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Lecture 5 - Chapter 7


Prepared by Helen Prankie Humber College
? 2012 McGrawHill Ryerson Ltd. Chapter 7

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Stocks and the Stock Market Market Values, Book Values, and Liquidation Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks There are No Free Lunches on Wall Street or Bay Street Market Anomalies and Behavioural Finance

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -2

Some Definitions
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Common Stock: Ownership shares in a publicly held corporation
Primary Market: Place where the sale of new stock first occurs
Initial Public Offering (IPO): First offering of stock to the general public

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Seasoned Issue: Sale of new shares by a firm that has already been through an IPO
Secondary Market: Market in which already issued securities are traded by investors

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LO1

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -3

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P/E Ratio: Price per share divided by earnings per share Dividend: Periodic cash distribution from the firm to the shareholders
? Dividends represent that share of the firm?s profits which are distributed

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Retained earnings: Profits that are retained in the firm and reinvested in its operations

LO1

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -4

There are three methods used for valuing a company?s shares: 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

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -5

Going concern value means that a well managed, profitable firm is worth more than the sum of the value of its assets
ASSET 1 $3 million ASSET 2 $2 million ASSET 3 $6 million

Assets sold separately have liquidation value of $11 million

ASSET 1
$3 million

ASSET 2

ASSET 3

$2 million

$6 million

The same assets functioning as a firm have going concern value of $15 million

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -6

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The difference between a firm?s actual market value and its? liquidation or book value is attributable to its “going concern value.” Factors of “Going Concern Value”
? ? ? Extra earning power Intangible assets Value of future investments

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? 2012 McGrawHill Ryerson Ltd.

Chapter 7 - 7

Expected Return: The percentage yield that an investor forecasts from a specific investment over a set period of time

Expected Return ? r ?

Div ? P ? P
1 1

0

P

0

Div1 P 1 ? P 0 Expected Return ? r ? ? P0 P0
Dividend Yield Capital Gains Yield

LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -8

Example: Assume that Blue Sky Corp?s shares are selling for $75 now. They are expected to produce $3 dividends during the year and is to be sold at $81 at the end of the year. What is the expected return from Blue Sky?s shares?

Expected Return = D1 + P1 – P0 P0 = $3 + 81 – 75 $75 = 0.12 = 12%

LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -9

For the same Blue Sky problem, we can also report the expected return in this form:

Expected return = Dividend Yield + Capital Gain = D1 + P1 – P 0 P0 P0 = $3 + $81 - $75 $75 $75 = 4% + 8% = 12%
LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -10

The Dividend Discount Model: Share value equals the present value of all expected future dividends. Thus, if the discount rate is ?r?, we can write:

Div1 Div2 Div H ? PH P0 ? ? ? ... ? 1 2 H (1 ? r ) (1 ? r ) (1 ? r )

LO2, LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -11

Example of dividend discount model: XYZ Company is

expected 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?

PV ?

3.00

1 2 (1 ? 0.12) (1 ? 0.12)

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3.24

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3.50 ? 94.48

3 (1 ? 0.12)

PV ? $75.00
LO2, LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -12

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Zero Growth Case: If the dividend paid by the

corporation is not expected to change, then we treat the dividend as a perpetuity. The present value of all dividends, then, is

P ?
0

Div r

1

LO2, LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -13

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Constant Growth Case: If the dividend paid by the

stock is expected to grow at a constant rate, then the cash flows are treated like perpetual flows with a growth rate. In that case, the PV of the cash flow will be

Div1 P0 ? r?g

LO2, LO3

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -14

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An Example: Calculate the price of Blue Sky shares if:

Next year?s dividend (D1) will be $3, dividends will grow at 8% in perpetuity. The discount rate is 12%.

Price of stock today = = =

Div

1

r-g $3.00 0.12 – 0.08
$75.00

LO2, LO3
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -15

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Expected Rate of Return from the DDM: rearranging the constant growth DDM formula gives us:

r =

D1 + g P0
Growth Rate

Dividend Yield

=

$3 $75

+ .08

= .04 + .08
LO3

= 4%

+ 8% =

12%

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -16

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Non-Constant Growth Case: Many companies grow at rapid or irregular rates for several years before finally settling down
? Before the growth rate settles down, we have to calculate each dividends separately

? When the growth rate does settle down, we can find the future stock price using the constant growth formula
? At the end, we have to find the present values of all the dividends and the future price
LO2, LO3
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -17

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An Example of non-constant growth stock:
? A firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock?

