CHAPTER 7

Stocks, Stock Valuation, and

Stock Market Equilibrium

1
Topics in Chapter
Features of common stock
Valuing common stock
Preferred stock
Stock market equilibrium
Efficient markets hypothesis
Implications of market efficiency
for financial decisions
2
 EQUITIES
Why? Business Application
Key to understanding For Investor:
valuations Determine value of
What is investment asset/business/compan
worth today? y
Value of:
Enterprise For Firm:
Entity Determine cost of
Company/Firm attracting investors &
raising equity capital
Selling ownership stake
to raise $

3
 Equities

Valuing companies that dont pay

dividends
Alternative valuation methods

4
 The Big Picture:
The Intrinsic Value of Common
Stock
Free cash flow
(FCF)

Dividends
Dividends
(D
(Dt))
t

D1 D2 D
ValueStock = + + +
(1 + rs )1 (1 + rs)2 ... (1 + rs)

Market interest rates Firms debt/equity mix

Cost
Costof
of
Market risk aversion equity Firms business risk
equity(r
(rs))
s
Common Stock: Owners,
Directors, and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Preemptive right.
Since managers are agents of
shareholders, their goal should be:
Maximize stock price.
6
When is a stock sale an
initial public offering (IPO)?
A firm goes public through an
IPO when the stock is first offered
to the public.
Prior to an IPO, shares are typically
owned by the firms managers, key
employees, and, in many
situations, venture capital
providers
7
What is a seasoned equity
offering (SEO)?
A seasoned equity offering occurs
when a company with public stock
issues additional shares.
After an IPO or SEO, the stock
trades in the secondary market,
such as the NYSE or Nasdaq.

8
Classified Stock
Classified stock has special
provisions.
Could classify existing stock as
founders shares, with voting rights
but dividend restrictions.
New shares might be called Class
A shares, with voting restrictions
but full dividend rights.
9
Tracking Stock
The dividends of tracking stock are tied
to a particular division, rather than the
company as a whole.
Investors can separately value the divisions.
Its easier to compensate division managers
with the tracking stock.
But tracking stock usually has no voting
rights, and the financial disclosure for
the division is not as regulated as for
the company.
10
 Bonds vs. Stocks

Issuer Cost Cost

(company) int. paid out (dividends pd out
(i) Cap gains

Bond value or price Stock value or price

today today
Discount the CFs by (i) Discount the CFs by (R)
(reqrd return) (reqrd return)
Cfs = Int pmts; principal Cfs = Dividends
PV, PMT,FV,N,i

11
 Bonds vs. Stocks

Bonds Value
Stocks Value
or Price Today or Price Today

= sum of the PVs of the = sum of the PVs of

future CFs; the future CFs;
That is discount CFs Discount CFs (divids) by
(int Pmts (PMT) & (R) (reqrd return) to get
Principal (FV)) by i% over Po (PV)
some period (N) to get
PV
PMT,FV,N,I known; solve
for PV
12
Different Approaches for
Valuing Common Stock
Dividend growth model
Constant growth stocks
Nonconstant growth stocks
Free cash flow method
Using the multiples of comparable
firms

13
 Why Invest in Stock?

For Growth in Value

From Dividends & Cap Gains

Generating Total Return = R

Stock Price = Growth = g

Dividend Return or Yield = Annual divid / Price of stock= D 1 /
Po

Return on Stock = Return on Divid + Growth (cap gains)
R = D1 /Po + g (but want price
today)
Rg = D1 /Po
Finally: Po = D1 / R - g 14
 Constant Growth Approach
to Equity Valuations
Po = D1 / R g
Discounting the Divids (or CFs) by R-g (return
adjusted for constant growth)
Constant growth model: works when g is constant
rate (%) & R > g
If g > R, then have supernormal or non-constant growth
If so, then look at PVs of CFs generated the stock to determine
its price today
If we need R (reqd return) to use as disct factor, we
can use SML relationship from CAPM
SML: Ri = rRF + (RM - rRF)bi .
15
 Stock Value = PV of
Dividends

^ D1 D2 D3 D
P0 = + + +
(1 + rs)1 (1 + rs)2 (1 + rs)3 + (1 + rs)

What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.
16
For a constant growth
stock:

D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
If g is constant and less than rs, then:
^ D0(1 + g) D1
P0 = =
rs g rs g
17
 Dividend Growth and PV of
Dividends: P0 = (PV of Dt)

$
Dt = D0(1 + g)t

0.25 Dt
PV of Dt
(1 + r)t
=

If g > r, P0 = !
Years (t)
18
 What happens if g > rs?

