Part 2 STOCK VALUATION AND TRADING

Size: px

Start display at page:

Download "Part 2 STOCK VALUATION AND TRADING"

Douglas Reynolds
5 years ago
Views:

1 Part 2 STOCK VALUATION AND TRADING Outline Common Stocks versus Preferred Stocks Stock Valuation Zero growth versus constant growth Multi stage growth Interpreting P/E Ratio Stock Trading 2

2 Equity What is equity? It represents the ownership of a company; An equity holder is a residual claimer The hierarchy of equity: Preferred Stock has preference over common stock in payment of dividends and claim to assets in the case of liquidation common stock ownership interest in a corporation after all other claims are satisfied warrants right to buy common stock at a specified price has similar feature to a call option 3 Preferred Stock It has the characteristics of debt, such as, a stated value value to be paid upon liquidation (cf. face value for debt) fixed dividends similar to debt coupon Cumulative dividends Non cumulative dividends often has mandatory redemption But it is still equity: dividends paid are not tax deductible shareholders cannot force bankruptcy if a firm misses payments 4

3 Why Preferred Stock? Offsetting tax effects: Seller s tax disadvantage: Issuing company can t deduct preferred dividends Buyer s tax advantage: Corporations who receive dividends can exclude 70% of them from taxable income (Dividends Received Deduction) Who issues preferred stock, and why? Companies with high leveraged and additional financing needs Companies concerning the diluting effect of additional common shares Start ups Give higher priority claim to venture capitalists without threat of bankruptcy 5 Common Stock Common stock (or ordinary share) represents equity or an ownership position in a corporation. Payments to common stock are in the form of dividends: cash dividend stock dividend share repurchase Contrary to payments to bondholders, payments to stockholders are uncertain in both magnitude and timing Traded in open markets (public vs. private)

4 Characteristics of common stock Residual claim stockholders have claim to the proportional profits of the firm shareholders rank after debt holders in terms of the claim on the assets and profits of the firm Limited liability shareholder s liability is limited to the extent of the fully paid share shareholders pay the total issue price on the IPO partial payment of no limited liability companies Characteristics of common stock Voting rights stockholders are entitled to vote for the board of directors and on other major decisions Straight Voting: Directors are elected one at a time You may cast all your votes for each member of the BOD Cumulative Voting: Directors are elected all at once You may cast all your votes for one member of the BOD Preferred by small investors

Initial public offering An initial public offering is the first public distribution of stock from a company that has not been publicly traded before The issuing firm develops and files the prospectus

5 Initial public offering An initial public offering is the first public distribution of stock from a company that has not been publicly traded before The issuing firm develops and files the prospectus with SEC Road show the firm s managers hold presentation for institutional investors in various cities Underwriter the party undertaking a contract to purchase securities that are not subscribed by investors, normally the investment bank IPO pricing Bookbuilding the underwriter solicits indications of interest in the IPO by institutional investors as to the number of shares that they may be demand at various offer prices The underwriter determines the offer price based on the feedback received Institutional investors pay a lower price and the issuing firm receives lower proceeds

6 IPO pricing Auction investors pay whatever they bid for the shares The issuing firm sets a minimum price Incurs lower costs than with a traditional IPO Example: Google s Dutch auction process Company AA IPO with Dutch auction for 1 million shares requested Investor Bid Amount/share # of Shares Shares Remaining A $10, ,000 B $ , ,000 C $ , ,000 D $29 550,000 99,000 E $25 100, F $ ,000 0 IPO procedure in China

7 Valuing Common Stock Stock valuation is more difficult than bond valuation: Cash flows are not explicit The life of a stock is forever The discount rate is not easily observed Fundamental theory of valuation: NPV= 0 = V + PV of future CFs The value of any financial asset equals the present value of all of its future cash flows Investors should expect to earn a normal rate of return the required rate of return The rate you use to discount future cash flows 13 Approaches to Equity Valuation Fundamental Analysis Attempt to establish an intrinsic value of a stock based on company level economic analysis If intrinsic value > market value, good buy If intrinsic value < market value, good short Technical Analysis Attempt to identify short term trading patterns to take advantage of price volatility 14

8 Keys to Fundamental Valuation of Common Stocks Cash flows to shareholders (dividends) Required rate of return Determined by Economy s risk free rate of return (including expected rate of inflation during the holding period) + Risk premium determined by the uncertainty of returns (risk) Asset pricing models: CAPM, APT, etc. 15 Intrinsic Value vs Market Price Fundamental analysis of equity valuation attempts to establish an intrinsic value and identify good investment opportunities Caveat: intrinsic value is subjective and not directly observable An example: SAIF Ventures Inc. is currently selling at RMB38/share. It is expected to pay RMB2 /share dividends next year and to sell at RMB44 /share a year later. The stock risk has been evaluated to have beta = 1.2. Is this stock a good buy? The expected return on SSE Index is 12% and the riskfree rate is 5%. 16

