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Source: http://www.doksinet Chapter 7 The Valuation and Characteristics of Stocks COMMON STOCK OWNERSHIP Stockholder Rights: Dividend Asset-ownership (Little role as "owner" in large public companies Stock is just an investment) Voting Preemptive right- Allow stockholders to maintain their proportionate ownership Common-stock classes Nonvoting stock Voting stock Voting Rights Majority Voting--(Statutory Voting) One share = One Vote In this case, often have no minority viewpoint representation on the Board of Directors If own 100 shares have 100 votes for each issue voted upon. Cumulative Voting Cumulative voting ensures some minority group representation on the board. Minority stockholders can cast all votes for a single seat. - - Each share of stock represents as many votes as there are directors to be elected. If you have 7 directors to be elected (7 issues) and you own 100 shares then you have 700 votes which you can cast. Can cast all votes for one director (on one

issue). Stock splits if management feels stock should sell at lower price to attract more purchasers it can effect a stock split seems that optimum price rage is $15-$60 accounting treatment: par value is adjusted accordingly ( ie. 2-1 split: par value is reduced by one half and the # of shares doubled) Reverse Stock Split used to bring low-priced shares up to more desirable level Stock Dividends dividend to stockholders that consists of additional shares of stock instead of cash Stock-Repurchases company repurchase own stock (known as treasury stock) Advantages: (1) no fixed-dividend obligation (2) decreased debt ratio Disadvantages: Source: http://www.doksinet (1) (2) high-cost of financing dilution of original owners claim RETURN ON AN INVESTMENT IN STOCK One year holding period: Stock Valuation Ke= D1 + P 1 - P o Po Po Po = D1 + P1 1+ k where Ke: Market Capitalization Rate D 1 : Expected dividend for t=1 P 1 : Expected price for t=1 P o : Current price The return on any

stock investment is the rate that makes the present value of future cash flows equal to the price paid today Common Stock (1) Cash flows: dividends capital gains K = P − P0 D1 + 1 Po P0 Dividend Yield (2) Capital Gain Growth E t+1 = E t + [ Et Et Retained Earnings Et * R] Source: http://www.doksinet Retained Earnings Earnings Return = +[ Earnings * ] next year this year on R.E this year E t+1 = E t + [ Retained *R] Earnings 1 + g = 1 + [Retention rate * R] g = (Retention rate)* (Return on earnings) Sources to find expected growth rates: Value Line Investment Survey Institutional Brokers Estimate System Zacks Earning Estimate CASH FLOWS FROM COMMON STOCK OWNERSHIP Analogous to bonds A regular series followed by a return of invested funds however Far less precise and regular Not contractually guaranteed 0 1 2 3 Years n-1 n D1 D2 D3 Dn-1 Dn Pn THE BASIS OF VALUE Make some assumption about the behavior of future dividends and the eventual selling price. Then

take the present value of future cash flows P0 = D1[PVFk,1] + D2[PVFk,2] + . + Dn[PVFk,n] + Pn[PVFk,n] Source: http://www.doksinet Example: Joe Simmons is interested in the stock of Teltex Corp. He feels it will pay dividends of $2 and $3.50 in the next two years, after which its price will be $75 Similar stocks return 12%. What should Joe be willing to pay for Teltex? Solution: P0 = D1[PVFk,1] + D2[PVFk,2] + P2[PVFk,2] = $2.00[PVF12,1] + $350[PVF12,2] + $7500[PVF12,2] = $2.00[8929] + $350[7972] + $7500[7972] = $64.37 Buy if the price is below about $64 Fundamental Analysis The Intrinsic (Calculated) Value and Market Price Joes research led to a forecast of future dividends and prices which led to a value of about $64. If other investors dont agree their intrinsic values will be different. Market price is a consensus of everyones intrinsic values. If Joe is right, he can make money. GROWTH BASED MODELS OF STOCK VALUATION We generally dont have the detailed information to