^ D0(1 + g)1 D0(1 + g)2 D0(1 +

P0 = + ++
rs)
(1 + rs)1 (1 + rs)2 (1 + rs)
(1 + ^
If g > rs, g)t > 1, P0 =
then (1 + rs)t and

So g must be less than rs for the

constant growth model to be
19
applicable!!
Required rate of return: beta =
1.2, rRF = 7%, and RPM = 5%.

Use the SML to calculate rs:

rs = rRF + (RPM)bFirm
= 7% + (5%)(1.2)
= 13%.

20
 Projected Dividends
D0 = $2 and constant g = 6%

D1 = D0(1 + g) = $2(1.06) = $2.12

D2 = D1(1 + g) = $2.12(1.06) =
$2.2472
D3 = D2(1 + g) = $2.2472(1.06) =
$2.3820
21
 Expected Dividends and
PVs (rs = 13%, D0 = $2, g
= 6%)
0 g = 6% 1 2 3

2.12 2.2472 2.3820

1.8761 13%
1.7599
1.6508

22
Intrinsic Stock Value:
D0 = $2.00, rs = 13%, g =
6%
Constant growth
model:
^ D0(1 + g) D1
P0 = =
rs g rs g

$2.12 $2.12
= = = $30.29.
0.13 0.06 0.07
23
Expected value one year
from now:
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on.

^ D2 $2.2472
P1 = = = $32.10
rs g 0.07

24
 Return = Dividend Yield +
Capital Gains Yield

D1
Dividend yield =
P0

^
P1 P 0
CG Yield = = New - Old
P0 Old

25
 Expected Dividend Yield
and Capital Gains Yield
(Year 1)
D1 $2.12
Dividend yield = = =
7.0%. P0 $30.2
9
^
P1 P 0 $32.10
CG Yield = =
P0 $30.29
$30.2
= 6.0%. 9
26
 Total Year 1 Return
Total return = Div yield + Cap gains
yield.
Total return = 7% + 6% = 13%.
Total return = 13% = rs.
For constant growth stock:
Capital gains yield = 6% = g.

27
Rearrange model to rate of
return form:

^ D1 ^ D1
P0 = to rs = + g.
rs g P0

Then,^rs = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.

28
If g = 0, the dividend
stream is a perpetuity.

0 r = 13% 1 2 3
s

2.00 2.00 2.00

^ PMT $2.0
P0 = = = $15.38.
r 00.13
29
 Supernormal Growth Stock
I
Supernormal growth of 30% for first three
years, then 6% constant g thereafter. Just
paid dividend of $2.00 /sh, & required
return for investments of this risk is 13%.
Whats the price today (Po)?
Can no longer use constant growth model.
However, growth becomes constant after
3 years.

30
 Nonconstant growth
followed by constant
growth
0 1 2 3 4
rs = ? %
g=?% g=?% g=?% g=?%
Do=?(1+g) D1=? D2=? D3=?
D4=?
?
?
?
^ D4
? P3 =
R-g
?? = ^
P0
31
 Nonconstant growth
followed by constant
growth (D0 = $2):
0 1 2 3 4
rs =
13%
g = 30% g = 30% g = 30% g = 6%
Do=2.00(1+g) D1=2.60 D2=3.38 D3=4.39
D4=4.66
2.30
2.65
3.05
^ $4.66
46.11 P3 = = $66.54
0.13
^ 0.06
54.11 = P0
32
 Using Cfs
After Determining: Future Divs & gk terminal
value (price)
CFo = Do CFo = 0
CF1 = D1 CF1 = 2.60
CF2 = D2 CF2 = 3.38
CF3 = D3 + P3 CF3 = 4.39 + 66.54
i=R% =70.93
Po = NPV = ? i = 13 %
Po = NPV = ? = $54.11

33
Expected Dividend Yield
and Capital Gains Yield (t
= 0)
Today (@ t
=0): D1 $2.60
Dividend yield = = =
4.81% P 0 $54.1
1

CG Yield = 13.0% 4.81% =

8.19%.
34
Expected Divd & Cap Gains
Yield (after t = 3)
During nonconstant growth, dividend yield
and capital gains yield are not constant.
If current growth is greater than gk, current
capital gains yield is greater than g.
After year 3 (t = 3), gk = constant = 6%, so
CGY = 6%.
Because rs = 13%, after yr 3 div yld =
13% 6% = 7%.

