Chapter 8 - The Valuation and Characteristics of Stock.

Chapter 8 - The Valuation and Characteristics of Stock

Common Stock

Corporations are owned by common stockholders

Most large companies are “widely held’ – Ownership spread among many investors.

Investors don’t think of their role as owners

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The Return on an Investment in Common Stock

Income in a stock investment comes from:– dividends– gain or loss on the difference between the purchase and sale

price

If you buy a stock for price P0, hold it for one year, receive a dividend

of D1, then sell it for price P1, you return, k, would be:

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1 1 0

0

1 01

0 0

dividend yield capital gains yield

D + P -Pk =

P

or

P -PDk = +

P P

A capital gain (loss) occurs if you sell the stock for a price greater (lower) than

you paid for it.


Solve the previous equation for P0, the stock’s price today:

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0 1 1 0

0 0 1 1

0 1 1

1 10

kP

P kP

1 P

P1

D P P

D P

k D P

D P

k


The return on a stock investment is the interest rate that equates the present value of the investment’s expected future cash flows to the amount invested today, the price, P0

Figure 8-1 Cash Flow Time Line for Stock Valuation

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The Nature of Cash Flows from Stock Ownership

– For stockholders:Expected dividends and future selling price are not known with any precision

Similarity to bond cash flows is superficial – both involve a stream of small payments followed by a larger payment

When selling, investor receives money from another investor

– For bondholders:Interest payments are guaranteed, constant

Maturity value is fixed

At maturity, the investor receives face value from the issuing company.

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Comparison of Cash Flows from Stocks and Bonds

The Basis of Value

The basis for stock value is the present value of expected cash inflows even though dividends and stock prices are difficult to forecast

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0 1 k,1 2 k,2 n k,n n k,nP = D PVF D PVF D PVF P PVF

Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows

Joe Simmons is interested in the stock of Teltex Corp. He feels it is going to have two very good years because of a government contract, but may not do well after that.

Joe thinks the stock will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now.

People who have invested in stocks like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex?

Concept Connection Example 8-1 Valuation of Stock Based on Projected Cash Flows

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Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and $3.50 plus $75 at the end of two years.

0 12%,1 12%,2 12%,2P = $2 PVF $3.50 PVF $75 PVF

$2[0.8929] $3.50[0.7972] $75.00[0.7972]

$64.37

The Intrinsic (Calculated) Value and Market Price

A stock’s intrinsic value is based on assumptions about future cash flows made from fundamental analysis of the firm and its industry

Different investors with different cash flow estimates will have different intrinsic values

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Growth Models of Common Stock Valuation

Based on predicted growth rates since forecasting exact future prices and dividends is difficult

More likely to forecast a growth rate of earnings rather than cash flows

12

Developing Growth-Based Models

A stock’s value today is the sum of the present values of the dividends received while the investor holds it and the price for which it is eventually sold

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1 2 n n

0 2

D D D PP =

1 1 1 1n nk k k k

An Infinite Stream of Dividends Many investors buy a stock, hold for awhile, then sell, as

represented in the above equation

Developing Growth-Based Models

A person who buys stock at time n will hold it until period m and then sell it– Their valuation will look like this:

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n + 1 m m

n m - n m - n

D D PP = +…+ +

1 + k 1 + k 1 + k

Repeating this process until infinity results in:

i

0 ii=1

DP

1 + k

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The Constant Growth Model

If dividends are assumed to be growing at a constant rate forever and the last dividend paid is, D0, then the model is:

1i

i

i0

0)k1(

)g1(DP

This represents a series of fractions as follows

2 3

0 0 00 2 3

D 1 g D 1 g D 1 gP =

1 k 1 k 1 k

If k>g, the fractions get smaller (approach zero) as exponents get larger

Constant Normal Growth The Gordon Model

Constant growth model can be simplified to

16

10

DP

gk

k must be greater than

g.