LO2, LO3
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -18

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Compute the dividends until growth levels off
? D1 = 1(1.2) = $1.20 ? D2 = 1.20(1.15) = $1.38 ? D3 = 1.38(1.05) = $1.449

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Find the expected future price

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Find the present value of the expected future cash flows
? P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

? P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66

LO2, LO3
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -19

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The fraction of earnings retained by the firm is called the plowback ratio

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The fraction of earnings a company pays out in dividends is called the payout ratio
Calculating “g” (growth rate) ? The growth rate for a company can be computed by multiplying the return on equity by the plowback ratio:

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g = ROE x plowback ratio
LO4
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -20

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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%. Calculate the value of the stock before and after the plowback decision
D1 = $5.00 r = 12% Return on equity = 20%

We have:

LO4
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -21

Without the growth, the price is: P0 = DIV1/r = 5/0.12 = $41.67 With growth, the situation is:

g = ROE x plowback ratio = 0.20 x 0.40 = 0.08 = 8%
P0 = DIV1/(r – g) = 3/(0.12 – 0.08) = $75
LO4
? 2012 McGrawHill Ryerson Ltd. Chapter 7-22

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Thus, growth accounts for $33.33 [=$75-$41.67] of the $75 price. In other words, the Present Value of Growth Opportunities (PVGO) is $33.33. The Present Value of Growth Opportunities (PVGO): The net present value of a firm?s future investments. Sustainable Growth Rate: Steady rate at which a firm can grow: plowback ratio X return on equity.

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Price-Earning Ratio: Stock price/EPS

LO4
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -23

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Definitions
? Technical Analysis – Attempting to identify undervalued stocky by searching for patterns in past stock prices ? Random Walk – Security prices change randomly, with no predictable trends or patterns ? Fundamental Analysis – Attempting to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects

LO5
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -24

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Random Walk:

LO5
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -25

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Fundamental Analysis
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Analysts find stocks for which price does not equal intrinsic value Stock price reaction to news Insider information

LO5
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -26

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Efficient Market: A market where prices reflect all available information. No free lunches.
? Weak Form Efficiency: A market where prices rapidly reflect all information contained in the history of past prices and volumes ? Semi-Strong Form Efficiency: A market where prices rapidly reflect all publicly available information ? Strong Form Efficiency: A market where prices reflect all information that could be used to determine true value of assets

LO5
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -27

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Market Anomalies: There are always some puzzles or apparent exceptions of the efficient market theory Earning Announcement Puzzle: Studies found that stock prices apparently did not reflect all available information at the ends of the earnings announcement days New Issues Puzzle: Researchers found that early gains from buying IPOs often turn into losses
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -28

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Behavioural Finance: The dot-com bubble of the nineties led many to believe that investors are not 100% rational all the time. The behavioural psychology issues gained ground and led to the development of behavioural finance. ? Attitude Toward Risk: When making risky decisions, people are particularly loath to incur losses, even if those losses are small. ? Beliefs About Probabilities: Investors are often tempted to project recent success into the future, but forget about the losses from distant past. They tend to be overconfident.
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -29

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Stocks and the Stock Market Reading Stock Market Listings Difference between Market Values, Book Values, and Liquidation Values Valuing Common Stocks Price and intrinsic value of common stocks The Dividend Discount Model
? Dividend Discount Model - price of a stock is the present value of its future dividends. If dividends are expected to remain constant, the value of the stock is equal to:

P0 = Div1 / r

? 2012 McGrawHill Ryerson Ltd.

Chapter 7 -30

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Calculating the Dividend Discount Model under no-growth, constant growth and non-constant growth Estimating Expected Rates of Return Growth stocks and income stocks There are No Free Lunches on Wall Street or Bay Street
? ? ? ? Technical Analysis Random Walk Fundamental analysis Efficient market hypothesis

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Market Anomalies and Behavioural Finance
? 2012 McGrawHill Ryerson Ltd. Chapter 7 -31


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