35
 Is stock price based on
short-term growth?
The current stock price is $54.11.
The PV of dividends beyond Year 3 is:
=terminal
^
or horizon value in year 3 (P3)
discounted to present by reqd Return (R=13%)
= $46.11
% of stock price due to long-
term dividends is:
$46.11
= 85.2%.
$54.1
1 36
Intrinsic Stock Value vs.
Quarterly Earnings
If most of a stocks value is due to
long-term cash flows, why do so
many managers focus on
quarterly earnings?

37
Intrinsic Stock Value vs.
Quarterly Earnings
Sometimes changes in quarterly
earnings are a signal of future
changes in cash flows. This
affects current stock price (Po).
Sometimes managers have
bonuses tied to quarterly
earnings.

38
Supernormal Growth Stock
II
Supernormal growth of 30% for
Year 0 to Year 1, 25% for Year 1 to
Year 2, 15% for Year 2 to Year 3,
and then long-run constant g = 6%.
Can no longer use constant growth
model.
However, growth becomes
constant after 3 years.

39
 Nonconstant growth
followed by constant
growth (D0 = $2):
0 1 2 3 4
rs =
13%
g = 30% g = 25% g = 15% g = 6%
2.6000 3.2500 3.7375 3.9618

2.3009
2.5452
2.5903
^ $3.9618
39.2246 P3 = = $56.5971
0.13
^ 0.06
46.6610 = P0
40
Expected Dividend Yield
and Capital Gains Yield (t
= 0)
At t = 0:
D1 $2.60
Dividend yield = = =
5.6% P 0 $46.6
6

CG Yield = 13.0% 5.6% = 7.4%.

(More)
41
Expected Dividend Yield and
Capital Gains Yield (after t =
3)
During nonconstant growth, dividend yield
and capital gains yield are not constant.
If current growth is greater than g, current
capital gains yield is greater than g.
After t = 3, g = constant = 6%, so the
capital gains yield = 6%.
Because rs = 13%, after t = 3 dividend
yield = 13% 6% = 7%.

42
 Is the stock price based on
short-term growth?
The current stock price is $46.66.
The PV of dividends beyond Year 3 is:
^
P3 / (1+rs)3 = $39.22

The percentage of stock price

due to long-term dividends
is: $39.22
= 84.1%.
$46.6
6 43
 Suppose g = 0 for t = 1 to 3,
and then g is a constant 6%.

0 1 2 3 4
rs = 13%
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861 ^ = 2.12 =
20.9895 P3 30.2857
25.7118 0.07
44
Dividend Yield and Capital
Gains Yield (t = 0)
Dividend Yield = D1/P0
Dividend Yield = $2.00/$25.72
Dividend Yield = 7.8%

CGY = 13.0% 7.8% = 5.2%.

45
Dividend Yield and Capital
Gains Yield (after t = 3)
Now have constant growth, so:
Capital gains yield = g = 6%
Dividend yield = rs g
Dividend yield = 13% 6% = 7%

46
Suppose negative growth:
If g = -6%, would anyone buy
stock? If so, at what price?

Firm still has earnings and still pays

dividends, so^ P > 0:
0

^ D0(1 + D1
P0 = =
g)r g rs g
s

$2.00(1-.0 $1.8
= = =
6) (-0.06)80.19
0.13
$9.89.
47
 Annual Dividend and
Capital Gains Yields

Capital gains yield = g = -6.0%.

Dividend yield = 13.0% (-6.0%)

= 19.0%.

Both yields are constant over time,

with the high dividend yield (19%)
offsetting the negative capital gains
yield. 48
 What if company pays no
dividends?
Discount Free Cash Flows (CFs which
can be returned to investors) instead of
dividends
Where FCF = NOPAT Net Capital
Spending

49
Uses of Free Cash Flows
Pay interest on debt
Repay principal on debt
Pay dividends to equityholders
Repurchase stock from
equityholders
Buy mrktbl securities or other non-
operating assets
50
 Equity Valuation using
FCFs
A young firm just recorded a $<1.0> million
FCF. It expects the FCF 1-yr from today to be
$<5.0>million. In yrs 2 & 3, they are expected
to become positive at $10 and $20 million. In
the 4th yr, a constant growth in FCFs is
expected to kick-in at 6%. The required return
for investments of this risk is 10%. The firm
has $40 million in debt, and 10 million shares
outstanding. Whats the price per share
today?
51
 Equity Valuation using
FCFs
0 1 2 3 4
rs =
10% g=6%
FCFo=<1> FCF1=<5> FCF2=10 FCF3=20 *(1+g)
FCF4=?
?
?
?
^ FCF4
? P3 =
R-g
?? = ^
P0
52
 Using Cfs for FCFs Equity Valuation
After Determining: Future Divs & gk terminal
value (price)
CFo = FCFo CFo = 0
CF1 = FCF1 CF1 = <5>
CF2 = FCF2 CF2 = 10
CF3 = FCF3 + P3 CF3 = 20 + 530
i=R% =550.00
Po = NPV =?= value of i = 10 %
firm Po = NPV = ? =
$416.94

