Ch 9 - Stock Valuation

Ace your homework & exams now with Quizwiz!

What makes up the price of stock?

1. Dividends 2. Capital gains -The discounted present value of the sum of next period's dividend plus next period's stock price -The discounted present value of all future dividends P0 = [(Div1)/(1+R)] + [P1/(1+R)] where Div 1 = expected dividend paid at year's end P1 = expected price at year's end R = discount rate

PE Ratio is a function of what three factors?

1. Investment opportunities. Companies with opportunities to invest in projects with large, positive NPVs are likely to have high PE ratios. 2. Risk. Low-risk stocks are likely to have high PE ratios. 3. Accounting practices. Firms following conservative accounting practices will likely have high PE ratios.

How do you find R?

= Dividend yield + Capital gains yield = (Div/P0) + g

Enterprise Value Ratios

= EV / EBITDA EV is equal to the market value of the firm's equity plus the market value of the firm's debt minus cash For example, imagine that Illinois Food Products Co. (IFPC) has equity worth $800 million, debt worth $300 million, and cash of $100 million. The enterprise value here is $1 billion (=800 + 300 − 100). The firm's EBITDA is $200 million. EV to EBITDA ratio = 1B / 200M = 5

Designated market makers

A person assigned by a security exchange to maintain a fair and orderly market for a group of securities. Formerly known as specialists - they act as dealers in particular stocks Each stock on the NYSE is assigned to one of these people They maintain a two-sided market, meaning they post and update bid and ask prices - they ensure that there is always a buyer or seller available

Electronic Communications Networks

A type of website that allows investors to trade directly with one another.

Broker

An entity that brings security buyers and sellers together but does not maintain an inventory.

Dealer

An entity that maintains an inventory and stands ready to buy and sell at any time.

Over-the-Counter Market

An informal network of brokers and dealers who negotiate sales of securities (not a formal exchange).

What are the three different types of license holders?

Designated market makers, floor brokers, and supplemental liquidity providers

Dividend yield

Dividends per share of common stock divided by market price per share. = Div/P0

Floor brokers

execute trades for customers, trying to get the best price possible generally employees of large brokerage firms such as Merrill Lynch these people interact with DMMs and are the key to non-electronic trading on the NYSE these people have become less important on the exchange floor because of the SuperDOT system, which allows orders to be transmitted electronically directly to the DMM

Secondary market

existing shares are traded among investors

Formula for firm's growth rate

g = Retention ratio x ROE

Supplemental Liquidity Providers

investment firms that agree to be active participants in stocks assigned to them their job is to regularly make a one-sided market [offering to either buy or sell] they trade purely for their own accounts [using their own money], so they do not represent customers

Day order

limit or stop order will be canceled if it is not executed by the end of the trading day

good-til-canceled order

limit or stop order will remain open until the customer specifically cancels it

NASDAQ

second largest stock market in the US is an OTC market has 3 levels of information access

Spread

the difference between the bid and ask prices

Ask price

the price at which the dealer will sell [sometimes called the asked, offered, or offering price]

Bid price

the price the dealer is willing to pay

Price-to-Earnings Ratio

the ratio of the stock's price to its earnings per share For example, if the stock of Sun Aerodynamic Systems (SAS) is selling at $27.00 per share and its earnings per share over the last year was $4.50, SAS's PE ratio would be 6 (=27/4.50).

Why does the denominator ignore depreciation and amortization?

Many practitioners argue that, since depreciation and amortization are not cash flows, earnings should be calculated before taking out depreciation and amortization. In other words, depreciation and amortization merely reflect the sunk cost of a previous purchase. However, this view is by no means universal. Others point out that depreciable assets will eventually be replaced in an ongoing business. Since depreciation charges reflect the cost of future replacement, it can be argued that these charges should be considered in a calculation of income.

New York Stock Exchange

NYSE - popularly known as the Big Board largest stock market in the world

Return on equity

Net income divided by total equity. Measures the profit per dollar of book equity

Suppose an investor is considering the purchase of a share of the Utah Mining Company. The stock will pay a $3 dividend a year from today. This dividend is expected to grow at 10 percent per year (g = 10%) for the foreseeable future. The investor thinks that the required return (R) on this stock is 15 percent, given her assessment of Utah Mining's risk. (We also refer to R as the discount rate of the stock.) What is the price of a share of Utah Mining Company's stock?

