Chapter 8 Stock Valuation

Chapter 12 Lessons from Capital Market History

 Stock Valuation (How it is different than bond valuation?)
 Common Stock & Preferred Stock Features
o Common Stock Valuation
 Risk & Return I (IAC)
o Risk- Return Trade-off
o Mehra- Prescott Equity Premium Puzzle
8.1 Common Stock Valuation
 Dividend Discount Model and Some Special Cases

 Zero Dividend Growth / Constant Dividends

D1 = D2 = D3 = D = Constant
P0 = D / r It is like a perpetuity
 Constant Dividend Growth / Gordon Growth Model
D1= D0 (1+g) D2= D1 (1+g)
Dt = Dt-1 (1+g) Dt = D0 (1+g)t

It is like a growing perpetuity.

 Two Stage Model (Supernormal Growth)
o Dividend growth for finite period of time

Example: Suppose Pfizer just paid a dividend of $1.5 per share. The dividends are expected to grow
at 8% for the next six years and then will grow at an annual rate of 4% thereafter when demand
subsides. Suppose that the annual return on a market portfolio is 15% and the annual return on a risk-
free bond is 10%. Pfizer’s stock has a beta coefficient of 1.2 .What is the price of the stock today?

Step 1: Find required return

r = rf + β (rm -rf)
= 10% + 1.2 (15% - 10%) = 16%
Step 2: Find P6
D0 = 1.5
D1 = 1.5 (1+ g1) =1.5 (1+8%) = $1.62
 D7 = 1.5 (1+8%)6(1+4%) =$ 2.4755
P6 = D7/(r- g2) =2.4755/(16% - 4%) =$20.6294
Step 3: Find P0

 No-dividend, negative earnings cases

o Price/Earning Ratio (P/E):
 Price at time t, Pt = Benchmark (P/E) Ratio x EPSt
o Benchmark (P/E): - based on similar companies (industry average or median)
- based on its own historical values
o Forward P/E ratio: based on coming years earnings
o Target Price: product of current P/E and earnings of coming year
If company is relatively new and not making any profit:
o Price/Sales ratio
8.2 Common Stock Features
 Shareholders’ Rights (what is this right?)
 Other Rights (under the Canadian Business Corporations Act)
o Share proportionally in declared dividends
o Share proportionally in remaining assets during liquidation
o The right to vote on shareholder matters of great importance, such as a merger, usually done at
the annual meeting or a special meeting.
o Preemptive right – first shot at new stock issue to maintain proportional ownership if desired
 Classes of stock
o Unequal voting rights
o Control of firm
o Non-voting shares must receive dividends no lower than voting shares
o Coattail provision (conversion of non-voting to voting during takeover)
Canadian Tire voting stocks: 61% offspring, rest to dealer, PenFun, public
 Dividend Characteristics:
o Dividends are not a liability of the firm until a dividend has been declared by the Board
o Consequently, a firm cannot go bankrupt for not declaring dividends
o Dividends and Taxes
 Dividend payments are not considered a business expense and are not tax deductible
 Dividends received by individual shareholders are partially sheltered by the dividend tax
credit
 Dividends received by corporate shareholders are not taxed
 This prevents double taxation of dividends
8.3 Preferred Stock Features
 Dividends
o Most preferreds have a stated dividend that must be paid before common dividends can be paid
o Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely
o Most preferred dividends are cumulative – any missed preferred dividends have to be paid before
common dividends can be paid
 Preferred stock generally does not carry voting rights
o The price of a stock is the present value of all future expected dividends
8.4 Stock Market Reporting

1) Growth Opportunities
 Growth opportunities are opportunities to invest in positive NPV projects.
 Another useful way to think about the price of a stock is as

 The first component, EPS/r, is the price of the stock if equity cash flows (or earnings) remain
constant forever. EPS = Div
 The second component is the expected NPV from future growth opportunities.
5. The DGM and the NPVGO Model
 We have two ways to value a stock:
o The dividend discount (or growth) model.
o The price of a share of stock can be calculated as the sum of its price as a cash cow plus the per-
share value of its growth opportunities.