The Gordon Model is a simple expression for forecasting the price of a stock that’s expected to grow at a constant, normal rate

Concept Connection Example 8-3 Constant Normal Growth - The Gordon Model

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Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on stocks similar to Atlas is about 11%. What should a share of Atlas Motors sell for today?

1

0

DP

k - g

$2.25 (1.06)

.11 - .06$47.70

The Zero Growth Rate Case —A Constant Dividend

If a stock is expected to pay a constant, non-growing dividend, each dollar dividend is the same

Gordon model simplifies to:

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0

DP

k

A zero growth stock is a perpetuity to the investor

The Expected Return

Recast Gordon model to focus on the return (k) implied by the constant growth assumption

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1

0

D

Pk g

The expected return reflects investors’ knowledge of a

company

If we know D0 (most recent dividend paid) and P0 (current actual stock price), investors’ expectations are input via the growth rate assumption

Two Stage Growth

At times, a firm’s future growth may not be expected to be constant– A new product may lead to temporary high growth

The two-stage growth model values a stock that is expected to grow at an unusual rate for a limited time– Use the Gordon model to value the constant portion– Find the present value of the non-constant growth

periods

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Figure 8-2 Two Stage Growth Model

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Concept Connection Example 8-5 Valuation Based on Two Stage Growth

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Zylon Corporation’s stock is selling for $48 a share.

We’ve heard a rumor that the firm will make an exciting new product announcement next week.

We’ve concluded that this new product will support an overall company growth rate of 20% for about two years.


We feel growth will slow rapidly and level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company.

The rate of return on stocks like Zylon is approximately 10%.

Is Zylon a good buy at $48?


D1 = D0 (1+g1) = $2.00(1.20) = $2.40

D2 = D1 (1+g1) = $2.40(1.20) = $2.88

D3 = D2(1+g2) = $2.88(1.06) = $3.05


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We’ll develop a schedule of expected dividend payments:

Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2, so:

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2

D $3.05P $76.25

k - g .10 - .06

6%$3.053

20%$2.882

20%$2.401

GrowthExpected DividendYear


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Then we take the present value of D1, D2 and P2:

0 1 k, 1 2 k, 2 2 k, 2

10, 1 10, 2 10, 2

P D PVF + D PVF + P PVF

$2.40 PVF + $2.88 PVF + $76.25 PVF

$2.40 0.9091 + $2.88 0.8264 + $76.25 0.8264

$67.57

Compare $67.57 to the listed price of $48.00. If we are correct in our assumptions, Zylon should be

worth about $20 more than it is selling for in the market, so we should buy Zylon’s stock.

Practical Limitations of Pricing Models

Stock valuation models give estimated results since the inputs are approximations of reality

Actual growth rate can be VERY different from predicted growth rates

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Practical Limitations of Pricing Models

Comparison to Bond Valuation

Bond valuation is precise because the inputs are precise.

Future cash flows are guaranteed in amount and time, unless firm defaults.

Stocks That Don’t Pay Dividends

Have value because of expectation that they will someday pay them.

Some firms don’t pay dividends even if they are profitable– Firms are growing and

using profits to finance the growth

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Valuing New Stocks Investment Banking and The Initial Public Offering (IPO)

IPOs are the first public sales of a new company stocks

IPO Process

Investment Banking

Syndication

Registration

Underwriting

Best Efforts

Promoting and Pricing the IPO

Quiet Period

Book Building and the Road Show

Ends before the IPO date

Prices After the IPO

The Investment Bank in the Middle

Underpricing and IPO Pops

A little Big Pop History

POP Strategies

Market Stabilization

Insights – Practical Finance

Facebook’s IPO

Most anticipated IPO in history

NASDAQ trading issues

Fourth largest IPO in history

Some Institutional Characteristics of Common Stock

Corporate Organization and Control

– Controlled by Board of Directors elected by stockholders

– Board appoints top management who appoint middle/lower management

– Board consists of top managers and outside directors (may include major stockholders)

– In widely held corporations, top management in “control”

