another Tool

Fundamental Analysts

Research the value of stocks using NPV and other

measurements of cash flow

Fundamental analysts are paid to uncover stocks

for which price does not equal intrinsic value.

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Strong Form Efficiency Hypothesis

Market prices reflect all information, both public and private (including insider information)

You cannot earn abnormal profit using private information when the capital market is strong form efficient

Empirical studies show the capital market is NOT strong form efficient

You can earn abnormal return if you have private information

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A Theory to fit the Facts

Competition among investment analysts will

lead to a stock market in which prices at all

time reflect true value.

True value

An equilibrium price which incorporates

all the information available to investors

at that point in time.

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A Theory to fit the Facts

If prices always reflect all relevant information, then they will change only when new information arrives. However new information cannot be predicted. Therefore, prices cannot be predicted.

If there were predictable cycles in stock prices, what will happen when investors perceive this bonanza?

It will self-destruct.

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Last

Month

This

Month

Next

Month

1,300

1,200

1,100

Market

Index

Cycles

disappear

once

identified

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Is Stock Market Efficient?

Most of the financial economists believe

financial markets are weak and semi-strong form

efficient most of the time.

But the markets are not efficient all the time.

We provide some puzzles and anomalies next.

Some Puzzles and Anomalies

There are many puzzles and anomalies

E.g., IPO

E.g., The earnings announcement puzzle

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IPO

Example:

Weight Watchers International when public

on Nov. 14. Offering price was $24. Closing

price = $28.50. 19% for a day.

That means 380% per year for 200 trading days.

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IPO

The New-Issue Puzzle: On average those

lucky enough to buy stock receive an

immediate capital gain.

However, the annual return is 33% less than a

portfolio of similar-size stocks if you hold the

stock for 5 years.

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Do Investors Respond Slowly to New

Information

The Earnings Announcement Puzzle: The top

10 % of the stocks of firms with the best

earnings news outperform those with the

worst news by more than 4% over the two

months following the announcement.

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Bubbles and Market Efficiency

There were some bubbles in recent history

Japanese stock and real estate bubble between

1985 and 1989

The dot-com bubble in U. S. between 1995 and

2000

Real bubbles and financial crisis in U. S. (2007 –

2009)

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Behavioral Finance

Some believe that deviations in prices from

intrinsic value can be explained by behavioral

psychology, in two broad areas:

Attitudes toward risk

Beliefs about probabilities

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Behavioral Finance

Attitudes toward risk--People generally dislike

incurring losses, yet they are more apt to take

bigger risks if they are experiencing a period of

substantial gains. Winners are more prepared to

run a risk of a stock market dip.

Losers tend to be more concerned not to risk a

further loss and therefore they become more risk-

averse.

Example: The winners cause the 2000 bubble.

The losers bust the bubble.

Stock Market Anomalies and Behavioral

Finance

Beliefs about probabilities: Investors tend to

project recent experience into the future and

to forget the lessons learned from the more

distant past. In addition, most of us believe

we are better-than-average drivers. In that

sense, most of us believe we can pick the

right stock and beat the market. And we

ignore the intrinsic value of stocks. These

beliefs caused the bubbles too.

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title: module 5 - valuing stocks speaker: rebecca stull ...c123).pdf · 7-3 valuing stocks this...

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