Stock Valuation and Market Efficiency Chapter 7 Brealey-Myers-Marcus 6th Edition Business Finance 620 Topics Covered Comparing bonds and stocks Stocks and the stock market Expected return Common stock valuation Dividend Discount Model (DDM) Sustainable growth Sources of stock value Income stocks and growth stocks Present value of growth opportunities (PVGO) Market efficiency Comparing Bonds and Stocks Corporate bonds Fixed maturity Guaranteed periodic income (if coupon-paying) Guaranteed sale price at maturity Limited ability to control sale price before maturity Common stock Uncertain maturity “Going concern” implies no future maturity Uncertain periodic dividend (may be none) Uncertain future sale price Stocks and the Stock Market Quick Terminology Review Primary market Initial public offering Seasoned offering Secondary market Common stock and preferred stock Dividend yield Standards of equity value Book value (balance-sheet net worth) Market value (value as a “going concern”) Liquidation value (value from asset sell-off) Valuation of Common Stock Valuation by comparables Book values cannot be used because they are unreliable estimates of market value. Comparables even in the same industry can be difficult to find; comparables are never precise. Price and intrinsic value Investors receive dividends during the time they own shares and the stock’s price when they sell. The PV of ALL future cash flows from a stock is called the stock’s intrinsic value. Intrinsic value often is called fair market value. Intrinsic Value Illustration You purchase a stock today that you expect to sell one year from today for $55 a share. The stock pays a $3 dividend at year-end. If the discount rate is 8%, what is the stock’s intrinsic value? Following the definition of intrinsic value: Expected Rate of Return Expected return for the stock just discussed: Notice that if you pay the intrinsic value, your expected return is the discount rate. At the same sale price and discount rate, would you pay $60 a share today? $45 a share? Explain. Components of Expected Return Expected return has 2 component parts: the expected dividend yield the expected capital gain The expected dividend yield is 5.6% and the expected capital gain is 2.4%. Is dividend yield always greater than capital gain? Dividend Discount Model A stock’s share price (value) equals the PV of all expected future cash flows: where: P0 is the price (share value) today DIV is the periodic cash dividend (may vary) R is the investor’s required return (discount rate) H is the investment horizon (“holding period”) PH is the sale price at the end of the holding period Dividend Discount Model Application A firm expects to pay the following dividends at the end of each of the next 3 years: Year 1 = $3.00 Year 2 = $3.24 Year 3 = $3.50 At the end of 3 years, the stock is to be sold for $94.48. If investors require a 12% return, how much is the stock worth today? Do we always know the future sale price? Constant-Growth Dividend Model Gordon Growth Model Forecasted dividends grow at a constant rate. With this assumption, only the first dividend to be earned must be forecasted, not every dividend in the future. The stream of dividends continues forever, in effect, a growing perpetuity: How does this version differ from the basic DDM? Constant Growth Dividend Model Application Consider the following information: A firm just paid a dividend of $1.50 per share. Dividends are expected to grow at 5% per year. Investors require an annual return of 10%. How much is the stock worth today? What happens to the price if G = 0? Why is this price lower than the price with dividend growth? Sustainable Growth What Determines the Rate of Dividend Growth? If a firm earns a constant ROE and reinvests a constant proportion of earnings, then: With a constant ROE and a constant plowback ratio, sustainable growth sets an upper limit for the growth of dividends. Under these circumstances, a board cannot expect dividends to grow faster than the sustainable rate. Using the sustainable rate in the Gordon model results in a more conservative stock valuation. Sustainable Growth A Graphic Representation $1,000 Equity $200 Earnings $80 Dividends $120 Added to Retained Earnings ROE = 20% Payout = 40% Plowback = 60% By how much does equity grow during this cycle? What about earnings (EPS) and dividends (DPS) during the second cycle? Sustainable Growth Application KMT Corporation reported the following results for 2008: An earnings per share (EPS) of $5.00 A dividend payout ratio of 40% A ROE (return on invested funds) of 20%. What is the firm’s sustainable growth rate? Interpretation: If the firm retains 60 cents of every dollar of earnings and earns 20% ROE on these reinvested funds, the additional earnings generated by the reinvested funds will represent a 12% increase in earnings per share (EPS). Furthermore, given a constant payout ratio, dividends per share (DPS) also will increase by 12%. ROE x (1 – Payout Ratio) = 0.20 x (0.60) = 12% Income Stocks & Growth Stocks Income stocks Returns are driven by dividends Purchased by investors seeking current income Exhibit relatively high payout ratios Stock’s value reflects current operations Growth stocks Returns are driven largely by capital gains Purchased by investors more interested in future earnings than current income Exhibit relatively high plowback ratios Stock’s value reflects future growth opportunities Sources of Stock Value The stream of future dividends used to value a share of stock under the DDM actually can be divided into two component streams: Future dividends on future reinvested earnings Future dividends on assets currently in place Assets a firm owns today are responsible for part of the dividends paid in the future, when managers follow a plowback strategy. These reinvested earnings, which increase equity and, in turn, earnings, are responsible for the rest of the dividends paid in the future. Sources of Stock Value PVGO Application Consider a company with an expected EPS of $5.00, a payout ratio of 60%, a ROE of 20%, and a dividend growth rate of 8%. Investors require a 12% return. If we value this stock using the DDM model, then the stock is worth $75.00 per share today: Remember, this value incorporates future dividends from two sources – future returns on assets in place and future returns on future reinvested earnings. Sources of Stock Value PVGO Application Now, instead of paying 60% of earnings in the form of dividends, suppose we distribute 100% of EPS. How is the value of the stock affected? The price of the stock declines by $33.33 per share. Why the difference? With no reinvestment of earnings, there is no growth from future reinvested earnings. The only source of future dividends is assets (equity) currently in place, an amount fixed in value. Sources of Stock Value PVGO Application The difference between the value of the stock: with some (40%) of the earnings reinvested, and with none of the earnings reinvested, illustrates the potentially significant impact on share price of the reinvestment of future earnings. The $33.33 difference between the share price with 40% reinvested earnings ($75.00), and with nothing reinvested ($41.67), is called the: Present Value of Growth Opportunities (PVGO) PVGO represents the value added to a stock’s price as a result of future investments. Efficient Markets Types of Information and Degrees of Efficiency An efficient market is one in which securities prices reflect all available information. Intense competition to find misvalued securities Investors rush to take advantage of information. Weak Form Efficiency Prices reflect all historical information Semi-Strong Form Efficiency Prices reflect all publicly available information Strong Form Efficiency Prices reflect all information, public and private Prices of securities in well-organized markets tend to reflect all available information. Electronic communications networks (ECNs) Unexpected news can affect a stock’s price: Good news precipitates a positive price reaction. Bad news precipitates a negative price reaction. Random Walk Theory The daily movement of stock prices DOES NOT reflect any predictable pattern. Statistically, stock prices follow a “random walk.” Efficient Markets A Contemporary Perspective Google’s Random Walk Strategies to Beat the Market Technical Analysis Attempts to identify undervalued and overvalued securities by looking for patterns in price trends Exploiting profitable patterns quickly can provide superior returns (foundation of day-trading) Fundamental Analysis Attempts to identify undervalued and overvalued securities by evaluating fundamental information on firms and industries (notably, earnings, asset values and growth prospects) Involves application of different valuation tools