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Some Institutional Characteristics of Common Stock

Preemptive Rights– Allows stockholders to maintain a

proportionate share of ownership – If firm issues new shares, existing

shareholders can purchase pro rata share of new issue

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Voting Rights and Issues

Each share of common stock has one vote – Vote for directors and other issues at the

annual stockholders’ meeting– Vote usually cast by proxy

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Majority and Cumulative Voting

Majority Voting

gives the larger group control of the company

Cumulative Voting

gives minority interest a chance at some representation on the board

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Shares With Different Voting Rights Different classes of stock can be issued different rights Some stock may be issued with limited or no voting rights

Stockholders’ Claim on Income And Assets

Stockholders have a residual claim on income and assets

What is not paid out as dividends is retained for reinvestment in the business (retained earnings)

Common stockholders are last in line, they bear more risk than other investors

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Preferred Stock

A hybrid security with characteristics of common stock and bonds– Pays a constant dividend forever– Specifies the initial selling price and the

dividend– No provision for the return of capital to the

investor

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Valuation of Preferred Stock

Since securities are worth the present value of their future cash flows, preferred stock is worth the present value of the indefinite stream of dividends.

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p

p

kD

P

Concept Connection Example 8-6 Pricing Preferred Stock

41

Roman Industries’ $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Roman’s preferred sell for today?

Just substitute the new market interest rate into the preferred stock valuation model to determine today’s price:

6766096

0 .$.$

P

Characteristics of Preferred Stock

Cumulative Feature - can’t pay common dividends unless cumulative preferred dividends are current

Never returns principal

Stockholders cannot force bankruptcy

Receives preferential treatment over common stock in bankruptcy

No voting rights

Dividend payments not tax deductible to the firm

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Securities Analysis

The art and science of selecting investments

Fundamental analysis looks at a company’s business to forecast value

Technical analysis bases value on the pattern of past prices and volume

The Efficient Market Hypothesis (EMH) - financial markets are efficient since new information is instantly disseminated

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Options and Warrants

Options

Gives the holder the temporary right to buy or sell an asset at a fixed price

Speculate on price changes without holding the asset

Warrants

Similar but less common

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Options and warrants make it possible to invest in stocks without holding shares

Stock Options

Stock options speculate on stock price movements

Trade in financial markets

Call option — option to buy

Put option — option to sell

Options are Derivative Securities– Derive value from prices of underlying

securities– Provide leverage – amplifying returns

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Call Option

Basic Call Option– Gives owner (the holder) the right to buy

stock at a fixed price (the exercise or strike price) for a specified time period

– Once expired, it can’t be exercised – Option price < price of the underlying stock

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Figure 8-3 Basic Call Option Concepts

Call Options

The more volatile the stock’s price, the more attractive the option– Stock’s price more likely to exceed the

strike price before the option expires

The longer the time until expiration the more attractive the option– The stock’s price is more likely to exceed

the strike price before the option expires

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The Call Option Writer

The option writer originates the contract

The original writer must stand ready to deliver on the contract regardless of how many times the option is sold

Call writer hopes stock price will remain stable or not rise

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Intrinsic Value

Intrinsic value of a call is the difference between the underlying stock’s current price and the option’s strike price

If out-of-the-money, intrinsic value is zero

Option always sells for intrinsic value or above– Time premium - difference between option’s

intrinsic value and price

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Figure 8-4 The Value of a Call Option

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Options and Leverage

Financial leverage – magnifies return on investment

Options offer leverage due to the lower price at which the option can be purchased when compared to the price of the underlying stock

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Options that Expire

Options are worthless at expiration – Risky because they expire after a short time

If the price of an out-of-the-money option does not exceed the strike price prior to expiration, the option expires and is worthless– Results in a 100% loss

The time premium approaches zero as the expiration date approaches

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Trading in Options

Options can be bought and sold at any time prior to expiration– Chicago Board Options Exchange (CBOE)

Price volatility in the options market– As the underlying stock’s price changes, the

option’s price changes by a greater relative movement due to the option’s lower price

Options are rarely exercised before expiration– If the price of a call option is not expected to

increase, the option is sold, not exercised

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Writing Options

People write options for the premium income, hoping that the option will never be exercised

Option writers give up what option buyers make

Covered option — writer owns underlying stock

Naked option — writer does not own the underlying stock

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Concept Connection Example 8-7 Stock Options

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The following information refers to a three-month call option on the stock of Oxbow, Inc.