53
Equity Valuation using
FCFs
Value of firm = $416.94
- Debt 40.00
=Value of equity $376.94 / 10 mil
shrs

=price per share of $37.69

54
Market Cap
(Capitalization)
= Market Value of firms equity
= (price/sh)*(#shs outstanding)

55
 Enterprise Value

= Value of firms underlying business,

unencumbered by Debt, and separate
from cash & marketable securities
Enterprise Value= MV of equity + Debt - cash
Think:: Enterprise Value = Net cost of
acquiring a firms equity, taking its cash,
and paying off debt. In essence, its
equivalent to owning the unlevered (debt-
free) business.
56
Market Cap & Enterprise
Value I
H.J. Heinz has a share price of
$46.78, its shares outstanding
were 319.2 million. It has a
market-to-book ratio of 8.00, a
book debt-equity ratio of 2.62, and
cash of $352 million.
Whats Heinzs market cap?
Whats its enterprise value?
57
 Using Stock Price Multiples
to Estimate Stock Price
Analysts often use the P/E multiple
(the price per share divided by the
earnings per share).
Example:
Estimate the average P/E ratio of
comparable firms. This is the P/E multiple.
Multiply this average P/E ratio by the
expected earnings of the company to
estimate its stock price.

58
 Multiples Approach I
Auto Industry Pinto Car Co
Industry P/E = 5 Pinto EPS = $1.50/sh

Industry Pinto
5/1 = P/E = ?/$1.50
So Pinto relative price
per share (P) = $7.50

If Pinto trading on NYSE

= $9.00
=overvalued (sell)
If $4.00 =undervalued (buy)
59
 Using Entity Multiples
The entity value (V) is:
the market value of equity (# shares of stock
multiplied by the price per share)
plus the value of debt.
Pick a measure, such as EBITDA, Sales,
Customers, Eyeballs, etc.
Calculate the average entity ratio for a
sample of comparable firms. For example,
V/EBITDA
V/Customers

60
 Using Entity Multiples
(Continued)
Find the entity value of the firm in question.
For example,
Multiply the firms sales by the V/Sales multiple.
Multiply the firms # of customers by the
V/Customers ratio
The result is the firms total value.
Subtract the firms debt to get the total
value of its equity.
Divide by the number of shares to calculate
the price per share.

61
 Problems w/ Market Multiple
Methods
It is often hard to find comparable firms.
What are relevant multiples?
New Co.s often lack earnings
Average ratio for sample of comparable firms
often has a wide range.
I.E, ave P/E ratio might be 20, but range from 10 to
50. How do you know whether firm should be
compared to low, average, or high performers?
Differences between firms in comparables pool
i.e: growth rates, risk, cost of capital
62
What if an equitys
dividend is fixed? No g !
^ D1
P0 =
rs g

So, Po = D1 /rs
And return = D1 / Po

Its a perpetuity

63
Preferred Stock
Hybrid security.
Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends
can be paid on common stock.
However, unlike bonds, preferred stock
dividends can be omitted without fear
of pushing firm into bankruptcy.

64
Expected return =?,
given Preferred stock share trading at
$50 & pays annual dividend = $5

Vps = $50 = $5
^
rps

rps = $5 = 0.10 =
^
$50 10.0%

65
 A determinant of Growth

Relationship between ROE, Retention Rate,

EPS growth, and Dividends
A firm has an ROE of 25% & Retention Rate
of 80%. If the most recent EPS was $3.00,
whats the expected dividend at the end of
the year?

66
Why are stock prices
volatile?
^ D1
P0 =
rs g

rs = rRF + (RPM)bi could change.

Inflation expectations
Risk aversion
Company risk
g could change.
67
 Consider the following
situation.

D1 = $2, rs = 10%, and g = 5%:

P0 = D1/(rs g) = $2/(0.10 0.05) =

$40.

What happens if rs or g changes?

