Chapter 7 Stocks Stock Valuation and Stock Market

Chapter 7 Stocks, Stock Valuation, and Stock Market Equilibrium Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 22

Background on Stock • A stock is a certificate representing partial ownership in a corporation • Stock is issued by firms to obtain long-term funds • Owners of stock: – Can benefit from the growth in the value of the firm – Are susceptible to large losses • Individuals and financial institutions are common purchasers of stock • The primary market enables corporations to issue new stock • The secondary market creates liquidity for investors who invest in stock • Some corporations distribute earnings to investors in the form of dividends Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 22

Background on Stock (cont’d) • Ownership and voting rights – The owners are permitted to vote on key matters concerning the firm: • • Election of the board of directors Authorization to issue new shares Approval of amendments to the corporate charter Adoption of bylaws – Voting is often accomplished by proxy – Management typically receives the majority of the votes and can elect its own candidates as directors Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 22

Background on Stock (cont’d) • Preferred stock – Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights – A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred dividends have been paid – Preferred stock is less risky because dividends on preferred stock can be omitted – Preferred stock is a less desirable source of funds than bonds because: • Dividends are not tax deductible • Investors must be enticed to purchase the preferred stock since dividends do not legally have to be paid Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 22

Background on Stock (cont’d) • Issuers participating in stock markets – The ownership feature attracts many investors who want to have an equity interest but do not necessarily want to manage their own firm – A firm issuing stock for the first time engages in an IPO – If a firm issues additional stock after the IPO, it engages in a secondary offering Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 22

Initial Public Offerings • An IPO is a first-time offering of shares by a specific firm to the public • Usually, a growing firm first obtains private equity funding from VC firms • An IPO is used to obtain new funding and to offer VC firms a way to cash in their investment – Many VC firms sell their shares in the secondary market between 6 and 24 months after the IPO Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 22

Initial Public Offerings (cont’d) • Going public – An investment banking firm normally serves as the lead underwriter for the IPO – Developing a prospectus • The issuing firm develops a prospectus and files it with the SEC • The prospectus contains detailed information about the firm and includes financial statements and a discussion of risks • The prospectus is intended to provide investors with the information they need to decide whether to invest in the firm • Once approved by the SEC, the prospectus is sent to institutional investors • Underwriters and managers meet with institutional investors in the form of a “road show” Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 22

Initial Public Offerings (cont’d) • Going public (cont’d) – Pricing • The offer price is determined by the lead underwriter • During the road show, the number of shares demanded at various prices is assessed – Bookbuilding • In some countries, an auction process is used for IPOs – Transaction costs • The issuing firm typically pays 7 percent of the funds raised • The lead underwriter typically forms a syndicate with other firms who receive a portion of the transaction costs Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 22

Initial Public Offerings (cont’d) • Underwriter efforts to ensure price stability – The lead underwriter’s performance can be measured by the movement in the IPO shares following the IPO • If stocks placed by a securities firm perform poorly, investors may no longer purchase shares underwritten by that firm – The underwriter may require a lockup provision • Prevents the original owners from selling shares for a specified period • Prevents downward pressure • When the lockup period expires, the share price commonly declines significantly Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 22

Initial Public Offerings (cont’d) • IPO Timing – IPOs tend to occur more frequently during bullish stock markets • Prices are typically higher • In the 2000– 2001 period, many firms withdrew their IPO plans – Initial returns of IPOs • First-day return averaged about 20 percent over the last 30 years • In 1998, the mean one-day return for Internet stocks was 84 percent • Most IPO shares are offered to institutional investors • About 2 percent of IPO shares are offered as allotments to brokerage firms Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 22

Initial Public Offerings (cont’d) • Abuses in the IPO market – In 2003, regulators attempted to impose new guidelines that would prevent abuses • Spinning is the process in which an investment bank allocated IPO shares to executives requiring the help of an investment bank • Laddering involves increasing the price above the offer price on the first day of issue in response to substantial demand • Excessive commissions are sometimes charged by brokers when there is substantial demand for the IPO Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 22

Initial Public Offerings (cont’d) • Long-term performance following IPOs – IPOs perform poorly on average over a period of a year or longer • Many IPOs are overpriced at the time of issue • Investors may be overly optimistic about the firm • Managers may spend excessively and be less efficient with the firm’s funds than they were before the IPO Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 22

Secondary Stock Offerings • A secondary stock offering is: – A new stock offering by a firm whose stock is already publicly traded – Undertaken to raise more equity to expand operations – Usually facilitated by a securities firm • In the late 1990 s, the volume of publicly placed stock increased substantially • From 2000 to 2002, the volume of publicly placed stock declined as a result of the weak economy • Existing shareholders often have the preemptive right to purchase newly-issued stock Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 22

Secondary Stock Offerings (cont’d) • Shelf-registration – A corporation can fulfill SEC requirements up to two years before issuing new securities – Allows firms quick access to funds – Potential purchasers must realize that information disclosed in the registration is not continually updated Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 22

Copyright © 2014 by Nelson Education Ltd. Essentials of Managerial Finance by S. Besley & E. Brigham 8 -16 Slide 16 of 22

Basic Valuation • The (market) value of any investment asset is simply the present value of expected cash flows. • The interest rate that these cash flows are discounted at is called the asset’s required return. • The higher expected cash flows, the greater the asset’s value. • It makes sense that an investor is willing to pay (invest) some amount today to receive future benefits (cash flows). Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 22

