FIN 432 Test 1-Stocks
What is a constant growth stock?
One whose dividends are expected to grow forever at a constant rate, g.
What is the formula for the dividend yield?
D₁ / P₀
If the required return is 13%, the most recent dividend was $2 and the growth rate is 0%, what will be the expected current price (p-hat₀) using the constant growth model?
P₀-hat = $2 / 0.13 = $15.38
What year's dividend would you use to find the expected price ten years from now?
The dividend in year 11, which would be divided by the required return minus the growth rate.
Are volatile stock prices consistent with rational pricing?
Yes. Small changes in expected growth and required return causes large changes in stock prices. As new information arrives, investors continually update their estimates of g and r sub s. If stock prices aren't volatile, this means there isn't a good flow of information.
What happens if the growth is greater than the required return?
You cannot use the constant growth model because the expected price would equal infinity. So growth must be less than the required return for the constant growth model to be applicable.
Nonconstant growth stocks.
Have nonconstant growth in the beginning of life until they begin constant growth in the second phase. Cannot use the constant growth model.
Total Year 1 Return
Is equal to the dividend yield plus the capital gains yield.
r sub s
required return of stock
Common Stock
Represents ownership -> ownership implies control -> stockholders elect directors -> directors hire management -> since managers are "agents" of shareholders, their goal should be: maximize stock price.
If most of a stock's value is due to long-term 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.
Tracking Stock
The dividends of tracking stock are tied to a particular division, rather than the company as a whole. -Investors can separately value the divisions. -Its easier to compensate division managers with the tracking stock. But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company. This might happen if one company acquires another.
What is the formula for the dividend yield at t=0 for a nonconstant growth stock? How do you find the capital gains yield?
The formula for the dividend yield does not change, it is still D₁ / P₀. P₀ was found using the nonconstant growth formula. Find the capital gains yield by substracting the dividend yield from the required return. It does not equal one of the growth rates in this instance. During nonconstant growth, dividend yield and capital gains yield are not constant. If current growth is greater than g long term growth, current capital gains yield is greater than g long term growth. For the time period in the future when constant growth starts, the capital gains yield will once again equal the growth rate.
For a constant growth stock, the capital gains yield equals what?
The growth rate.
If the expected return is lower than the required return, is the stock price too low or too high?
The price is too low and the stock is a bargain. Buy orders will exceed sell orders and the price will be bid up until equilibrium is established.
Different Approaches for Valuing Common Stock
-Dividend Growth Model (Constant & Non-constant) -Free Cash Flow Method -Using the multiples of comparable firms
What is the value of common stock?
The PV of all future dividends.
Implications of Market Efficiency for Financial Decisions
-Many investors have given up trying to beat the market, explaining the growing popularity of index funds which try to match overall market returns by buying a basket of stocks that make up a particular index. -Important implications for stock issues, repurchases, and tender offers. -If the market prices stocks fairly, managerial decisions based on over and undervaluation might not make sense. -Managers have better information but they cannot use for their own advantage and cannot deliberately defraud investors.
Conclusions
-Markets are rational to a large extent, but at times they are also subject to irrational behavior. -One must do careful, rational analyses using finance tools and techniques. -Recognize that actual prices can differ from intrinsic values, sometimes by large amounts and for long periods. -Differences between actual prices and intrinsic values provide wonderful opportunities for those able to capitalize on them (unfortunately, those people are probably institutional investors haha).
Efficient Market Hypothesis
-Securities are normally in equilibrium and are "fairly" priced. One cannot "beat the market" except through good luck or insider information. -EMH does not assume all investors are rational. -EMH assumes that stock market prices track intrinsic values fairly closely. -If stock prices deviate from instrinsic values, investors will quickly take advantage of mispricing. -Prices will be driven to new equilibrium level based on new information. -It is possible to have irrational investors in a rational market.
Rational Behavior v. Not
-Stock market bubbles of 2000 and 2008 suggest that something other than pure rationality in investing is alive and well. -People anchor too closely on recent events when predicting future events. Ex when the market is performing better than average, they tend to think it will continue to perform better than average. -Other investors emulate them, following like a herd of sheep.
Outline of the Nonconstant Growth Method to find the current expected price.
Add up the PV of all Dividends and the Horizon Value. *Remember the horizon value is in the period previous to nonconstant growth and so has an associated dividend for that period.
Why are stock prices volatile?
