ISBN: 0-03-028931-9
Chapter 9 Stocks and Their Valuation
Corporate decisions should be analyzed in terms of how alternative courses of action are likely to affect a firm's value. However, it is necessary to know how stock prices are established before attempting to measure how a given decision will affect a specific firm's value. This chapter showed how stock values are determined, and also how investors go about estimating the rates of return they expect to earn. The key concepts covered are summarized below.
A firm's common stockholders hold the right to elect the firm's directors, who in turn elect the officers to manage the firm's business. In a small company, the major stockholder(s) typically assume the positions of president and chairperson of the board of directors. In a large firm there is usually a great deal of separation between ownership and control.
A proxy is a document that gives one person the power to act for another person, typically the power to vote shares of common stock. A proxy fight occurs when an outside group solicits stockholders' proxies in an effort to vote a new management team into office.
A takeover occurs when a person or group succeeds in ousting a firm's management and taking control of the company.
Stockholders often have the right to purchase any additional shares sold by the firm. This right, called the preemptive right, protects the control of the present stockholders and prevents dilution of their stock's value.
Although most firms have only one type of common stock, in some instances classified stock is used to meet the special needs of the company. One type of classified stock is founders' shares. This is stock owned by the firm's founders that carries sole voting rights but restricted dividends for a specified number of years.
A closely held corporation is one that is owned by a few individuals who are typically associated with the firm's management.
A publicly owned corporation is one that is owned by a relatively large number of individuals who are not actively involved in its management.
Whenever stock in a closely held corporation is offered to the public for the first time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market.
The value of a share of stock is calculated as the present value of the stream of dividends the stock is expected to provide in the future.
Because of the great deal of difficulty in forecasting an infinite stream of dividends, most stocks are assumed to reach a state of constancy over time. When the dividend growth rate is expected to be constant into the foreseeable future, the following equation can be used to find the value of a stock:
The expected total rate of return from a stock consists of an expected dividend yield plus an expected capital gains yield. For a constant growth firm, both the expected dividend yield and the expected capital gains yield are constant.
The equation for ks, the expected rate of return on a constant growth stock, can be expressed as follows:
A zero growth stock is one whose future dividends are not expected to grow at all, while a supernormal growth stock is one whose earnings and dividends are expected to grow much faster than the economy as a whole over some specified time period and then to grow at the ``normal'' rate.
To find the present value of a supernormal growth stock: (1) find the dividends expected during the supernormal growth period, (2) find the price of the stock at the end of the supernormal growth period, (3) discount the dividends and the projected price back to the present, and (4) sum these PV's to find the current value of the stock, P0.
The terminal date is the date when individual dividend forecasts are no longer made because the dividend growth rate is assumed to be constant.
The terminal value is the value at the horizon date of all future dividends after that date.
The corporate value model is a valuation technique that determines the total firm value based upon the discounting of the firm's future free cash flows discounted at the WACC.
Equilibrium is a condition in which the expected return on a security is just equal to its required return. Furthermore, the stock's intrinsic value must be equal to its market price.
The Efficient Markets Hypothesis (EMH) holds (1) that stocks are always in equilibrium and (2) that it is impossible for an investor who does not have inside information to consistently ``beat the market.'' Therefore, according to the EMH, stocks are always fairly valued (P0 = P0), the required return on a stock is equal to its expected return (k = k), and all stocks' expected returns plot on the SML.
Differences can and do exist between expected and realized returns in the stock and bond markets. Only a short-term, risk-free asset would it be fairly likely that expected and actual (or realized) returns equal.
When U.S. investors purchase foreign stocks, they hope (1) that the stock prices will increase in the local market and (2) that the foreign currencies will rise relative to the U.S. dollar.
Preferred stock is a hybrid security having some characteristics of debt and some of equity.
Most preferred stocks are perpetuities, and the value of a share of perpetual preferred stock is found as the dividend divided by the required rate of return:
Maturing preferred stock is evaluated with a formula that is identical in form to the bond value formula.
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