Corporate Finance Lecture 8 Dr Solt Eszter BME

Corporate Finance Lecture 8 Dr. Solt Eszter BME 2017

Why is it important how stocks are valued? • You may wish to check that any shares that you own are fairly priced and to gauge your beliefs against the rest of the market • Corporations need to have some understanding of how the market values firms in order to make good capital budgeting decisions • A project is attractive if it increases shareholder wealth • You can judge it if you know how shares are valued

Shares/common stocks • Firms issue shares of common stock to the public when they need to raise money • They typically engage investment banking firms such as Merrill Lynch or Goldman Sachs to help them market these shares • A shareholder is a part-owner of the firm • A shareholder is entitled to a certain percent of the profit of the company in dividend payments and to a certain percent of the votes at the company’s annual meeting • Equity” is still another word for stock. Stockholders are often referred to as “equity investors. ”

Primary market issues • Sales of new stock by the firm occur in the primary market • The two types of primary market issues: i. In an initial public offering, or IPO, a company sells stock to the public for the first time ii. Seasoned offerings by established firms that already have issued stock to the public and decide to raise money by issuing additional shares

Secondary markets • Exchanges are secondary markets for secondhand stocks • Stocks of large firms are listed on a stock exchange, which allows investors to trade existing stocks among themselves • The New York Stock Exchange (NYSE) is an example of an auction market : stocks are handled by a specialist, who acts as an auctioneer • The specialist ensures that stocks are sold to those investors who are prepared to pay the most and that they are bought from investors who are willing to accept the lowest price • By contrast, Nasdaq operates a dealer market, in which each dealer uses computer links to quote prices at which he or she is willing to buy or sell shares • A broker must survey the prices quoted by different dealers to get a sense of where the best price can be had

Book Values • The balance sheet shows the value of the firm’s assets and liabilities • The simplified balance sheet in slide 7 shows that the book value of all Pepsi. Co’s assets (plant and machinery, inventories of materials, cash in the bank etc. ) was $22, 660 million at the end of 1998. • Pepsi. Co’s liabilities (money that it owes the banks, taxes that are due to be paid, etc. ) amounted to $16, 259 million.

Book Values • The difference between the value of the assets and the liabilities was $6, 401 million, (about $6. 4 billion) • This was the book value of the firm’s equity. • Book value records all the money that Pepsi. Co has raised from its shareholders plus all the earnings that have been plowed back on their behalf.

BALANCE SHEET FOR PEPSICO, INC. , DECEMBER 26, 1998 (figures in millions of dollars) Assets Liabilities and Shareholders’Equity Plant, equipment, and other assets 22, 660 Liabilities 16, 259 Equity 6, 401

Liquidation value per share • The amount of cash per share a company could raise if it sold off all its assets in secondhand markets and paid off all its debts • The difference between a company’s actual value and its book or liquidation value is often attributed to going-concern value

Market versus book values August 1999 Firm Stock Price Book Value per Share Ratio: Price/Book Value Amgen 77. 31 5. 41 14. 3 Consolidated Edison 42. 88 26. 80 1. 6 Ford 51. 44 23. 38 2. 2 Mc. Donald’s 42. 00 6. 77 6. 2 Microsoft 85. 00 4. 91 17. 3 Pfizer 34. 75 2. 20 15. 8 Walt Disney 29. 19 10. 06 2. 9

Where did all that extra value come from for Pfizer? Largely from the cash flow generated by the drugs it has developed, patented, and marketed. These drugs are the results of a research and development (R&D) program that since 1985 has averaged about $500 million annually. But United States accountants don’t recognize R&D as an investment and don’t put it on the company’s balance sheet. Successful R&D does show up in stock prices, however.

The factors of going-concern value It refers to three factors: • Extra earning power A company may have the ability to earn more than an adequate rate of return on assets. • Intangible assets There are many assets that accountants don’t put on the balance sheet. Some of these assets are extremely valuable to the companies owning or using them but would be difficult to sell intact to other firms. (take Pfizer, a pharmaceutical company, which sells at 15. 8 times book value per share)

The factors of going-concern value • Value of future investments If investors believe a company will have the opportunity to make exceedingly profitable investments in the future, they will pay more for the company’s stock today. When Netscape, the Internet software company, first sold its stock to investors on August 8, 1995, the book value of shareholders’ equity was about $146 million. Yet the prices investors paid for the stock resulted in a market value of over $1 billion. By the close of trading on that day, the price of Netscape stock more than doubled, resulting in a stock market value of over $2 billion, nearly 15 times book value. In part, this reflected an intangible asset, the Internet browsing system. In addition, Netscape was a growth company. Investors believed in successful follow-on products.

Market price Going concern • Market price need not, and generally does not, equal either book value or liquidation value • Market value treats the firm as a going concern • Neither book value nor liquidation value treats the firm as a going concern

Valuing common stocks Today’s price and tomorrow’s price The cash payoff to owners of common stocks comes in two forms: • (1) cash dividends and • (2) capital gains or losses Usually investors expect to get some of each • Suppose that the current price of a share is P 0 (time zero, which is today), that the expected price a year from now is P 1, and that the expected dividend per share is DIV 1 • We simplify by assuming that dividends are paid only once a year and that the next dividend will come in 1 year • The rate of return that investors expect from this share over the next year is the expected dividend per share DIV 1 plus the expected increase in price P 1 – P 0, all divided by the price at the start of the year P 0

The expected rate of return The rate of return that investors expect from this share over the next year is the expected dividend per share DIV 1 plus the expected increase in price P 1 – P 0, all divided by the price at the start of the year P 0: r = [DIV 1 + (P 1 – P 0)]/P 0

