Exam 2 Part 2- Stocks

Equity

"equity" originates from the Latin word "Aequitas", which means equality, justice, or fairness. Historically, equity referred to multiple merchants' involvement in a commercial venture where profits and losses from the venture are shared "equitably." In modern times, equity more generally refers to part ownership of a company.

Dividend trends

- As of September 30, 2019, 84% of S&P 500 companies are dividend payers. In contrast, only 29% of non-S&P500 U.S. companies pay dividends.1 - S&P 500 companies altogether pay around $475 billion a year in dividends to their shareholders. S&P 500 companies' dividend payout ratio is around 36% (payout ratio = annual dividends / annual earnings). This is down from around 90% in the 1930s and around 50% in the 1980s.2 The dividend payout ratio has decreased significantly over time as stock buybacks (repurchases) -- an alternative method of distributing cash to shareholders -- have become increasingly popular. - S&P 500's dividend yield is 2.1% (as of September 2019), meaning that S&P 500 companies are expected to pay around 2.1% of their current market capitalization as dividends over the coming year.3 The remainder of investors' returns will have to come from price appreciation (capital gains or losses), which has a high amount of uncertainty associated with it. - Companies in sectors with dependable cashflow streams pay more dividends, such as energy(e.g., Exxon Mobil, Chevron), real estate (American Tower Corp, Public Storage), and utilities (Duke Energy, American Electric Power). In contrast, companies in sectors with less stable cashflows and greater uncertainty are less likely to pay dividends, such as information technology (Microsoft, Apple, Google) and consumer discretionary (Home Depot, Disney, Starbucks).

Companies go public for a number of reasons, these reasons can be different for each company. Some of the reasons include:

- To raise capital and potentially broaden opportunities for future access to capital. - To increase liquidity for a company's stock, which may allow owners and employees to sell stock more easily. - To acquire other businesses with the public company's stock. - To attract and compensate employees with public company stock and stock-options. - To create publicity, brand awareness, or prestige for a company.

Before deciding to become a public company, there are important factors to consider:

- Your company's public offering will take time and money to accomplish. - Your company will take on significant new obligations, such as filing SEC reports and keeping shareholders and the market informed about the company's business operations, financial condition, and management, which will take a significant amount of time for your company's management and result in additional costs. - Your company and you may be liable if these new legal obligations are not satisfied. - You may lose some flexibility in managing your company's affairs, particularly when public shareholders must approve your company's actions. - Information about your company, such as financial statements and disclosures about material contracts, customers and suppliers, will become available to the general public (including your competitors).

Implementation

1) Project short-term cash flows and put them on the timeline. 2) Put yourself at the exact point on the timeline where the stock's terminal phase begins, where cash flows are expected to grow at the stable growth rate (year T). Compute the discounted value of all future cash flows (T+1 and beyond) using the formula for the present value of a growing perpetuity (Equation 2.15): PVgrowing perpetuity = CF / (i-g). This gives us the stock's "Terminal Value" (TV) 3) Discount TVT and all contemporaneous and earlier cash flows one by one back to the present and sum them.

Shareholders Advantages

1. Control rights 2. Limited Liability 3. Upside potential

Two main ways stockholders make money

1. Dividends 2. Capital gains

Two ways to calculate terminal value

1. Perpetuity Growth Method 2. Exit Multiple Method

Three major differences between the valuation of stocks and bonds

1. Stocks do not have a fixed term. Even though a given stock will almost certainly cease to exist at some point (due to bankruptcy, delisting, acquisition, etc.), because that date is unknown we have to approach stock valuation as if the company has an infinite life. 2. Cashflows to stockholders are not fixed. We were able to price bonds using the annuity shortcut for the coupon payments, but we cannot do that for stocks since cashflows are volatile. Furthermore, bond cashflow types were obvious (coupons and face value), which is not the case with stock cashflows. There are various different cashflow measures that can be used in stock valuation. 3. Stocks are riskier since cashflows are far more volatile and further into the future. For the discount rate, we will not be able to rely on the term structure of interest rates and default risk. Instead, we will have to use an expected return model called the Capital Asset Pricing Model (CAPM), but this will have to wait until Part 6 (Risk and Return).

