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Financial Management-2

Winter Semester 2011

NCBA&E

Instructor: Jamal Nasir Khan

Equity Markets & Stock Valuation


Learning Objectives

Common Stock Valuation

Dividend Growth model


Zero Growth Constant Growth

Multiple/Variable Growth
Components of Required Return Features of Stocks Stock Markets

Capital Market Securities

Fixed Income (Bonds)


Treasuries
Agencies Municipals Corporate

Equities
Preferred Stock Common Stock

Stocks
It is an equity ownership in a corporation, initially issued to raise capital Points to keep in mind (vs Bonds)

C/Fs are NOT known in advance


Life of stocks is forever no maturity Difficult to observe required rate of return for discounting

Stocks
How do we come up with the Price of a Stock? PV of all future expected C/Fs? Assumptions will be needed!

Assume a dividend the stock will pay.


Assume a selling price at the end of 1 year. Come up with a required rate of return.

Stocks Valuation
Assumptions will be needed!
Assume a dividend the stock will pay. Assume a selling price at the end of 1 year. Come up with a required rate of return.

Example: At the end of 1 year Stock selling price is $70

Stock dividend will be $10


U need a 25% return PV will be 80/(1.25) = $64 (u should pay today)

Stocks Valuation
Example: For 1 year
Stock selling price is $70 (P1) Stock dividend will be $10 (D1) U need a 25% return (R) PV will be 80/(1.25) = $64 (Po) (u should pay today)

Therefore we can write: Po = (D1+P1) / (1+R)


NOTE: coming up with a stock price @ end year is not easy!!

Stocks Valuation
Example: For 1 year

P1 @ t1, would be found the same way by assuming the year 2 price & dividend: P1 = (D2+P2) / (1+R) Here then P1 really equals the P1 we used at Po. Thus we can substitute:

Stocks Valuation
Example: For 1 year

substituting P1 in Po equation:

Po = (D1+ (D2+P2)/1+R) / (1+R) = D1/(1+R)^1 + D2/(1+R)^2 + P2/(1+R)^2

If u repeat this forever, the P2 ultimately has a PV of almost ZERO!!

Stocks Valuation
Formula: Po = E Dn / (1+R)^n PV of all future dividends

as a general valuation framework.


Dividends to infinity are still a problem at this stage!

Stocks Valuation
The problem of NO dividends.

This formula assumes the company will pay something at some point in its life to its shareholders.
A Corp where money goes in but nothing comes out doesnt exist. Or shouldnt exist!

Stocks Valuation

Special Cases. of dividends Zero-growth:

Here the dividend is constant, D1=D2=D


So, the value of the stock is a Perpetuity (ordinary), Po = D/R
same as PV = C/r

Stocks Valuation
Example zero-growth

Suppose a company pays Rs. 10 dividend always.

If this policy is forever, Whats the stock price if the required return is 20%?

Stocks Valuation
Example zero-growth

Suppose a company pays Rs. 10 dividend always.

If this policy is forever, Whats the stock price if the required return is 20%?
Po = 10 / 0.2 = Rs 50 per share

Stocks Valuation
Special Cases. of dividends Constant Growth Model:
Suppose the dividend grows at a constant rate g.
If dividend just paid is Do, then the next D1 is:

D1 = Do x (1+g)
& for 2 periods is: D2 = Do x (1+g)^2
D2 = (Do x (1+g)) x (1+g)

(FV formula)

Stocks Valuation
Growing Perpetuity:
An asset where the C/Fs grow at a constant rate forever.

Putting these dividends in the formula: Po = Do(1+g)^1/(1+R)^1 + Do(1+g)^2/(1+R)^2


we can write this simply as: Po = Do x (1+g) / R-g OR D1 / R - g

Stocks Valuation
Dividend Growth Model:
Determines the Stock Price with constant growth dividends.

Po = Do x (1+g) / R-g OR

D1 / R - g

(g<R)

Stocks Valuation
Example:
Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share?

Stocks Valuation
Example:
Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share?