forecast exact dividends and prices. However, we can usually forecast a growth rate. Develop a model based on today and an assumed growth into the future. Need to change focus: Thinking from a Finite Number of Dividends and a Price, to an Infinite Stream of Dividends P0 = D1[PVFk,1] + D2[PVFk,2] + . + Dn[PVFk,n] + Pn[PVFk,n] or Po = D1 + D 2 + .+ D n + Pn 2 n (1+ K e ) (1+ K e ) (1+ K e ) (1+ K e )n Source: http://www.doksinet Imagine the buyer in period n as having a model in mind for Pn stretching farther into the future to period m and ending with Pm Pn = D n +1 + . + Dm + Pm m (1 + K e ) (1 + K e ) (1 + K e )m Replace Pn with that model pushing the selling price farther into the future. Keep doing this until sale is infinitely distant and its PV = 0 Result is value based on only the PV of an infinite stream of dividends ∞ Dt Po = ∑ (1+ K e )t t +1 A Market Based Argument The only thing a company can return to equity investors is all of its dividends. The investing

community as a whole has nothing else on which to base value. Working With Growth Rates Growth rates work just like interest rates. If g = 6% $100 grows at rate g: $100 x .06 = $6, $100(1+g) = $100 x 1.06 = $106 Growing dividends beginning with the last one, D0: D1 = D0 + gD0 = D0 (1+g) D2 = D1 (1+g) D2 = D0 (1+g)2 GROWTH MODEL THE CONSTANT In general: Di = i inf D ( 1 + g ) P = ∑ i 0 i D0 0(1 +i =g) 1 (1 + k ) An infinite series of fractions P0 = Multiply by (1+g) repeatedly for successive values dividend D0 (1 + g ) D0 (1 + g ) 2 ofDa0 (growing 1 + g)3 (1 + k ) + (1 + k ) 2 + (1 + k ) 3 + . infinity   (1 + g ) (1 + g ) 2 (1 + g ) 3 + . inf  + + P0 = D0  2 3   (1 + k ) (1 + k ) (1 + k ) If k is larger than g (normal growth), the fractions in the brackets get smaller as the exponents get larger and the expression is finite TM 7-5 Slide 1 of 2 Source: http://www.doksinet The Constant (Normal) Growth Model The Gordon Model ν Assume a constant growth

in dividends – Dividends expected to grow at a constant rate, g, over time Po = D1 Ke - g D1 = Do (1 + g) - g: growth rate - k e : required return - Keee >> gg –D1 is the expected dividend at end of the first period –D1 =D0 (1+g) ν Implications of constant growth – Stock prices grow at the same rate as the dividends – Stock total returns grow at the required rate of return » Growth rate in price plus growth rate in dividends equals k, the required rate of return – A lower required return or a higher expected growth in dividends raises prices Example 7-3: Atlas Motors will grow at 6% indefinitely. It recently paid a dividend of $2.25 a share Similar stocks return about 11% What should Atlas sell for? Solution: D0 = $2.25, k = 11, g = 06 Po = 2.25(106) .11 − 06 The Zero Growth Case - A Constant Dividend A perpetuity P0 = D0 K Source: http://www.doksinet THE EXPECTED RETURN Solve the Gordon model for k D1 K = −g P0 An estimate of the return at price P0

assuming the growth rate is g Compare with one year return Ke= D1 + P 1 - P o Po Po g = capital gains yield TWO STAGE GROWTH We can sometimes forecast a temporary "super normal" growth rate followed by a long term normal rate. Eg, firm grows at super normal rate g1 for two years then grows indefinitely at normal rate g2 0 g1 1 2 3 4 D0 D1 D2 D3 D4 g2 . . P2 = P0 D3 k − g2 PVs Figure 7-2 Two Stage Growth Model Use the Gordon model at the beginning of the infinite period of constant normal growth D3 P2 = k − g2 TM 7-7 Source: http://www.doksinet Example 7-5 Zylon stock is selling for $48. A new product will support a growth rate of 20% for two years, after which growth will slow to 6%. The annual dividend of $2.00 will grow with the company Similar stocks return 10%. Is Zylon a good buy at $48? D1 = D 0 ( 1 + g1 ) = $2.00( 120 ) = $240 Solution: D 2 = D1 ( 1 + g1 ) = $2.40( 120 ) = $288 D 3 = D 2 ( 1 + g 2 ) = $2.88( 106 ) = $305 g1=20% 1 0