Initial Public Offering (IPO)

A corporation issues shares publicly (as opposed to a select few private investors) for the very first time and becomes a publicly traded company on a stock exchange.

Seasoned Equity Offering (SEO)

An already public corporation issues more shares publicly.

Perpetuity Growth Method:

As a company matures, it should eventually begin to grow at an average rate close to the growth rate of the economy in which it operates (It can't grow faster than the whole economy in perpetuity; it would surpass the economy before too long, which cannot happen). This growth rate is called the "stable growth rate" (g) and the point on the timeline where cash flows begin to grow at this stable rate in perpetuity is called the company's "Terminal phase." We will forecast the company's short-term cash flows leading up to the terminal phase and assume stable growth in perpetuity beyond that.

Who owns U.S. stocks?

As of the end of 2018, the total value of publicly listed U.S. stocks was approximately $43 trillion, with the majority held by institutional investors (62%) and the rest (38%) held directly by households.4 Largest institutional investors were funds (mutual funds, closed-end funds and ETFs), foreign institutions, retirement funds (public and private pensions), non-financial corporations, financial institutions (banks, insurance companies, and broker/dealers), and the government (federal, state, and local).

Discount Cash Flow (DCF) Valuation

Concept 1: The value of a security is the present value of all its future cashflows, discounted at an "appropriate" discount rate. We use this approach to value stocks, the same way we used it to value bonds. But there are three major differences between the valuation of stocks and bonds that makes stock valuation much more complicated

Which of the following is NOT an advantage of going public? A. An IPO raises capital for the company's growth opportunities B. Enables the company's owners, employees and early investors to sell their stock C. Creates publicity and adds to the prestige of the company D. Increases the company's flexibility in managing its affairs E. Enables stock compensation, which attracts skilled employees

D. Increases the company's flexibility in managing its affairs

Equation 5.3

EV to Price Formula

Equity Value

Equity Value is the total value of the company's shares outstanding, also referred to as Market Capitalization if the stock is publicly traded. To calculate the stock price (a.k.a., share price, price per share), we divide the estimated Equity Value by the total number of shares outstanding.

Equation 5.4

FCFF = EBIT x (1-Tax rate) + Depreciation & Amortization - Capital Expenditures - Acquisitions - Change in net working capital

Equation 5.5

FCFF = EBIT x (1-Tax rate) x (1 - Reinvestment Rate)

Cashflow measure

For the purposes of this course, we will focus on one that is popular and theoretically sound: Free Cash Flow (FCF). FCF reflects how much "free" (meaning not "tied" to or needed to support the company's operations) cash flow the firm is expected to generate. Specifically, we will use Free Cash Flow to the Firm (FCFF), which measures the free cash flow available to all investors (including creditors) as opposed to only stockholders. This way the cash flow measure will be "above" any capital structure decisions (for example, issuing or paying down debt does not affect FCFF). This is how much free cash flow the firm generates from its operations regardless of how it finances itself. Free cash flow to the firm is also known as "Unlevered free cash flow" because it is the free cash flow that would belong to the shareholders if the company had no debt and made no interest payments.

Discounted Cash Flow (DCF) Model: Summary

For the sake of a simple DCF, you need at least three pieces of information: - Free Cash Flow to Firm forecasts for the short-term - Stable growth rate in perpetuity (to calculate the Terminal Value) - Cost of Capital (to discount the FCFFs to Present Value) Once you have all of this information: 1) Project FFCFs until terminal phase 2) Calculate Terminal Value (value of the firm at the beginning of terminal phase) 3) Discount all cash flows 4) Sum up discounted cash flows = Enterprise Value 5) Find Equity Value = Enterprise Value - Debt + Cash 6) Find Share price = Equity Value / Total number of shares outstanding

Gross profit margin

Gross profit margin = Gross profit / Total revenues

Which cash flow measure to use?

Net Income is the company's bottom-line for its shareholders. But there are two problems with it as a cash flow measure that cause issues in stock valuation: 1) In valuation, cash is king but net income is not cash -- it is an accounting number used for reporting purposes. In particular, net income includes certain non-cash income and expenses while excluding certain important cash expenses. 2) Net income reflects the outcome of not only the company's operations, but also its capital structure choices. For example, a company increasing its debt (and therefore its interest expense) will lower its net income. If we want to measure the total value of a company from its operations, we need to use a measure higher up on the income statement, before interest is expensed. This will be the Operating Income (a.k.a., EBIT: Earnings before interest and taxes).