Example: Consider a firm that has EPS of $5 at the end of the first year, a dividend-payout ratio of 30-
percent, a discount rate of 16-percent, and a return on retained earnings of 20-percent. Calculate the
value of the growth opportunities, NPVGO.
• The dividend at year one will be D1=$5 × .30 = $1.50 per share.
• The retention ratio is .70 ( = 1 -.30) implying a growth rate in dividends of 14% = .70 × 20%
Growth rate = (retention rate)(ROE)
From the dividend growth model, the price of a share is:

6. The NPVGO Model

 First, we must calculate the value of the firm as a cash cow.

 Second, we must calculate the value of the growth opportunities.

Alternatively, NPVGO = RE1(ROE/r -1)/(r – g) = 3.5(0.20/0.16 – 1)/(0.16-0.14) = $43.50

7. Summary of Stock Valuation
Lessons from Capital Market (Chapter 12) (IAC –till end)
 Required Return
 In general sense: higher the risk higher the required return
 How can we measure the risk?
 How can we say that one investment is riskier than the other?
 What returns should we expect from financial assets and what are the risks from such investments?
Financial Crisis of 2008
 the annual return for the S&P/TSX Composite in 2008 was −33.00 percent, the index's worst return
in decades.
 In the recovery period, the S&P/TSX posted impressive returns of 34.35 percent in 2009 and 17.25
percent in 2010;
 U.S. stocks, measured by the S&P 500, showed more modest returns of 9.26 percent and 8.10
percent for these years

12.2 | The Historical Record

 Capital market history is of great interest to investment consultants
 Roger Ibbotson and Rex Sinquefield conducted a famous set of studies dealing with rates of return
in U.S. financial markets.
 James Hatch and Robert White examined Canadian returns.
 These data present year-to-year historical rates of return on six important types of financial
investments
 Six important types of financial investments.
1. Canadian common stocks. The common stock portfolio is based on a sample of the largest
companies (in total market value of outstanding stock) in Canada.
2. U.S. common stocks. The U.S. common stock portfolio consists of 500 of the largest U.S.
companies. The full historical series is given in U.S. dollars. A separate series presents U.S.
stock returns in Canadian dollars adjusting for shifts in exchange rates.
3. TSX Venture stock. The TSX Venture stock portfolio consists of small and emerging
companies that do not yet meet listing requirements for the S&P/TSX Composite Index.
 4. Small stocks. The small stock portfolio is composed of the small-capitalization Canadian
stocks as compiled by BMO Nesbitt Burns.
5. Long bonds. The long bond portfolio has high-quality, long-term corporate, provincial, and
Government of Canada bonds.
6. Canada Treasury bills. The T-bill portfolio has Treasury bills with a three-month maturity.
Table 12.1 – Annual Market Index Returns (1948 – 2014)

Figure 12.4 – If you invested $1 in 1957, how much would you have in 2014?
 The equity premium puzzle is a term coined in 1985 by economists Rajnish Mehra & Edward
Prescott.
 In the US, equities have outperformed bonds by around 7% p.a. for most of the 20th century.
 A phenomenon that describes the anomalously higher historical real returns of stocks over
government bonds.
 The equity premium puzzle is based on the observation that in order to reconcile the much higher
returns of stocks compared to government bonds in the U.S, individual must have implausibly high
risk aversion according to standard economics models.
 The difference is too large to reflect a "proper" level of compensation that would occur as a result of
investor risk aversion; therefore, the premium should actually be much lower than the historic
average noted.
 Possible Explanations:
o The puzzle is an illusion:
the empirical data are wrong
o High risk aversion
o Autocorrelation in returns (serial correlation)
o Time varying expected returns
o Heterogeneous investors (opposite of Markowitz Portfolio Theory – all investors have same
expectations and make same choices for given circumstance)