g2=6% 2 . 3 . D0 = $2.00 D1 = $2.40 D2 = $2.88 D3 = $3.05 P2 = $76.25 TM 7-8 Slide 1 of 2 Use the Gordon model at the point in time where the growth rate changes and constant growth begins, year 2 in this case. P2 = D3 $3.05 = = $76.25 k − g 2 .10 − 06 Add present values of everything a buyer at time zero gets: D1, D2, and P2. P0 = D1[ PVFk ,1 ] + D 2 [ PVFk , 2 ] + P2 [ PVFk , 2 ] P0 = $2.40[ PVF10 ,1 ] + $288[ PVF10 , 2 ] + $7625[ PVF10 , 2 ] P0 = $2.40( 9091) + $288( 8264) + $7625( 8264) P0 = $67.57 Compare $67.57 to the market price of $4800 If assumptions are correct weve found a bargain! TM 7-8 Slide 2 of 2 Source: http://www.doksinet TWO STAGE GROWTH ν Multiple growth rates: two or more expected growth rates in dividends – Ultimately, growth rate must equal that of the economy as a whole – Assume growth at a rapid rate for n periods followed by steady growth ν Multiple growth rates – First present value covers the period of super-normal (or

sub-normal) growth – Second present value covers the period of stable growth » Expected price uses constant-growth model as of the end of super- (sub-) normal period » Value at n must be discounted to time period zero Two Period Growth Model: m t 1 Do (1+ g 1 ) = ∑ + ( D m+1 ) Po t m (1+ K e ) (1+ K e ) K e - g 2 t=1 m = length of time firm grows at g 1 g2 < k g 1 : growth rate for period 1 g 2 : growth rate for period 2 k e : required return Source: http://www.doksinet Example: required rate of return =18% at 12% for first 6 years then at 6% Current dividend is 2.00 dividends are expected to grow Present value of First 6-Years Dividends: 6 ∑ [ D0 (1+ g 1 )t /(1+ k e )t ] t=1 Year t Dividend Dt P.V Interest Factor PVIF 18.t = 1/(1 + 18) t Present Value D t x PVIF 18.t 1 $ 2.240 .874 $ 1.897 2 2.509 .718 1.801 3 2.810 .609 1.711 4 3.147 .516 1.624 5 3.525 .437 1.540 6 3.948 .370 1.461 PV (First 6-Years Dividends Value of Stock at End of

Year 6: P 6 = D 7 /(K e - g 2 ) where g 2 = .06 D 7 = D 6 (1 + g 2 ) = 3.948(1 + 06) = $4185 P 6 = 4.185/(18 - 06) = $34875 Present Value of P 6 PV(P 6 ) = P 6 /(1 + k e )6 = $34.875/(1 + 18)6 = $34.875 x 370 = $12904 Value of Common Stock (P o ) P o = PV(First 6-Years Dividends) + PV(P 6 ) = 10.034 + 12904 = $2294 $10.034 Source: http://www.doksinet Two period growth model: 1+ g 1 N N -1 ) ] D (1+ g 1 ) (1 - g 2 ) 1+ k +[ 1 ] k - g1 (1+ k )N (k - g 2 ) D1 [1 - ( Po = N = No. of years growing at g 1 1.12 6 ) ] 2.24(112 )5 (106) 1.18 + .18 - 12 (.18 - 06)(118 )6 2.24[1 - ( P= 2.24[1 - 7312] 224(176)(106) + .06 (.12)(26996) 10.04 + 4.18 = .3239 10.04 + 1290 = $2294 Source: http://www.doksinet PRACTICAL LIMITATIONS OF PRICING MODELS Although problems solve to the penny, our answers are not that accurate. Results can never be any more accurate than the inputs. Projected growth rates and the interest rate can both be off by a lot. An additional problem arises because of the