D1 / R - g

(g<R)

2.3 x (1.05) / (0.13-0.05) 2.415 / 0.8 = 30.19

Stocks Valuation
Note: You can use this to find the stock price at any point in time!
Just find the D for that year,

grow it at (1+g)
& then divide by R-g

Stocks Valuation
Example:
Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share in 5 years?

D6 / R - g

(g<R)

Stocks Valuation
Example:
Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share in 5 years?

Formula is: Dt+1 / R - g


(g<R)

Stocks Valuation
Example:
Suppose Do = 2.30, R=13%, g=5%.

Whats the price per share in 5 years?

D6 / R - g

(g<R)

2.3 x (1.05)^5 / (0.13-0.05) 2.935x(1.05) / 0.8 = 3.0822/.08 = 38.53

Stocks Valuation
Example:
Suppose Company Ts next dividend will be $4. Required return is 16%. Dividend increases by 6% every year.

Whats the price per share today?

& in 4 years?

Stocks Valuation
Example:
Suppose next dividend will be $4. Required return is 16%. Dividend increases by 6% every year. D1 = 4 , R=16%, g=6%. (since D1 is given, dont need to grow by g)

Whats the price per share today?

Po = D1 / R - g
Whats the price per share in 4 yrs?

(g<R)

4/ (.16-.06) = 4/.1 = $40 = Po

Find D5 first, D1 (1+g)^4 = 4(1.06)^4 = 5.05 5.05/0.1 = 50.50 = P4

Stocks Valuation
Notice here:

P4 = Po (1+g)^4 50.50 = 40 x (1.06)^4

So, Stock price grows at the same constant rate as the Dividend! P4 is simply D5/(R-g)

Components of Required Return


Lets break down the R, discount rate which we used in the Dividend Growth Model or DDM Po = D1 / (R-g) if we rearrange to solve for R. then R-g = D1/Po R = D1/ Po + g

Components of Required Return


R = D1/ Po + g

This means TR has 2 components:

D1/Po = Dividend Yield


g = same rate as the increase in stock price = Capital gains yield

Components of Required Return


EXAMPLE

R = D1/ Po + g

If a stock is selling for $20 per share. Next dividend will be $1 per share. Dividend will grow by 10% per year forever.
What is the return on this stock?

Components of Required Return


EXAMPLE

R = D1/ Po + g If a stock is selling for $20 per share. Next dividend will be $1 per share. Dividend will grow by 10% per year forever. What is the return on this stock?

= Div yield + Cap gains yield


= 1/20 + 10% = 5% + 10% = 15%

Stocks Valuation
Multiple Growth Model
Company grows at a certain high rate first, then slows down to grow at a constant sustainable rate.

illustrate concept

Stocks Valuation
Multiple Growth Model
Company grows at a certain high rate first, then slows down to grow at a constant sustainable rate. Value = PV of dividends + PV of terminal price = E Do(1+g)^t / (1+k) + Dn(1+g)/(k-g).1/1+k^n illustrate concept

Stocks Valuation
Intrinsic Value & Market Price

If

IV > Mkt Price = under/over-valued? IV < Mkt Px = under/over valued?

Stocks Valuation
Multiple growth

Example:
MCB is expanding and is expected to grow at a rate of 20% per year for the next three years. Current dividend is Rs. 2 per share. After this rapid growth, the company is likely to slow down to a normal growth of 7% for the foreseeable future. Required return on this stock is 22%. D1 = 2*(1.20) = 2.40 , R=22%, G1= 20%, g=7%.

Whats the price per share today?

Solution in Excel MCB

Relative Valuation Techniques


Making Valuations through comparisons P/E = Price to Earnings ratio
so if comparable stocks are trading at x15. & Earnings for a stock are equal to: $3 What should be the stock price? 45

Forward P/E = Po/E1

Relative Valuation Techniques

Making Valuations through comparisons

P/E = Payback period! P/E = 15, EPS= $3, Px=45 So P/E of 15= 15 years payback! Also: 1/15 = 6.66% yield indicating low pay-off for investors!