Net profit margin

Net profit margin = Net income / Total revenues

Operating profit margin

Operating profit margin = Operating income / Total revenues

Dividends

Profitable companies can choose to distribute some of their profits to shareholders by paying a cash dividend. Dividends are typically paid quarterly. Most dividend paying companies follow a stable dividend policy, trying to pay the same amount every quarter even though profits fluctuate. They tend to increase dividends only if they expect future profits to be sufficient to cover them and they tend to be very reluctant to cut dividends. As a result, the market reacts favorably when a company announces dividend initiations or increase, and very unfavorably when a company cuts its dividends. Stocks that pay a higher than average dividend are sometimes referred to as "income stocks."

Limited Liability: Shareholders advantage

Shareholders are granted limited liability, meaning that their financial liability is limited to the value of their investment in the corporation and that the corporation's creditors cannot go after shareholders' personal assets outside the corporation.

Control rights: Shareholders advantage

Shareholders have control rights as owners of the corporation, such as the right to vote on matters of corporate policy, including board elections, executive compensation, and proposed M&A (mergers and acquisition) transactions.

Discount rate

Since we are using cash flows at the firm level, the discount rate will also have to be at the firm level, reflecting the required returns of both lenders and stockholders. This required return can be viewed as the company's overall cost of capital (the higher the required return of investors, the costlier the capital). We call this the Weighted Average Cost of Capital (WACC).

Example 5.5: A company is projected to generate total revenues of $100 million next year. If its projected operating profit margin is 13%, what is the projected EBIT next year?

Solution: Operating profit margin = Operating income (EBIT) / Total revenues --> Operating income (EBIT) = Operating profit margin x Total revenues = 13% x $100 million = $13 million

Example 5.6: Let's say you've pulled the following figures from a company's financial statements. What was its FCFF for that year? - Earnings Before Interest and Taxes (EBIT): $208,636 - Tax rate: 30% - Depreciation and Amortization: $41,439 - Capital Expenditures: $79,829 - Acquisitions: $0 - Change in Working Capital: $84,288

Solution: Using Equation 5.4: FCFF = EBIT x (1-Tax rate) + Depreciation & Amortization - (Capital Expenditures + Acquisitions) - Change in net working capital FCFF = $208,636 (1 - 0.3) + $41,439 - $79,829 - $84,288 = $23,367.2

Example 5.7: Let's say you are given the following figures for the same company from Example 5.6. What is its FCFF ? - Earnings Before Interest and Taxes (EBIT): $208,636 - Tax rate: 30% - Reinvestment Rate: 84% (must be a company that is pursuing high growth, based on this very high reinvestment rate)

Solution: Using Equation 5.5: FCFF = EBIT x (1-Tax rate) x (1 - Reinvestment Rate) = $208,636 x (1 - 0.3) x (1 - 0.84) = $23,367.2

Example 5.2: What is the estimated stock price of the company in Example 5.1, if it has $300 million in debt outstanding, $10 million in cash, and 20 million shares outstanding?

Solution: We had found EV = $1,607 billion, or $1,607 million. Equity Value = EV - Debt + Cash = $1,607 million - $300 million + $10 million = $1,317 million Stock Price = Equity Value/Number of shares outstanding = $1,317 million/20 million = $65.9 per share

Capital gains

Stock prices change constantly during each trading day as investors buy and sell them. If the stock price increases in response to good news about expected future profits, you can sell your shares at a profit, which generates capital gains. In contrast, if you sell a stock for a lower price than you initially paid, you incur a capital loss. Stockholder's total return = Capital gain (or losses) + Dividend yield Stockholders total return= Ending Price- Beginning price + Dividends/ Beginning Price

Stock

The higher the stock's risk, the higher the required return of stockholders, the lower the stock price today, and the higher the company's cost of capital via a stock offering.

Dilution

The reduction in the percentage ownership of a company due to the issuance of new stock to other investors.

Equation 5.1

Very important! This terminal value is the discounted value of the perpetuity as of year T -- one year before the first cash flow. Recall the rule for deferred annuities and perpetuities from Part 2.