P₀-hat = D₁ / (r sub s - g) r sub s = r sub RF + (RM sub M) b sub i inflation expectations risk aversion company risk r sub s can change & g can change
Strong EMH
All information, even inside information, is embedded in stock prices. Not true-insiders can gain by trading on the basis of insider information, but that's illegal.
Semi-strong EMH
All publicly available information is reflected in stock prices, so it doesn't pay to pore over annual reports looking for undervalued stocks. Largely true.
How does r sub s and g affect stock prices?
As required returns go up, stock prices go down. As growth goes up, stock prices go up. You can see this in 2 equations. First: P₀-hat = D₁ / (r sub s - g) The smaller the denominator, the larger the price will be. Secondly, as required returns go up, stock prices go down. But since required returns= DY + CGY and CGY=g, as g goes up, the required return gets larger.
What are two formulas for the capital gains yield?
CGY= r sub s - DY Or the capital gains yield is equal to the total return minus the dividend yield. The second is (P₁ - P₀) / P₀
Weak EMH
Can't profit by looking at past trends. A recent decline is no reason to think stocks will go up or down in the future. Evidence supports weak-form EMH but "technical analysis" is still used.
If g= -6% and the required return is 13%, what is the dividend yield? What is the capital gains yield?
DY= 13% - (-6%) = 19% CGY = -6% The DY offsets the negative CGY, giving you the right required return of 13%.
How do you find the horizon value?
First, find the expected price of the stock for the year previous to when the constant growth begins using the constant growth formula (but not the one using D₀ since growth was not constant at that time). If constant growth begins in year 4, your horizon value will be the expected price of the stock in year 3. You will use year 4's dividend to find the price in year 3. Since the price is the FV of cashflows, not the current cash flows, the constant growth/horizon value is measured the period before it begins and not in the actual period. P₃-hat= D₄ / (r -g) Then discount this price back to the current year 0. So P₀-hat = P₃-hat / (1 + r)³ **This is how you find the horizon value but since you also need to discount the dividend for this period, you can add that to P₃-hat and discount them together to save time.
Market Efficiency
For most stocks, most of the time, it is generally safe to assume that the market is reasonably efficient. However, periodic shifts can and do occur, causing most stocks to move strongly up or down.
Classified Stock
Has special provisions. Could be founders' shares with voting rights but dividend restrictions. New shares might be called "Class A" shares with voting restrictions but full dividend rights.
What is the formula to find the % of stock price due to long-term dividends?
Horizon Value/P₀-hat *It is usually around 80%.
So how do you value nonconstant growth stocks?
If constant growth begins in, year 4, then to find the current expected price P₀-hat you would find the PV of D₁, D₂, D₃, and P₃ and you would add them together to find P₀-hat. You just use the constant growth model to find P₃. A shortcut is to add D₃ and P₃ and discount them together to find the PV.
What is the formula to find the expected return?
If we rearrange the model we can find our expected return by taking the dividend yield plus the growth rate. r-hat sub s = DY + G r-hat sub s= DY + CGY
What is stock market equilibrium?
In equilibrium, the intrinsic price must equal the actual price. If the actual price is lower than the fundamental value, then the stock is a "bargain." Buy orders will exceed sell orders, the actual price will be bid up. The opposite occurs if the actual price is higher than the fundamental value. FCF and risk are affected by managerial actions, the economic environment and the political climate. The stock's intrinsic value is based on true expected FCF and true risk. The stock's market price is based on perceived FCF and perceived risk. When the equal each other, there is market equilibrium.
Besides using the dividends to find the price one year from now, what is another method?
Multiply the expected current price (P₀-hat) by (1 + g). Because the current growth rate is constant, it also applies to price as well as dividends.
What is unique about a stock whose growth rate is 0? What is a real life example of this?
The stock is a perpetuity and you can simply divide the dividend payment by the required return to find the expected current price (p-hat₀). P₀-hat = pmt / r If you were to insert 0 into the growth formula, you would get the formula above because $2 would be multiplied by one and the 0 subtracted from the required return is equal to the required return. A real life example is preferred stock.
Why are markets generally efficient?
There are over 100,000 highly educated trained analysts that work for financial institutions. These analysts have similiar access to data and megabucks to invest. Thus, news is reflected in P₀ almost instantaneously. Markets are also becoming more efficient with technolog.
For a constant growth stock, if the required return is 13%, the most recent dividend was $2 and the growth rate is 6%, what will be the total 1 year return (r sub s)? What is the capital gains yield? What is the dividend yield?
Total 1 year return is 13% The capital gains yield is 6%=g The dividend yield is 7%.