difference in estimates in the denominator. Result blows up when the difference is small Bond valuation is exact because cash flows are contractually specified and very likely to occur. Market yields are also precise Stock valuation is comparatively fuzzy. Stocks That Dont Pay Dividends Have value because they are expected to pay them someday (Even if management says it wont) No Dividend Model CAPM = r j = r f + B j ( r m - r f ) CORPORATE ORGANIZATION AND CONTROL Corporations are controlled by Boards of Directors whose members are elected by stockholders. The board appoints senior management which runs the company. Major strategic decisions are considered by the board. A few really big issues, like mergers, are voted on by the stockholders. Boards generally are made up of top managers and outside directors. Board members may be major stockholders, but dont have to be. If stock ownership is widely distributed with no single party having a large share, top managers have control with

little accountability to stockholders. 7-12 Source: http://www.doksinet PREFERRED STOCK • Has a mix of the characteristics of common stock and bonds •Referred to as a hybrid Features Par price Preferred is generally issued at prices of $25, $50, and $100 Pays a constant dividend forever (norm) Adjustable rate-preferred stock Cumulative feature Preferred dividends can be passed but must be caught up before common dividends can be paid. Designed to enhance safety for investors Participation in “extra” dividends Maturity Call feature Convertible Voting rights-none Advantages of Preferred Stock Financing (1) Preferred dividend payments are potentially flexible. (2) Increase a firms degree of financial leverage. (3) 70% exclusion of dividend received from other companies from federal income. Disadvantages (1) High after-tax cost as compared with L-T debt. E.g: If the interest rate is 10%, preferred shares sold at $100 would offer a dividend of $10. Refer to as a $10 preferred

issue rather than as a 10% preferred issue. Think of the 10% rate as similar to the coupon rate on a bond, and the $100 initial selling price as similar to a bonds face value VALUATION OF PREFERRED STOCK Valued as a perpetuity Po = Dp Kp 7-13 Source: http://www.doksinet Example 7-6: Roman Industries $6 preferred originally sold for $50. The rate on similar issues is now 9%. For what should Romans preferred sell? Solution: P=6/.09 = 6667 Notice current price is above the original issue price because interest rates have fallen from ($6/$50=) 12% to 9%. • • • • • • • Comparing Preferred Stock with Common Stock and Bonds Payments to investors - Constant, like bonds Maturity and return of principal - No maturity, like stock Assurance of Payment - Cumulative feature - Between Priority in bankruptcy - Between Voting rights - None, like stock Tax deductibility of payments - Not deductible, like stock The Order of Risk - Between 7-14 Source: http://www.doksinet

SECURITIES ANALYSIS Valuation is a part of Securities Analysis Fundamental Analysis Discover as much as possible about a firm and its industry Use that knowledge to project future cash flows Calculate intrinsic value Compare with market price Invest if market price is below intrinsic value Technical Analysis Historical patterns of price and volume repeat over time Chart prices and volumes to predict changes Technicians are also called chartists The Efficient Market Hypothesis (EMH) Financial markets are efficient in that new information is disseminated very quickly and prices adjust immediately. Hence technical analysis is useless because all available information is already in the price of stocks. Fundamental analysis also wont help an investor consistently beat the market because an army of professional analysts will have figured everything out first. STOCK MARKET EFFICIENCY Weak-form: security prices reflect all market-related data from past. Semistrong: security prices reflect

all past information but also all public information. Strong: prices reflect all information including private or insider info. Tests Weak-form: look for non-random patterns in sec. prices Semistrong: Event studies benchmark to test for abnormal returns 7-15 Source: http://www.doksinet ^ CAPM: r j = r f + β(r m - r f ) abnormal return: ^ rj - rj = e ^ r j : actual r j : estimated e: is difference Question: is e significantly different from zero 7-16