68
Stock Prices vs. Changes
in rs and g
g
rs 4% 5% 6%
9% $40.00 $50.00 $66.67
10% $33.33 $40.00 $50.00
11% $28.57 $33.33 $40.00

69
Are volatile stock prices
consistent with rational
pricing?
Small changes in expected g and r s
cause large changes in stock prices.
As new information arrives, investors
continually update their estimates of
g and rs.
If stock prices arent volatile, then
this means there isnt a good flow of
information.

70
 What is market
equilibrium?
In equilibrium, the intrinisic price must
equal the actual price.
If the actual price is lower than the
fundamental value, then the stock is a
bargain. Buy orders will exceed sell
orders, the actual price will be bid up. The
opposite occurs if the actual price is
higher than the fundamental value.

(More)
71
 Intrinsic Values and Market Stock
Prices
Managerial Actions, the Economic
Environment, and the Political Climate

True Expected True Perceived Perceived

Expected
Future Cash Risk
Flows Future Cash Flows Risk

Stocks Stocks
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
 In equilibrium, expected
returns must equal required
returns:
^
rs = D1/P0 + g = rs = rRF + (rM rRF)b.

73
Expected Return vs. Required
Return

16% > 15% reqrd to invest

:: undervalued

Stock priced too low so

buy b/c bargain
As more people buy it,
Price & return
:: then reach
equilibrium level of
return
10% <
:: overvalued -SELL

74
 How is equilibrium
established?

^
^ D1
If rs = + g > rs, then P0 is too
P0
low.

If the price is lower than the

fundamental value, then the stock is a
bargain. Buy orders will exceed sell
^
orders, the price will be bid up until:
D1/P0 + g = rs = rs. 75
 Whats the Efficient Market
Hypothesis (EMH)?
Securities are normally in equilibrium
and are fairly priced. One cannot
beat the market except through good
luck or inside information.
EMH does not assume all investors are
rational.
EMH assumes that stock market prices
track intrinsic values fairly closely.
(More)
76
 EMH (continued)
If stock prices deviate from intrinsic
values, investors will quickly take
advantage of mispricing.
Prices will be driven to new
equilibrium level based on new
information.
It is possible to have irrational
investors in a rational market.
77
Weak-form EMH
Cant profit by looking at past
trends. A recent decline is no
reason to think stocks will go up
(or down) in the future. Evidence
supports weak-form EMH, but
technical analysis is still used.

78
Semistrong-form EMH
All publicly available information is
reflected in stock prices, so it
doesnt pay to pore over annual
reports looking for undervalued
stocks. Largely true.

79
Strong-form EMH
All information, even inside
information, is embedded in
stock prices. Not trueinsiders
can gain by trading on the basis
of insider information, but thats
illegal.

80
Markets are generally
efficient because:
100,000 or so trained analysts
MBAs, CFAs, and PhDswork for
firms like Fidelity, Morgan, and
Prudential.
These analysts have similar access
to data and megabucks to invest.
Thus, news is reflected in P0 almost
instantaneously.
81
Market Efficiency
For most stocks, for most of the
time, it is generally safe to
assume that the market is
reasonably efficient.
However, periodically major shifts
can and do occur, causing most
stocks to move strongly up or
down.
82
Implications of Market
Efficiency for Financial
Decisions
Many investors have given up
trying to beat the market. This
helps explain the growing
popularity of index funds, which try
to match overall market returns by
buying a basket of stocks that
make up a particular index.

83
 Implications of Market
Efficiency for Financial
Decisions
Important implications for stock issues,
repurchases, and tender offers.
If the market prices stocks fairly,
managerial decisions based on over- and
undervaluation might not make sense.
Managers have better information but
they cannot use for their own advantage
and cannot deliberately defraud
investors.
84
 Rational Behavior vs. Animal
Spirits, Herding, and Anchoring
Bias
Stock market bubbles of 2000 and 2008
suggest that something other than pure
rationality in investing is alive and well.
People anchor too closely on recent
events when predicting future events.
When market is performing better than
average, they tend to think it will continue to
perform better than average.
Other investors emulate them, following
like a herd of sheep.
85
 Conclusions
Markets are rational to a large extent, but at
time they are also subject to irrational behavior.
One must do careful, rational analyses using the
tools and techniques covered in the book.
Recognize that actual prices can differ from
intrinsic values, sometimes by large amounts
and for long periods.
Good news! Differences between actual prices
and intrinsic values provide wonderful
opportunities for those able to capitalize on
them.

86