9 Intrinsic Value vs Market Price Required return by CAPM: E[R] R f β(r R D1 P1 P Expected HPR 21% P 38 So it seemsundervalued. Another way to look at it After one year, theproceed you expect D P. To calculate its present 1 1 So the fair value of this stock shouldbe V M f 0 ) *( ) 13.4% to obtain from this stock will be value, we need to discount D1 P1 1 E[ R] But it is now selling for only RMB38, so it is undervalued. 0 this by E[R] 13.4% Stock Valuation Formula Current stock price is the discounted sum of future stock price and cash distributions (dividends paid) P D 1 1 r P 1 0 where r is the required rate of return or valuing a stock as the PV of future dividends: P 0 D 1 D 2 1 r (1 r) D 3 (1 r) Case 1: Zero growth: D 1 = D 2 = D 3 = = D (constant) 2 3 P 0 D r

10 Dividend Growth Model D 0 D 0 (1+g) D 0 (1+g) 2 D 0 (1+g) 3 P 0 Case 2: Assume dividends are growing at a constant rate D 1 =D 0 (1+g); D 2 =D 1 (1+g); D t =D 0 (1+g) t D (1 ) r g r D 0 g g P 1 0 The dividend growth model can also be used to find the required return for observed stock price D r P 1 g 0 Dividend yield Capital gain yield Example: At a 10% required market return, a stock has just paid $2 dividend. This dividend is expected to grow at a rate of 5%. a) What is the stock price today? P 0 = D 1 / (r g) =$2.10 / (.10.05) = $42 b) What is D 3? D 3 = D 0 (1+5%) 3 = $2* = $2.32 c) What price do we expect to see in the second year? P 2 = D 3 / (r g) =$2.32 / (.10.05) = $46.4 Example: Suppose a stock has just paid a $5 per share dividend. The dividend is projected to grow at 5% per year. If it sells today for $655/8, what is the required return? r = D 1 /P 0 + g = $5.25/$ = 13%

11 Two Stage Growth Model Case 3: a more realistic model is high dividend growth followed by low dividend growth D 1 D 2 D 3 D 4 D 4 (1+g 2 ) D 4 (1+g 2 ) 2 D 0 D 0 (1+g 1 ) D 0 (1+g 1 ) 2 D 0 (1+g 1 ) 3 D 0 (1+g 1 ) 4 P 0 P4 (1 r) 4 D 4(1 g 2) P4 r g 2 General Approach: 1. Calculate PV of dividends in years Calculate PV of remaining dividends using growing perpetuity formula and discounting Example: IBM currently pays $1.00 a share dividend. Analysts expect IBM s dividend to grow back to $2.00 a share in 4 years, and then grow at a 10% rate thereafter. The expected return is 12%. What is IBM s common stock value? What is the dividend growth rate between years 0 and 4? Use FV = PV (1+r) t or the Rule of 72. g 1 =18% (exact calculations yield 1*(1+g 1 ) 4 =2 g 1 =18.92%)

12 Present value of first four dividends Year g D PV Sum Present value of dividends beginning at end of year 4: 1 The present value of as of today: The present value of all dividends (or ): Estimating the Growth Rate g Earnings are either paid out or retained for investment Payout ratio: the percentage paid out as dividends Retention ratio: the fraction not paid out Suppose: Cash Flow = Earnings CF t+1 = CF t + Retained earnings R retained earnings where R retained earnings is Return on retained earnings Divide each side by CF t : CF t+1 /CF t = CF t / CF t + Retained earnings / CF t R retained earnings CF t (1+g )/ CF t =1+ Retention ratio R retained earnings 1+g =1+ Retention ratio R retained earnings g = Retention ratio R retained earnings (e.g., ROE) 24

13 Estimating the Growth Rate g Example: Q Corp. has EPS of $1 at the end of the year, a dividend payout ratio of 40%, a discount rate of 17%, and a return on retained earnings (often called ROE or return on equity) of 20%. What is the price per share? g = retention ratio ROE = 60% 20% =12% DIV = $1 40% = $0.40 Using dividend discount model: P = DIV / (r g) = $0.40 / (17% 12%) = $8 An Alternative Approach Difficulty with dividend discount model One still needs to know what the company will earn on its new investments An Alternative: Consider equity has two parts Equity Value = In Place Equity Value + NPV of Growth Opportunities This leads to the NPVGO model: EPS r Price per share = + per share NPVGO 26