Price of the underlying stock: $30Strike price of the three-month call: $25Market price of the option: $8

a. What is the intrinsic value of the option? The intrinsic value represents by how much the option is in-the-money. Since the stock price is $30 and the call option’s strike price is $25, the option is in-the-money by $5, which is the intrinsic value.


b. What is the option’s time premium at this price?

The time premium represents the difference between the market price of the option and the intrinsic value, or $8 - $5 = $3.

c. Is the call in or out of the money?

The call option is in the money because it has a positive intrinsic value

d. If an investor writes and sells a covered call option, acquiring the covering stock now, how much has he invested?

The premium ($8) that the writer receives for the option will offset some of the purchase price of the stock ($30), therefore the investor has invested $30 - $8 = $22.


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e. What is the most the buyer of the call can lose?The buyer can lose, at most, 100% of his investment which is the purchase price of the option of $8.

f. What is the most the writer of a naked call option on this stock can lose?In theory since the stock price can rise to any price the writer can lose an infinite amount. However, a prudent writer would limit his losses by purchasing the stock once it started to rise in value.


Just before the option’s expiration Oxbow is selling for $32.

g. What is the profit or loss from buying the call?

The buyer would exercise the option paying $25 for the stock and simultaneously selling the stock for $32, resulting in a gain of $7. However, this gain would be offset by the $8 premium paid for the option, resulting in an overall loss of $1.


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h. What is the profit or loss from writing the call naked?A naked writer would have to buy the stock for $32 and sell it to the option owner for $25, resulting in a loss of $7. However, this loss would be offset by the premium received on the writing of the option of $8, resulting in an overall gain of $1.

i. What is the profit or loss from writing the call covered if the covering stock was acquired at the time the call was written?The call writer bought the stock for $30 and sold it for $25, resulting in a loss of $5, but the loss is offset by the $8 premium received for writing the option. The overall gain is $3.

Put Options

Option to sell stock at a specified price by a specified date

Put buyer profits if underlying stock declines

Intrinsic value – “in-the-money” – difference between the option’s strike price

and the current stock price (when positive),

Option is out-of-the-money if the strike price is above the current stock price

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Figure 8-5 Basic Put Option Concepts

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Figure 8-6 The Value of a Put Option

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Option Pricing Models

Option pricing model is more difficult than pricing models for stocks and bonds

Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model– Determines option’s price based on

Price of underlying stockStrike price of optionTime remaining until expiration of optionVolatility of underlying stock’s market priceRisk-free interest rate

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Warrants

Options – Trade between

investors, not between the companies that issue the underlying stocks

– Secondary market instruments

Warrants – Issued by underlying

company – When exercised – new

stock is issued and company receives the exercise price

– Primary market instruments while options are secondary market instruments

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Warrants

Similar to calls with a longer expiration period (several years vs. months)

Issued as a “sweetener” (especially for risky bonds)

Can generally be detached from another issue and sold separately

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Employee Stock Options

More like warrants than traded options– Expire after several years– Strike price set far out of the money– May receive options instead of salary increases

Wanted if future expectations are good

Companies offering options may pay lower salaries

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Employee Stock Options

Executive Stock Option Problem

Senior executives may receive most of the stock options

Provide an incentive for executives to misstate financial statements and inflate stock prices

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Chapter 8 - The Valuation and Characteristics of Stock.

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Transcript of Chapter 8 - The Valuation and Characteristics of Stock.