Basic Valuation Model V 0 = CF 1 + (1 + k)1 CF 2 + … + (1 + k)2 CFn (1 + k)n Where: V 0 = value of the asset at time zero CFt = cash flow expected at the end of year t k = appropriate required return (discount rate) n = relevant time period Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 22

Common Stock Valuation • If an investor buys a share of stock, it is expected to receive cash in two ways – The company pays dividends – The investor sell shares, either to another investor in the market or back to the company • As with bonds, the price of the stock is the present value of these expected cash flows Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 22

Common Stock Valuation - Example Suppose an investor is thinking of purchasing the stock of Moore Oil, Inc. and he expects it to pay a € 2 dividend in one year, and he believes that he can sell the stock for € 14 at that time. If he requires a return of 20% on investments of this risk, what is the maximum he would be willing to pay? Solution: Compute the PV of the expected cash flows Price = (14 + 2) / (1. 2) = € 13. 33 Now what if he decides to hold the stock for two years? In addition to the dividend in one year, he expects a dividend of € 2. 10 in and a stock price of € 14. 70 at the end of year 2. Now how much would he be willing to pay? Solution: PV = 2 / (1. 2) + (2. 10 + 14. 70) / (1. 2)2 = 13. 33 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 22

Developing the valuation model The price of the stock is just the present value of all expected future dividends Value of = V = Pˆ = PV of expected future dividends s 0 stock = ˆ D 1 (1+ k s ) 1 + Essentials of Managerial Finance by S. Besley & E. Brigham ˆ D 2 (1+ k s ) 2 +L + ˆ¥ D (1+ k s ) ¥ Slide 21 of 22

Stock Valuation Models The Zero Growth Model • The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 22

The Zero Growth Model Essentials of Managerial Finance by S. Besley & E. Brigham Slide 23 of 22

Stock Valuation Models The Constant Growth Model • The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year -- year after year. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 24 of 22

The Constant Growth Model Essentials of Managerial Finance by S. Besley & E. Brigham Slide 25 of 22

If g = -6%, Would Anyone Buy the Stock? If So, at What Price? Firm still has earnings and still pays ^ dividends, so P 0 > 0: D 0(1+g) D 1 ^ P 0 = = rs – g $2. 00(0. 94) $1. 88 = = = $9. 89 0. 13 – (-0. 06) 0. 19 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 26 of 22

Dividend and Earnings Growth • Growth in dividends occurs primarily as a result of growth in EPS. • Earnings growth results from a number of factors: (1) inflation, (2) reinvested profit, and (3) ROE. • Firms cannot increase stock price by just raising the current dividend. • There is a tradeoff between current dividends and future dividends. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 27 of 22

Long-Term or Short-Term • If most of a stock’s value is due to longterm cash flows, why do so many managers focus on quarterly earnings? • Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. • Sometimes managers have bonuses tied to quarterly earnings. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 28 of 22

Maturity Companies • The constant growth model is often appropriate for mature companies. • The growth rate is generally expected to be at about the rate of GDP growth. • A zero growth stock can be valued by setting g = 0, that is, ^ D 0(1+0) P 0 = rs - 0 Essentials of Managerial Finance by S. Besley & E. Brigham = D 0 rs Slide 29 of 22

What Happens if g > RS? ^ P 0 = D 0(1+g)1 D 0(1+g)2 (1+rs)2 If g > rs, then + 1 (1+g)t (1+rs)t +…+ > 1, and D 0(1+rs)∞ ^ P 0 = ∞ So g must be less than rs to use the constant growth model. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 30 of 22

Stock Price Volatility • Are volatile stock prices consistent with rational pricing? • Small changes in expected g and rs cause large changes in stock prices. • As new information arrives, investors continually update their estimates of g and rs. • If stock prices are not volatile, then this means there is not a good flow of information. Copyright © 2014 by Nelson Education Ltd. Essentials of Managerial Finance by S. Besley & E. Brigham 8 -31 Slide 31 of 22

Stock Market Equilibrium • In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. • The expected price, P, must equal the actual price, P. • In other words, the fundamental value must be the same as the price. -32 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 32 of 22

In Equilibrium, Expected Returns Must Equal Required Returns: ^ rs = D 1/P 0 + g = rs = r. RF + (r. M – r. RF)b Essentials of Managerial Finance by S. Besley & E. Brigham Slide 33 of 22

How is Equilibrium Established? ^ D If rs = 1 + g > rs, then P 0 is “too low. ” P 0 ^ If the price is lower than the fundamental value, then the stock is a “bargain. ” Buy orders will exceed sell orders; the price will be bid up until: ^ D 1/P 0 + g = rs Essentials of Managerial Finance by S. Besley & E. Brigham Slide 34 of 22

The Efficient Markets Hypothesis • Weak form efficiency—past price information is contained in current prices • Semistrong form efficiency—publicly available information is contained in current prices • Strong form efficiency—all information, public and private, is contained in current prices Essentials of Managerial Finance by S. Besley & E. Brigham Slide 35 of 22

Markets are Generally Efficient Because: • 100, 000 or so trained analysts––MBAs, CFAs, and Ph. Ds––work for firms like Fidelity, Merrill, Morgan, and Prudential. • These analysts have similar access to data and megabucks to invest. • Thus, news is reflected in P 0 almost instantaneously. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 36 of 22