Note that Pˆ0 is the intrinsic value of the stock today, based on a particular investor's assessment of the stock's expected dividend stream and the risk of that stream. If we were to sum the present values of each future dividend, this sum would be the value of the stock, Pˆ0.
Do Stock Prices Reflect Long-Term or Short-Term Events?
So the issue is this: do shareholders prefer higher current dividends at the expense of lower future dividends, or the opposite, or are shareholders indifferent. Taxes also play a role: Since dividends and capital gains are taxed differently, dividend policy affects investors' taxes. Another reason why many managers focus on short-term profits is that some companies pay management bonuses based on current profits rather than stock prices (which reflect future profits).
For these managers, concerns with quarterly earnings are not due to their effect on stock prices – it is due to their effect on bonuses.7.
When Can the Constant Growth Model Be Used?
SELF-TEST
Expected Rate of Return on a Constant Growth Stock
In this form, we see that rˆs is the expected total return and that it consists of an expected dividend yield, D1/P0⫽ 5.4%, plus an expected growth rate or capital gains yield, g ⫽8%. We can extend the analysis, and in each future year the expected capital gains yield will always be equal to g, the expected dividend growth rate. The expected total rate of return, rˆs, is equal to the expected dividend yield plus the expected growth rate: rˆs⫽dividend yield ⫹ g.
Thus, if we say that the growth rate is expected to remain constant at 8%, we believe that the best prediction for the growth rate in any
Valuing Stocks That Have a Nonconstant Growth Rate
Find the expected price of the stock at the end of the volatile growth period when the stock has become steadily growing. Find the present value of the expected dividends during the volatile growth period and the present value of the expected stock price at the end of the volatile growth period. This produces the PVs shown to the left below the timeline, and the sum of the PVs is the value of the supernormal growth stock, $39.21.
With a financial calculator, you can find the PV of the cash flow as indicated on the timeline with the cash flow (CFLO) register of your calculator.
Stock Valuation
Market Multiple Analysis
Another method of stock valuation is market multiple analysis, which applies a market-determined multiple to net income, earnings per share, revenue, book value or, for businesses such as cable television or mobile phone systems, the number of subscribers. To estimate the company's stock value using the multiple price-to-earnings ratio, simply multiply the earnings per share of $7.70 by the market multiple of 12 to get its value. That's why it's called an entity multiple. The EBITDA market multiple is the average EBITDA multiple for comparable listed companies.
Multiplying a company's EBITDA by the market multiple gives an estimate of the company's total value.
Preferred Stock
Note that measures other than net income can be used in the market multiple approach. If the required rate of return on this preferred stock is 10%, its value is $100, found by solving Equation 8-8 as follows:. If we know the current price of a preferred stock and its dividend, we can solve for the expected return as follows:
Is the equation used to value preferred stock more similar to that used to value a perpetual bond or that used for common stock.
Stock Market Equilibrium
Vpsis preferred stock value, Dpsis preferred dividend and rpsis required rate of return. If you know the share price of the preferred stock, you can calculate I/YR to find the expected rate of return, rˆps. Since the expected rate of return is less than the required rate of return of 16%, this marginal investor would want to sell the stock, as would most other holders.
The expected return of a stock, as seen by the marginal investor, must equal the required return: rˆi⫽ri.
Changes in Equilibrium Stock Prices and Market Volatility
The Efficient Markets Hypothesis
As we discussed briefly in Chapter 7, a set of theories called the Efficient Markets Hypothesis (EMH) asserts (1) that stocks are always in equilibrium and. 2) that it is impossible for an investor to consistently "beat the market". Basically, those who believe in the EMH note that there are 100,000 or more full-time, highly trained professional analysts and traders operating in the market, while there are fewer than 3,000 major stocks. Therefore, if each analyst followed 30 stocks (which is about right, since analysts tend to specialize in stocks in a specific industry), there would be an average of 1,000 analysts following each stock. In addition, as a result of SEC disclosure requirements and electronic information networks, as new information about a stock becomes available, these 1,000 analysts generally receive and evaluate it at about the same time.
Weak-Form Efficiency
Semistrong-Form Efficiency
However, insiders (for example, company presidents) who have information that is not publicly available can earn consistently abnormal returns (returns that are higher than those predicted by the SML) even under semi-strong form efficiency. Another consequence of the efficiency of the semi-strong form is that stock prices will react only when the information differs from what was expected. For example, if a company announces a 30% increase in earnings, and if that increase is about what analysts expected, the announcement should have little or no effect on the company's stock price.
On the other hand, the stock price would probably fall if analysts had expected earnings to rise by more than 30%, but would probably rise if they had expected a smaller increase.
Strong-Form Efficiency
Is the Stock Market Efficient?
For example, studies show that investors tend to hold too long stocks that have performed poorly in the past (ie, losers) but sell winners too quickly. Although some investors behave irrationally, such as holding losers too long and selling winners too quickly, it does not mean that the markets are not efficient. For example, in mid-1999 a "rational" investor might have concluded that the Nasdaq was overvalued when it was trading at 3,000.
Based on our reading of the evidence, we believe that for most stocks it is generally safe to assume that the market is reasonably efficient in the sense that the intrinsic price is approximately equal to the actual market price. (Pˆ0艐P0).
Implications of Market Efficiency for Financial Decisions
The EHM further assumes that when stock prices deviate from their intrinsic values due to a delay in incorporating new information, investors will quickly take advantage of mispricing by buying undervalued stocks and selling overvalued stocks. If that investor had acted on that assumption and sold stock short, he or she would have lost a lot of money the following year when the Nasdaq rose to over 5,000. Ultimately, if our "rational investor" had the courage, patience, and financial resources to hang on for the run, he or she would have been vindicated, as the Nasdaq subsequently fell to around 1,300.
But as the economist John Maynard Keynes said, “In the long run we are all dead.”
Summary
Azero growth stock is one whose future dividends are not expected to grow at all, while an above normal growth stock is one whose earnings and dividends are expected to grow much faster than the economy as a whole over a specified period and then growing 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 divi - declines and the projected price back to the present, and (4) sum these PVs to find the current intrinsic, or expected, value of the stock, Pˆ0. The marginal investor is a representative investor whose actions reflect the beliefs of those people who are currently trading a stock.
Equilibrium is the condition under which the expected return on a security, as seen by the marginal investor, is exactly equal to the required return, rˆs⫽ rs.
Questions
As a result, the company's profits and dividends are declining at a steady rate of 4% per year. Suppose the average company in your company's industry is expected to grow at a constant rate of 6% and has a dividend yield of 7%. Assuming that the calculated growth rate is expected to continue, you can add the dividend yield to the expected growth rate to get the expected total return.
Using the data from part a, what is the value of the Gordon (constant growth) model for Brooks Sisters stock if the required rate of return is 15% and the expected growth rate is (1) 15% or (2) 20%.
Spreadsheet Problem
Now assume that TTC's period of above-normal growth will last another 5 years rather than 2 years. What will TTC's dividend yield and capital gains yield be once its period of above-normal growth ends. Hint: These values will be the same whether you are examining the case of 2 or 5 years of above-normal growth; the calculations are very easy.).
Of what importance to investors is the changing relationship between dividend yield and capital gains over time.
Cyberproblem
Suppose Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow at a rate of 6% indefinitely. What would the stock price be if the dividends were expected to have zero growth? Now suppose that Temp Force is expected to experience supernormal growth of 30% over the next three years, before returning to its constant long-term growth rate of 6%.
What is the Efficient Market Hypothesis, what are its three forms and what are its implications.
Selected Additional Cases
