McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Valuing Stocks

This chapters introduces valuations techniques for equity (stocks).

The Dividend Discount Model provides an excellent measure of a stock’s intrinsic value.

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The Stock MarketThe two principal stock exchanges in the US are the New York

Stock Exchange & NASDAQ

Primary Market vs. Secondary Market

Initial Public Offering

Primary Offering

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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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Bid Price/Ask PriceBid 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

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TerminologyInvestors use a number of methods to determine the

quality of a company’s shares.Market Cap

P/E Ratio

Dividend Yield

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Basic Terminology: ExampleYou 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?Market Capitalization $50 1,000,000 $50,000,000

$50P/E Ratio 8.33

$6$2

Dividend Yield .04 4%$50

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Measures of ValueThree ways to value a firm:

Book Value

– Net worth of the firm according to the balance sheet.

Liquidation Value

– Net proceeds that could be realized by selling the firm’s assets and paying off its creditors.

Market Value

– The value of the firm as determined by investors who would be willing to purchase the company.

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Going-Concern ValueThe difference between a company’s actual value and its

book or liquidation value is called its going-concern value.

Refers to three factors:1. Extra earning power

2. Intangible assets

3. Value of future investments

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Price and Intrinsic Value

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Price and Intrinsic ValueWhat 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%.

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Expected Return

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Expected Return: ExampleWhat 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%?

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The Dividend Discount Model

HHH

r

PDiv

r

Div

r

DivP

)1(...

)1()1( 22

11

0

where :

Time Horizon

Dividend in the i period.

Required Rate of Return

thi

H

Div

r

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The Dividend Discount Model

Consider three cases:

1.No growth

2.Constant Growth

3.Nonconstant Growth

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The Dividend Discount Model

Case 1: No Growth

What should the price of a share of stock be if dividends are projected at $5/share, the discount rate is 10%, and growth is 0%?

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The Dividend Discount Model Case 2: Constant Growth

Example: What should the price of a share of stock be if the firm will pay a $4 dividend in 1 year that is expected to grow at a constant rate of 5%? Assume a discount rate of 10%.

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The Dividend Discount Model

Case 3: Nonconstant Growth

HH

HH

r

P

r

Div

r

Div

r

DivP

)1()1(...

)1()1( 22

11

0

PV of dividends from year 1 to horizon

PV of stock price at horizon

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Nonconstant Growth Dividend Discount Model

Example:

A firm is expected to pay $2/share in dividends next year. Those dividends are expected to grow by 8% for the next three years and 6% thereafter. If the discount rate is 10%, what is the current price of this security?

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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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Sustainable Growth RateIf 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?

.10 (1 .35) .065 6.5%g

Return on Equity Plowback Rate =

:

g ROE b

earnings dividendswhere b

earnings

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Valuing Growth Stocks

Present Value of Growth Opportunities (PVGO) –

Where:EPS = Earnings per sharePVGO = Present Value of Growth Opportunities

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Valuing Growth Stocks: Example

Suppose a stock is selling today for $55/share and there are 10,000,000 shares outstanding. If earnings are projected to be $20,000,000, how much value are investors assigning to growth per share? Assume a discount rate of 10%.

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Methods of AnalysisInvestors have many strategies for trying to

beat the market consistently.

Technical Analysis

Fundamental Analysis

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Technical AnalysisTechnical analysts try to achieve superior returns by

spotting and exploiting patterns in stock prices.

Problem with this approach: Prices follow a “random walk”

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Technical Analysis

Are successive security prices related?.

Returns on NYCI on two successive weeks, 1970-2010

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Fundamental AnalysisFundamental analysts are paid to uncover stocks

for which price does not equal intrinsic value.

What happens in a market with many talented and competitive fundamental analysts?

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Efficient Market HypothesesIs the US stock market a highly efficient market?

Degrees of efficiency:• Weak-form Efficiency

• Semistrong-form Efficiency

• Strong-form Efficiency

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Market AnomaliesThere are a number of market anomalies that seem to puzzle efficient market

theorists, including:

The Earnings Announcement Puzzle

The New-Issue Puzzle

Bubbles

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Behavioral FinanceSome believe that deviations in prices from intrinsic value can be explained by behavioral psychology, in two broad

areas:

1. 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.

2. Beliefs about probabilities--Individuals commonly look back to what has happened in recent periods and assume this is representative of future outcomes.