Chapters 6 – Valuing Stocks

Slide 1 Stock Valuation

Book Value • Equity = Assets less Liabilities

Liquidation • Sale value of assets less payment of outstanding liabilities • May represent amount greater or less than book value of equity

Going Concern (A firm likely to continue in business)

• Extraordinary earning power of assets (ROA/ROE) - Book value represents only cost less financing plus past undistributed earnings - Liquidation could ignore the synergy from the collective use of all assets • Intangible Assets - Book value only records the additional price paid over the net tangible value of the asset - Liquidation could approximate market in the case of a patent • Value of Future Investments - Book value records past earnings only - Liquidation reflects future earnings from the assets separated by their sale

Slide 2 Stock Valuation

1. The General Case

In general, the price today of a share of stock, P0, is the present value of all of its future dividends, D1, D2, D3, . . .

Stock Value = D1/(1+r)1 + D2/(1+r)2 + D3/(1+r)3 + … forever where r is the required return.

2. Zero Growth: D1 = D2 = D3 = … Stock Value = D/r [ Perpetuity]

3. Growing Dividend: D2 = D1 x (1+g); D3 = D1 x (1+g)2

Stock Value = D1/(r-g) [Growing Perpetuity]

Slide 3 Stock Valuation - Differential Growth

• Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter. • To value a Differential Growth Stock, we need to: - Estimate future dividends in the foreseeable future. - Estimate the future stock price when the stock becomes a Constant Growth Stock. - Compute the total present value of the estimated future dividends and future stock price at the appropriate discount rate.

Slide 4 Stock Valuation - Differential Growth

Slide 5 Growth Versus Income

Growth • Junior company that has not fully developed its technology and has not yet captured a consistent stream of profit • More difficult to rely on debt to fund its investments and operations since this requires consistent payment of fixed interest expense • Equity is more logically plowed back into the business as ROE probably higher than investor’s return from reinvested dividends
Income
• Mature company with established and consistent stream of profits • Capable of funding a portion of its investments and operations from debt • Majority of cash needs for operation since fixed assets needs focused primarly of replacement only • Likely that investors can earn a higher return outside the company than could be earned if funds were retained
Conclusions
Growth • Low debt/equity ratio • Low dividend payout/high plowback • Dividend Discount Model: - little or no payment of current dividend - value in capital gains (premium future dividends) Income • Higher debt/equity ratio • High dividend payout/low plowback • Dividend Discount Model - value in income from dividends

Slide 6 Efficient Market Hypothesis

Weak Form of EMH:

• Market focuses on past price information only • Minimum level of efficiency one could expect from the market • Technical analysis supports connection of past prices to future, but a more complex relationship than time series

Semi Strong Form of EMH:

• Markets reflect all past pricing inform. + all publicly available information • Implies that the market has acquired one additional step of sophistication so that the ability to outperform is decreased from the weak form of EMH

Strong Form of EMH:

• Markets reflect all past pricing information + all publicly available information + all other relevant (whether public or not) • Virtually impossible to outperform market • Insider information is revealed by studying and imitating actions of those with insider information [pic]

+

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Efficient market reaction

Efficient market reaction: The price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases.

Delayed reaction: The price partially adjusts to the new information; 8 days elapse before the price completely reflects the new information

Overreaction: The price overadjusts to the new information; it “overshoots” the new price and subsequently corrects.

Slide 8

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Slide 7 Reaction of Stock Price to New Information in

Efficient and Inefficient Markets

220
180
140
100

Overreaction and correction Delayed reaction

+7

+6

+4

+2

0

–2

–4

–6

–8

Days relative to announcement day

Price ($)

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