14 Price and Earning Ratio P/E ratio (or multiple) is a commonly quoted measure in the investment community At a first glance, one tends to interpret it as the number of periods to recoup your investment if earnings are all paid out If this is the case should you only be interested in small P/E stocks? Two ways to compute the P/E ratio: From the NPVGO model: P/E ratio = 1 NPVGO r EPS From dividend discount model P/E ratio = D r 1 g E 27 Price Earnings To Growth Ratio Rule of thumb: (Peter Lynch) A stock should trade around the price where P/E = g 100 It is believed that this ratio is more useful in indicating potential value. It is defined as PEG ratio = Price/Earning Ratio Annual EPS Growth A company with lower PEG is considered more undervalued Example: If Microsoft has a P/E of 37 and an earning growth of 14%. In contrast, the S&P500 has a P/E of 24 and earning growth of 9.6%. PEG Microsoft = 37/14 = 2.64 PEG S&P 500 = 24/9.6 = 2.50 Therefore, Microsoft is pricier than S&P

15 Price and Earning Ratio Portfolio managers and analysts often use PEG ratios to identify under and over valued stocks PEG Ratio > 1 overvalued PEG Ratio < 1 undervalued Why? Interpreting the P/E Ratio: Firms with high P/E ratios are usually associated with high growth opportunities given a constant payout ratio P/E ratio is negatively related to the firm s discount rate The firm s choice of accounting methods 深市主板中小企业板创业板深圳市场行业代码行业名称公司家数加权平均公司家数加权平均公司家数加权平均公司家数加权平均 A 农林牧渔 B 采矿业 C 制造业 D 水电煤气 E 建筑业 F 批发零售 G 运输仓储 H 住宿餐饮 I 信息技术 J 金融业 K 房地产 L 商务服务 M 科研服务 N 公共环保 O 居民服务 P 教育 Q 卫生 R 文化传播 S 综合

16 Stock Exchange The shares of companies are traded on exchanges, which are places where buyers and sellers meet and decide on a price The purpose of a stock market is to facilitate the exchange of stocks between buyers and sellers This is the secondary market role of equity markets The primary market is where securities are created The secondary market is where investors trade previouslyissued securities without the involvement of the issuingcompanies Stock market classifications Organized exchanges Computer based trading systems e.g. Shanghai Stock Exchange (SSE), Australian Stock Exchange (ASX) Specialists market e.g. New York Stock Exchange (NYSE) Over the counter (OTC) market National Association of Securities Dealers Automated Quotation (NASDAQ), also known as a dealer market

17 Shanghai Stock Exchange China Construction Bank Corp. Buy Sell Broker Quantity Bid Price ( ) Offer Price ( ) Quantity Broker ACCS ORDW CVLA JSWA AMSA BWCA FRAA AMSA New York Stock Exchange

18 New York Stock Exchange Specialists Broker role to execute orders of other brokers Dealer role market maker, to buy or sell the stock that they are assigned from their own accounts if no other investors are willing to participate, also known as making a market Specialists quote their bid and ask prices to buy and sell stocks on their accounts The specialists are required to use the highest outstanding offered buying price and lowest outstanding offered selling price when matching orders, which results in an auction market NASDAQ NASDAQ is an over the counter (OTC) market No physical trading floor (decentralized) NASDAQ is a communication network between thousands of computers and transactions are completed via an electronic market NASDAQ is largely a price quotation, not a trading system NASDAQ is a dealer market Dealers are the market makers who stand ready to buy or sell particular securities Dealers must maintain continuous two sided quotes (bid and ask) within a predefined spread

19 NASDAQ NADSAQ is a negotiated market Only one specialist is assigned to a stock in the NYSE Each stock on the NASDAQ has more than one market makers (dealers) Electronic Communication Networks (ECNs) is an electronic system that attempts to facilitate (for market makers) or eliminate (for individual investors) third party orders entered by a client s brokerage to be executed in whole or in part ECNs are computerized systems that automatically match orders between buyers and sellers (SEC definition) NASDAQ Dealer ECN Level I Individual investor Broker Level II Direct access account Level III

20 Stock Trading Cash account versus margin account Only margin account allows you to borrow to invest Stock symbols NYSE/Amex versus NASDAQ stocks Long versus short Short selling allows you to sell a stock using borrowed shares Limit order versus market order Limited order specifies the price you are willing to pay or sell Stop order, Open or good till cancelled order, Fill or kill order Duration of an order: Day, Good till Cancelled (GTC) 39

Chapter 6. Stock Valuation

Chapter 6. Stock Valuation Chapter 6 Stock Valuation Comprehend that stock prices depend on future dividends and dividend growth Compute stock prices using the dividend growth model Understand how growth opportunities affect stock