Example • Suppose Red Rose stock is selling for $75 a share (P 0 = $75). Investors expect a $3 cash dividend over the next year (DIV 1 = $3). They also expect the stock to sell for $81 in a year (P 1 = $81). Then the expected return to stockholders is : r = ($3 + $81 – $75)/$75 =. 12 = 12% Expected rate of return = expected dividend yield + expected capital gain: . 04 +. 08 =. 12

The market value of the stock • You can also explain the market value of the stock in terms of investors’forecasts of dividends and price and the expected return offered by other equally risky stocks • This is just the present value of the cash flows the stock will provide to its owner: Price today = P 0 = (DIV 1 + P 1)/1 + r

The market value of the stock For Red Rose DIV 1 = $3 and P 1 = $81 If stocks of similar risk offer an expected return of r = 12%, then today’s price for Red Rose should be $75: P 0 = ($3 + $81)/1. 12 = $75 How do we know that $75 is the right price? Because no other price could survive in competitive markets

Actual return Expected return • The actual return for a company may turn out to be more or less than investors expect. • At each point in time all securities of the same risk are priced to offer the same expected rate of return. • This is a fundamental characteristic of prices in well-functioning markets. It is also common sense.

The dividend discount model • Future stock prices are not easy to forecast, so a formula that requires tomorrow’s stock price to explain today’s stock price is not generally helpful ! • We use the discounted cashflow model of today’s stock price • It states that share value equals the present value of all expected future dividends

The dividend discount model P 0 = present value of (DIV 1, DIV 2, DIV 3, . . . , DIVt = = DIV 1/(1 +r) + DIV 2/(1 +r)2 + DIV 3/(1 +r)3 + …. . DIV/(1 +r)t How far out in the future could we look? In principle, 40, 60, or 100 years or more (!) corporations are potentially immortal. However, far-distant dividends will not have significant present values. For example, the present value of $1 received in 30 years using a 10 percent discount rate is only $. 057. Most of the value of established companies comes from dividends to be paid within a person’s working lifetime

Simplifying the Dividend Discount Model • Consider a company that pays out all its earnings to its common shareholders. • Such a company could not grow because it could not reinvest. * • Stockholders might enjoy a generous immediate dividend, but they could forecast no increase in future dividends. The company’s stock would offer a perpetual stream of equal cash payments, DIV 1 = DIV 2 =. . . = DIVt =. . • *We assume it does not raise money by issuing new shares

Simplifying the Dividend Discount Model • The dividend discount model says that these no-growth shares should sell for the present value of a constant, perpetual stream of dividends. • Just divide the annual cash payment by the discount rate. The discount rate is the rate of return demanded by investors in other stocks of the same risk: P 0 = DIV 1/r

The dividend discount model for no growth • Since our company pays out all its earnings as dividends, dividends and earnings are the same: Value of a no-growth stock = P 0 = EPS 1/r • where EPS 1 represents next year’s earnings per share of stock

Example/Solution Moonshine Industries has produced a barrel per week for the past twenty years but cannot grow because of certain legal hazards. It earns $25 per share per year and pays it all out to stockholders. The stockholders have alternative, equivalentrisk ventures yielding 20 percent per year on average. How much is one share of Moonshine worth? (Assume the company can keep going indefinitely) Solution: P 0 = DIV 1/r = $25/$. 20 = $125

The constant-growth model • Many companies grow at rapid or irregular rates for several years before finally settling down. Obviously we can’t use the constant-growth dividend discount model in such cases. • In some mature industries growth is reasonably stable and the constant-growth model is approximately valid. • In such cases the model can be turned around to infer the rate of return expected by investors.

The constant-growth model • The higher the fraction of earnings plowed back into the company, the higher the growth rate. • So assets, earnings, and dividends all grow by g = return on equity x plowback ratio P 0 = DIV 1/r-g

The Example of Red Rose For Red Rose DIV 1 = $3 and P 1 = $81 If stocks of similar risk offer an expected return of r = 12%, then today’s price for Red Rose should be $75: P 0 = ($3 + $81)/1. 12 = $75

The Example of Red Rose • Suppose that Red Rose’s existing assets generate earnings per share of $5. 00. It pays out 60 percent of these earnings as a dividend. This payout ratio results in a dividend of. 60 × $5. 00 = $3. 00. The remaining 40 percent of earnings, the plowback ratio, is retained by the firm and plowed back into new plant and equipment. (The plowback ratio is also called the earnings retention ratio. ) On this new equity investment the firm earns a return of 20 percent. (ROE)

The Example of Red Rose • If all of these earnings were plowed back into the firm, Red Rose would grow at 20 percent per year. • Because a portion of earnings is not reinvested in the firm, the growth rate will be less than 20 percent. • The higher the fraction of earnings plowed back into the company, the higher the growth rate. So assets, earnings, and dividends all grow by • g = return on equity x plowback ratio = 20% ×. 40 = 8%

The Example of Red Rose What if Red Rose kept to its policy of reinvesting 40 percent of its profits but the forecast return on this new investment was only 12 percent? In that case the expected growth in dividends would also be lower: g = return on equity × plowback ratio = 12% ×. 40 = 4. 8% P 0 = DIV 1/r – g = $3. 00/ =. 12 –. 048 = $41. 67.

The Example of Red Rose • To repeat, if Red Rose did not plow back earnings or if it earned only the return that investors required on the new investment, its stock price would be $41. 67. • The total value of Re Rose stock is $75. Of this figure, $41. 67 is the value of the assets already in place, and the remaining $33. 33 is the present value of the superior returns on assets to be acquired in the future. • The latter is called the present value of growth opportunities, or PVGO. (Remember that investors expected Rose to earn 20 percent on its new investments, well above the 12 percent expected return necessary to attract investors)