Important note:

We will focus on the FCF the company is expected to generate over time, but this doesn't mean that shareholders get their hands on it, at least not right away. This is another important way stock valuation differs from bond valuation, where bondholders do receive coupons and face value from the issuer. In the case of stocks, the company may use the free cash flow it generates to pay dividends directly to shareholders, but also to buy back its stock, make financial investments, pay down its debt, or increase its cash holdings. In all these cases, free cash flow generates value for the firm's investors and therefore must be included in DCF valuation even if it is not received by investors immediately.

Solution

We will make short-term cash flow projections (anywhere from zero to 10 years, 3-5 is pretty common) and estimate a Terminal Value for the discounted value of all cash flows beyond that. Enterprise Value = PV of short-term cash flow projections + PV of Terminal Value

We have a problem:

We're assuming companies have an infinite life - that they'll be around forever. There are two problems with this set-up: 1) We cannot discount an infinite number of cash flows. 2) Cash flow beyond a few years are highly uncertain and our forecasts will be unreliable. So, we need a way to get rid of the infinite summation to make DCF stock valuation feasible.

Estimated Equity Value and Stock Price

When valuing a company through the DCF method with FCFF as the cash flow measure, we are given the Enterprise Value of the company as our end result. However, it is useful to speak in terms of the stock price, or the amount each share would be worth. In order to calculate the stock price, we must "walk the bridge" from Enterprise Value (total firm value) to Equity Value (amount equity holders are entitled to). To calculate Equity Value, we must take the Enterprise Value, subtract out the value of debt (amount debt holders are entitled to) and add back the value of excess cash. Note: The practice of subtracting debt and adding cash is also referred to as subtracting "net debt". It is possible that the company has more cash than debt. In that case, net debt is negative and equity value is greater than enterprise value.

Upside potential: Shareholders advantage

While shareholders have the greatest downside as residual claimants, they also have the greatest upside potential if the corporation performs well.

S&P 500

a popular stock market index that tracks the stock performance of 500 of the largest companies listed on U.S. exchanges. While by number it captures only around 15% all publicly traded US corporations (500 out of 3,500 or so, but the total number of companies changes a lot over time), it accounts for around 80% of the total U.S. stock market capitalization.

We make these adjustments because

i) Depreciation and amortization are non-cash expenses, but they lower EBIT, so they need to be added back, ii) Capital expenditures and acquisitions are real cash expenses that are critical for the company's operations, but they do not reduce EBIT, so they need to be expensed, iii) an increase in net working capital (NWC) costs the company cash, so must be expensed.

A private corporation owned by a small number of shareholders can become a public corporation by

issuing shares to the general public via a process called the Initial Public Offering (IPO). The shares of public corporations are held by a large number of shareholders (both individual and institutional investors) and traded on stock exchanges (e.g., NYSE, Nasdaq).

Corporation

its ownership is divided into shares known as "stock." The owner of a share of stock in a corporation is known as an equity holder, stockholder, or shareholder. A shareholder is a part owner of the company and is entitled to a share of the company's profits, typically in the same proportion as the number of shares they own relative to the corporation's total shares outstanding.

Purpose behind incorporating a company is to

raise capital from outside investors by issuing stock. The primary cost of raising capital this way is the dilution of the original owners' ownership of the company. Contrast this with debt financing, where the company commits to pay back a certain amount by a certain time but does not give up any ownership stake. In addition, the company pays underwriting commissions to the investment banks managing the stock offering.

Shareholders are the corporations

residual claimants -meaning that they have a right to the corporation's cash flows and assets only after all existing creditors are paid. These creditors include lenders (e.g., banks, bondholders, etc.), employees (if they are owed wages or other compensation), suppliers (e.g., trade credit extended by suppliers), customers (paid for goods/service in advance), and the government (taxes owed). Shareholders are last in line and the least likely to be paid. Shareholders own the riskiest claim and require a higher rate of return on their investment in the corporation compared to more senior claimants. Key concept: Required return of shareholders > Required return of creditors of the same firm

Enterprise Value

the resulting discounted value of cash flows. the value of the entire firm rather than only the value of stock, or in other words, how much it would cost to take over the entire firm and pay down its debt in the process.