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FINE 2000

CHAPTER 6 VALUING STOCKS 6.1 Stocks and the Stock Market  The owners of common stock of a firm are entitled to the firm’s residual cash flow (the remaining cash flow after employees and all other suppliers, lenders, and the government have been paid). They can also vote for the board of directors through one vote per share.  Firms issues shares of common stock to the public when they need to raise money. They engage an investment dealer that provides investment banking services to help them price and sell these shares  Sales of new stock of the firm occur in the primary market (market for the sale of new securities by corporations). > in an initial public offering (IPO), a company that has been privately owned sells stock to the public for the first time  Seasoned offerings: when established firms raise money by issuing more shares and these new shares are also primary market issues  Secondary market: market in which already-issued securities are traded among investors Stock Market Listings  Dividend yield: a stock’s cash dividend divided by its current price (like current yield on a bond as it also ignores capital gains/losses)  Price-earnings (PE) multiple: ratio of stock price to earnings per share  Preferred stock: stock that takes priority over common stock in regards to dividends 6.2 Book Values, Liquidation Values, and Market Values  Investors do not just buy and sell book value per share (because assets on a firm’s balance sheet are recorded at historical cost less and allowance for depreciation and don’t always represent current market value)  Stock prices don’t equal liquidation value per share either (net proceeds that would be realized by selling the firm’s assets and paying off its creditors)  The going concern value is the difference between a company’s accrual value and its book or liquidation value 1. Extra earning power: company may have the ability to earn more than an adequate rate of return on assets (value higher than book value) 2. Intangible Assets: many assets that accountants don’t put on the balance sheet (i.e. research and development, brand name etc..) 3. Value of future investments: investors believe the company will have the opportunity to make exceedingly profitable investments in the future, they will pay more for the stock today ** buy stock based on present and future earning value***  Market value balance sheet: financial statement that uses the market value of all assets and liabilities -> contains two classes of assets (1) already in pace, both tangible and intangible (2) opportunities to invest in attractive future ventures 6.3 Valuing Common Stocks  The cash payoff to owners of common stocks comes in two forms (1) cash dividends, and (2) capital gains or losses Expected return= r= DIV1+P1-Po/ Po = expected dividend yield + expected capital gain DIV1= expected dividend per share Po= time zero, which is today P1= time 1, which is 1 year hence  For many investors, both dividends and capital gains are taxable= look at after-tax rate of return for the best measure of the actual earnings on a stock After-tax rate of return= Div1- dividend tax/ Po + Capital gain- capital gains tax/Po The Dividend Discount Model  Discounted cash flow model of today’s stock price that states that share value equals the present value of all expected future dividends  Far-distant dividends will not have significant present values  For one period investor. The valuation formula looks like this: Po= DIV1+p1/ 1+r  Add on terms for each additional period Po= DIV1/1+r+ DIV2/ (1+r) +…+ DIVh+ Ph/ (1+r) h  The value of a stock is the present value of the dividends it will pay over the investor’s horizon plus the present value of the expected stock price at the end of that horizon  Regardless of the investment horizon the stock value will always be the same. This is because the stock price at the horizon date is determined by expectations of dividends from that date forward. Therefore, as long as the investors are consistent in their assessment of the prospects of the firm, they will arrive at the same present value  The principle holds for horizons of 1, 3, 10, 20 and 50 years or more 6.4 Simplifying the Divided Discount Model The Dividend Discount Model With No Growth  Company that pays out all its earnings in dividends= cannot grow because it does not reinvest  This model says that the no-growth shares should sell for the present value of a constant, perpetual stream of dividends (Po= DIV1/r)  Since the company pays out all its earnings as dividends, dividends and earnings are the same, and we could just as well calculate stock value (Value of no-growth stock= Po= EPS1/r)  EPS1 represents next year’s earnings per share of stock. We can loosely say that “stock price is the present value of future earning The Constant-Growth Dividend Discount Model  Requires a forecast of dividends for every year into the future which poses a bit of a problem for stocks with lives that are potentially infinite= assume no-growth perpetuity that
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