P0 = Div / (R-g) = 3 / (.15-.10) = 60

Consider Elixir Drug Company, which is expected to enjoy rapid growth from the introduction of its new back-rub ointment. The dividend for a share of Elixir's stock a year from today is expected to be $1.15. During the next four years, the dividend is expected to grow at 15 percent per year (g1= 15%). After that, growth (g2) will be equal to 10 percent per year. Calculate the present value of a share of stock if the required return (R) is 15 percent.

PV of dividends Y1-5 = $5 P5 = 44.25 P5 / (1+R)^5 = 22 22+5 = 27

Suppose we observe a stock selling for $20 per share. The next dividend is expected to be $1 per share. You think that the dividend will grow by 10 percent per year more or less indefinitely. What expected return does this stock offer you?

R = Dividend yield + Capital gains yield = (Div/P0) + g = 1/20 + .10 = .15

Retention ratio

Ratio of retained earnings to earnings Retained earnings divided by net income. Also called the plowback ratio 1 + g = 1 + Retention ratio x Return on retained earnings

Pagemaster Enterprises just reported earnings of $2 million. The firm plans to retain 40 percent of its earnings in all years going forward. In other words, the retention ratio is 40 percent. We could also say that 60 percent of earnings will be paid out as dividends. The ratio of dividends to earnings is often called the payout ratio, so the payout ratio for Pagemaster is 60 percent. The historical return on equity (ROE) has been .16, a figure expected to continue into the future. How much will earnings grow over the coming year?

Retained Earnings = (2,000,000)*(.40) = 800,000 ROE = (800,000)*.16 = 128,000 g = Retention Ratio x ROE = (.40)*(.16) = .064 Change in earnings / total earnings = 128,000/2,000,000 = .064

Comparables

Similar firms should have similar PE or EV/EBITDA ratios

Market order

The current price a security is trading at in the market.

If the dividend discount model is correct, why aren't no-dividend stocks selling at zero?

The firm can pay out dividends now, or it can forgo dividends now so that it can make investments that will generate even greater dividends in the future. Many firms choose to pay no dividends—and these firms sell at positive prices. For example, most Internet firms, such as Amazon.com, Google, eBay, and Facebook pay no dividends. Rational shareholders believe that they will either receive dividends at some point or they will receive something just as good. That is, the firm will be acquired in a merger, with the stockholders receiving either cash or shares of stock at that time.

Order flow

The flow of customer orders to buy and sell stocks.

Limit order

The most a customer is willing to pay for a stock

Zero growth

The price of a share of stock with a constant dividend is given by: P0 = [Div1/(1+R)] + [Div2/(1+R)^2] ... assume that Div1 = Div2 = ...

Constant growth

The price of a share of stock with a constant growth rate is given by: P0 = [Div/(1+R)] + [Div*(1+g)/(1+R)^2)] + [Div*(1+g)^2/(1+R)^3] + [Div*(1+g)^3/(1+R)^4] ... = Div/(R-g) where g = growth rate Div = dividend on the stock at the end of the first period

Capital gains yield

The rate at which the value of an investment grows This is also the same as the dividend growth rate and the stock price's growth rate, denoted g

Should we discount dividends or earnings?

We should discount dividends, not earnings. This is sensible since investors select a stock for the cash they can get out of it. They only get two things out of a stock: dividends and the ultimate sales price, which is determined by what future investors expect to receive in dividends. The calculated stock price would usually be too high were earnings to be discounted instead of dividends. As we saw in our estimation of a firm's growth rate, only a portion of earnings goes to the stockholders as dividends. The remainder is retained to generate future dividends. In our model, retained earnings are equal to the firm's investment. To discount earnings instead of dividends would be to ignore the investment that a firm must make today in order to generate future earnings and dividends.

Stop order

When the price of a stock gets this low, the broker will automatically sell stock

Is there any advantage to the EV/EBITDA ratio over the PE ratio?

Yes. Companies in the same industry may differ by leverage, i.e., the ratio of debt to equity. Leverage increases the risk of equity, impacting the discount rate, R. Thus, while firms in the same industry may be otherwise comparable, they are likely to have different PE ratios if they have different degrees of leverage. Since enterprise value includes debt and equity, the impact of leverage on the EV/EBITDA ratio is less.

Primary market

aka new-issue market where new issues of stocks are first brought to the market and sold to investors to raise money


Related study sets

Personal finance Chapter 4 terms

View Set

Marketing Exam 3 Quiz, Marketing Test 2, MKTG 321 Ch 10 Final Exam

View Set

Biology 1201-Newcomer: Chapter 17

View Set