Relative Valuation Techniques

Making Valuations through comparisons P/BV = Price to Book Value (S.Equity) ratio
so if comparable stocks are trading at x10. & BV for a stock is equal to: $5 What should be the stock price?

50

Relative Valuation Techniques

Making Valuations through comparisons P/S = Price to Sales ratio


so if comparable stocks are trading at x1. & Sales for a stock is equal to: $5 What should be the stock price?

Cash Flows between the Firm and the Financial Markets


Total Value of Firms Assets Total Value of the Firm to Investors in the Financial Markets

B. Firm invests in assets Current Assets Fixed Assets

A. Firm issues securities

Financial Markets
Short-term debt Long-term debt Equity shares

E. Retained cash flows

F. Dividends and debt payments

C. Cash flow from firms assets

D. Government

Major Types of Financial Assets


ORGANIZATION

DIRECT INVESTING
Non-Marketable

INDIRECT INVESTING Investment Companies

securities Money Markets Capital Markets Derivatives Markets

Mutual Funds Stock, Bond Funds Unit Investment Trusts

What are Major Types of Financial Assets? Direct Investing


Capital Market Securities

Fixed Income (Bonds)


Treasuries Agencies Municipals Corporate

Equities
Preferred Stock Common Stock

What are Major Types of Financial Assets? Direct Investing


Equity Securities

Equity Security: Preferred Stock:

Common Stock:
Voting Rights:

What are Major Types of Financial Assets? Direct Investing


Equity Securities

Equity Security: Represents an ownership interest in a corporation.

After payment of all obligations to fixed-income claims, provides residual claim. b/w Bonds & common stocks. However, dividends may be deferred.

Preferred Stock: Hybrid security: Pays dividends known in advance & falls Common Stock:
Represents ownership interest of corporations or Equity of stock holders (also called Equity securities)

Example: 100 shares of common stock represents 100/n% ownership interest in the corp (n=outstanding shares).

Voting Rights: Gives C.S. Holders legal control of the Corp.


of Directors as their reps. To run the corp.

Elect the board

What are Major Types of Financial Assets? Direct Investing


Equity Securities

Common Stock Characteristics


Par Value: Book Value:

Limited Liability:
Market Value (Cap): Dividends:

Dividend Yield:
Payout Ratio: Retention Ratio:

What are Major Types of Financial Assets? Direct Investing


Equity Securities

Common Stock Characteristics


Par Value: Not a significant economic variable. Any number can be chosen. New
stock usually sells for more than PAR.

Book Value: The accounting value of the equity as shown on the Balance Sheet.
Sum of Stock Outstanding, Capital in excess of Par & Retained Earnings.

Limited Liability: Investors cannot lose more than their investment.


have access only to the assets of the corp.

Creditors

Market Value:

Market Capitalization: Price of Stock x Shares outstanding

Dividends: Cash Payments declared & paid to stockholders Dividend Yield: 12 month dividend / current stock price Payout Ratio: Dividends / Earnings (indicates % of a firms earnings paid out) Retention Ratio: 1 Payout Ratio (% of firms earnings retained)

What are Major Types of Financial Assets? Direct Investing


Equity Securities

Stock Example
Coca-Colas 2002 EPS = $1.23. Paid annual dividend DPS of $0.8. If price of KO is $45, calculate the following.
DY? Payout ratio?

If the company reported $11.8 Billion in Stockholder Equity & the outstanding shares are 2.478 Billion, whats the BVS?

What are Major Types of Financial Assets? Direct Investing


Equity Securities

Stock Example
Coca-Colas 2002 EPS = $1.23. Paid annual dividend DPS of $0.8. If price of KO is $45, calculate the following.
Dividend Yield: 0.8/45 = 1.8% Payout Ratio: 0.8/1.23 = 65%

If the company reported $11.8 Billion in Stockholder Equity & the outstanding shares are 2.478 Billion, whats the BVS?
BVS = 11.8 / 2.478 = $4.76

What are Major Types of Financial Assets? Direct Investing


Equity Securities

More Common Stock Characteristics


Stock Dividend: Stock Split: P/E Ratio:

What are Major Types of Financial Assets? Direct Investing


Equity Securities

More Common Stock Characteristics


Stock Dividend: Payment of a dividend in the form of stock (instead of cash)

Stock Split: Issuance of stock in proportion to shares outstanding


P/E Ratio:
Stock Price/ EPS (what investors are paying per dollar of earnings)

Example: Price of X = $25, EPS = 1.5


P/E = 25/1.5 = ?

