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

online.wsu.edu MODULE 5 VALUING STOCKS

Revised by Gene Lai

7-2 Valuing Stocks

This module introduces valuations techniques for equity (stocks).

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

7-3 Outline

 Stocks and the  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

7-4 Stocks & Stock Market

Primary Market - Place where the sale of new stock first occurs. Initial (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

7-5 Stocks & Stock Market

Common Stock - Ownership shares in a publicly held corporation. - market in which already issued securities are traded by . Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by . 7-6 Stocks & Stock Market

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 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?

7-8 Basic Terminology: Example You are considering investing in a firm whose shares are currently selling for $50 per share with 1,000,000 . Expected are $2/share and earnings are $6/share.

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

7-9 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 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

7-10 Valuing Common Stocks

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).

7-11 Expected Return

7-12 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%?

7-13 Valuing Common Stocks

The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

7-14 Required Rates of Return Estimating Expected Required Rates of Return:

Example: What should an investor expect on a share of stock with a $2 expected dividend and 8% growth rate that sells today for $60?

7-15 Price and Intrinsic Value

7-16 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%.

7-17 Valuing Common Stocks

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.

7-18 Valuing Common Stocks

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?

7-19 Valuing Common Stocks

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?

7-20 The Dividend Discount Model

Consider three cases:

1. No growth

2. Constant Growth

3. Nonconstant Growth

7-21 Valuing Common Stocks

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.

7-22 Valuing Common Stocks 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.

7-23 Example (cont.)

7-24 The Dividend Discount Model  Case 2: Constant Growth

7-25 Valuing Common Stocks

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.

7-26 Valuing Common Stocks

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.

7-27 Valuing Common Stocks

 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.

7-28 Valuing Common Stocks

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

7-29 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?

7-30 Valuing Growth Stocks

Present Value of Growth Opportunities (PVGO) –

Where: EPS = Earnings per share PVGO = Present Value of Growth Opportunities

7-31 Valuing Common Stocks

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?

7-32 Valuing Common Stocks

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

7-33 Valuing Common Stocks

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%).

7-34 Case 3: non-constant growth

 We have discussed no growth case and constant growth case. Next, we will talk about non-constant growth case.

7-35 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

7-36 Case 3: non-constant growth

Note that to find P3, you need Div 4.

7-37 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 2  DIV2 = 1.92(1.2) = 2.765 3  DIV3 = 1.92(1.2) = 3.318 3  DIV4 = 1.92(1.2) * 1.04 = 3.45

7-38 Example (cont.)

7-39 There are No Free Lunch on Wall Street

 It is not easy to beat the market or earn abnormal return

7-40 Performance of Money Manager

Average Annual Return on 1493 Mutual Funds and the Market Index

7-41 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 term).

7-42 Random Walk (Weekly Evidence)

7-43 No Free Lunches

Technical Analysts Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

7-44 Random Walk Theory

Coin Toss Game Heads $106.09 Heads $103.00 $100.43 Tails $100.00

Heads $100.43 $97.50 Tails $95.06 Tails

7-45 Random Walk Theory

S&P 500 Five Year Trend? or 5 yrs of the Coin Toss Game?

180

Level 130

80 Month

7-46 Random Walk Theory

7-47 Random Walk Theory

 The second one is S&P 500

7-48 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.

7-49 Efficient Market Theory

 There are three types of efficient market hypotheses:

 Weak form

 Semi-strong form

 Strong form

7-50 Efficient Market Theory  Weak Form Efficiency Hypothesis  Market prices reflect all historical information  is useless  You cannot earn abnormal profit using historical information when the is weak form efficient  Empirical studies show the capital market is weak form efficient

7-51 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”

7-52 Technical analysis is useless

Market Index 1,300

1,200

1,100

Cycles disappear once Last This Next identified Month Month Month

7-53 Efficient Market Theory

 Semi-Strong Form Efficiency Hypothesis  is useless  Empirical studies show that mutual funds do not necessarily outperform stock market indexes

7-54 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.

7-55 Efficient Market Theory

 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 7-56 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.

7-57 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.

7-58 Technical analysis is useless

Market Index 1,300

1,200

1,100

Cycles disappear once Last This Next identified Month Month Month

7-59 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.

7-60 Some Puzzles and Anomalies

 There are many puzzles and anomalies

 E.g., IPO

 E.g., The earnings announcement puzzle

7-61 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.

7-62 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.

7-63 7-64 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.

7-65 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)

7-66 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

7-67 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. 7-68

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.

7-69