What are Major Types of Financial Assets? Direct Investing


Equity Securities

More Common Stock Characteristics


Stock Dividend: Payment of a dividend in the form of stock (instead of cash) Stock Split: Issuance of stock in proportion to shares outstanding P/E Ratio:
Stock Price/ EPS (what investors are paying per dollar of earnings)

Example: Price of X = $25, EPS = 1.5 P/E = 25/1.5 = 16.6

Financial Markets?
US Securities Markets for Equities
Dow Jones Industrial Average

Standard & Poors (S&P 500)

Nasdaq

Pakistani Securities Markets for Equities


KSE (Karachi Stock Exchange)

Financial Markets?
US Securities Markets for Equities
Dow Jones Industrial Average
30 Blue chip stocks stock price weighted average

Standard & Poors (S&P 500)


500 stock composite

Nasdaq
100 Large cap companies

The Dow Jones Industrial Average consists of the following 30 companies: 3M Co. (NYSE: MMM) (conglomerates, "manufacturing") ALCOA Inc. (NYSE: AA) (aluminium) Altria Group, Inc. (NYSE: MO) (tobacco, foods) American International Group, Inc. (NYSE: AIG) (property & casualty insurance) American Express Co. (NYSE: AXP) (credit services) AT&T Inc. (NYSE: T) (telecoms) Boeing Co., The (NYSE: BA) (aerospace/defense) Caterpillar, Inc. (NYSE: CAT) (farm & construction equipment) Citigroup, Inc. (NYSE: C) (money center banks) Coca-Cola Co. (NYSE: KO) (beverages) E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals) Exxon Mobil Corp. (NYSE: XOM) (major integrated oil & gas) General Electric Co. (NYSE: GE) (conglomerates, media) General Motors Corporation (NYSE: GM) (auto manufacturers) Hewlett-Packard Co. (NYSE: HPQ) (diversified computer systems) Home Depot, Inc. (NYSE: HD) (home improvement stores)

Honeywell International, Inc. (NYSE: HON) (conglomerates) Intel Corp. (NYSE: INTC) (semiconductors)

International Business Machines Corp. (NYSE: IBM) (diversified computer systems)


JPMorgan Chase and Co. (NYSE: JPM) (money center banks) Johnson & Johnson Inc. (NYSE: JNJ) (consumer and health care products conglomerate)

McDonald's Corp. (NYSE: MCD) (restaurant franchise)


Merck & Co., Inc. (NYSE: MRK) (drug manufacturers) Microsoft Corp. (NYSE: MSFT) (software) Pfizer, Inc. (NYSE: PFE) (drug manufacturers) Procter & Gamble Co. (NYSE: PG) (consumer goods) Verizon Communications (NYSE: VZ) (telecoms) Wal-Mart Stores, Inc. (NYSE: WMT) (discount, variety stores) Walt Disney Co., The (NYSE: DIS) (entertainment)

United Technologies Corp. (NYSE: UTX) (conglomerates

Types of Orders
Market Order
Limit Order Stock Order

Clearing Procedures (T+3)

Types of Orders
Market Order
Limit Order
Best price on the floor ENSURES EXECUTION NOT PX specified or better price ENSURES PX NOT EXECUTION

Stop Order
Automatic execution at specified price BUY STOP PROTECTS PROFITS SELL STOPS PROTECT LOSSES

Clearing Procedures (T+3)


Trade Day plus 3 business days

Short Sales
Being Long
Being Short Short Sale

Short Interest Ratio

Short Sales
Being Long
normal position of buying stock

Being Short
having sold stock not owned

Short Sale
selling stock not owned but borrowed

Short Interest Ratio


shares short to average daily volume