Stocks

Marcela Valenzuela

1/37

Stock Issuance
Why do firms issue stocks?
To raise capital, finance investments, acquire other
companies, repurchase debt.
Where do firms issue stock?
Sales of shares to raise new capital are said to occur in the
primary market.
However, such sales occur relatively infrequently and most

trades take place on the stock exchange, where investors buy

and sell existing shares.
Stock exchanges are really secondary markets.

2/37

Stock Market Indexes

The Standard and Poors 500 Index (S&P 500) is a stock
market index based on the market capitalizations of 500 large
companies having common stock listed on the NYSE or NASDAQ.
The FTSE 100 Index is a stock market index based on the
market capitalizations of 100 large companies having common
stock listed on the London Stock Exchange.
The Selective Stock Price Index (Indice de Precios Selectivo de
Acciones, or IPSA) is composed of the 40 most heavily traded
stocks in Santiago Stock Exchange.

3/37

Stock Market Indexes

SP500

1000
500

recession and markets down

recession and markets up

100
50
10
5
1
1860

1880

1900

1920

1940

1960

1980

2000

4/37

Transactions Involving Stock

Buy (Long Position)
Savings motive.
Expect stock to increase in value.

Sell
Liquidity needs.
Expect stock to decline in value.

Short Sell (Sell stock without first owning it)

Borrow stock from your broker with the promise to return it
at some later date.
Sell the borrowed stock.
Repurchase it at a later date to return it to your broker.
The short seller is responsible for paying the dividend.

5/37

Types of Orders
Market Orders
Buy or sell at the current market price.

Limit Orders
Buy or sell at a pre-specified price.
Limit by time period.

6/37

Valuing Common Stocks

Expected Return (r ): The percentage return that an investor
expects to get from a specific investment over a set period of time.
Suppose that: the current price of a share is P0 , the expected
price at the end of a year is P1 , and the expected dividend per
share is Div1 , then:

r=

Div1 + P1 P0
P0

7/37

Valuing Common Stocks

(E) If a company is selling for $150 per share today and is
expected to sell for $170 one year now. If investors expect the
dividend per share to be equal to $10, the expected retun is:
r=

10 + 170 150
= 20%
150

We can break the return formula into two parts: dividend yield
and capital appreciation:

r=

Div1
P
| {z0 }

Dividend Yield

P1 P0
P
| {z0 }

Capital Gain Rate

Typically capital gains are the larger fraction of returns.

8/37

Valuing Common Stocks

The discount rate r is the rate of return investors can expect to
earn on securities with similar risk.
Group of stocks with the same risk have to offer the same
expected return.
If it does not hold? This is a condition of market equilibrium. If
it did not hold, the share would be overpriced or underpriced, and
investors would rush to sell or buy it. The flood of seller or buyers
would force the price to adjust.
All securities in an equivalent risk class are priced to offer the
same expected return

9/37

Valuing Common Stocks

The value of a stock is equal to the stream of cash payments
discounted at the rate of return that investors expect to receive on
other securities with equivalent risks.
Stocks do not have a fixed maturity; their cash payments
consist of an indefinite stream of dividends.
The discounted-cash-flow (DCF) formula for the present value
of a stock is:

PV =

Divt

(1 + r )t

t =1

10/37

Valuing Common Stocks

PV =

Divt

(1 + r )t

t =1

The price an investor is willing to pay for a share of stock

depends upon:
Magnitude and timing of expected future dividends.
Risk of the stock.

However, the cash payoff to owners of common stocks comes in

two forms: cash dividends and capital gains/losses. Where are
capital gains and losses?
11/37

Valuing Common Stocks

If investors have forecasts of dividends, prices and the expected
return offered by other equally risky stocks, they can predict
todays price:
P0 =

Div1 + P1
1+r

What about P1 , the next years price?

P1 =

Div2 + P2
1+r

Plugin P1 in the todays price expression:

P0 =

Div1
Div2
P2
+
+
1+r
(1 + r )2 (1 + r )2

12/37

Valuing Common Stocks

Continuing indefinitely gives:

P0 =

Div1
Div2
PH
DivH
+
++
+
2
H
1+r
(1 + r )
(1 + r )
(1 + r )H
H

P0 =

Divt

PH

(1 + r )t + (1 + r )H

t =1

As H approaches infinity, the price of a stock equals the present

vaue of its cash flows.

13/37

Example
XYZ Company is forecast to pay dividends of $3, $3.24, and
$3.5 over the next three years, respectively. At the end of three
years you anticipate selling your stock at a market price of $94.48.
What is the price of the stock given a 12% expected returns?

PV =

3.24
3.5 + 94.48
3
+
= $75
+
2
1 + 0.12 (1 + 0.12)
(1 + 0.12)3

14/37

Constant Dividend Growth

Dividends grow at rate g : where Div1 is the dividend at the end
of the first period.

P0 =

Div1 (1 + g )
Div1 (1 + g )t 1
Div1
+
+

+
+
1+r
(1 + r )2
(1 + r )t

Applying the growing perpetuity formula:

P0 =

Div1
r g

note g < r

15/37

Market Capitalization Rate

It is often helpful to twist the previous formula around and use
it to estimate the market capitalization rate r , given P0 and
estimates of Div1 and g :
r

Div1
+g
P0

The expected return equals the dividend yield plus the expected
rate of growth in dividends g .
This formula rest on the assumption of constant dividend
growth in perpetuity. This may be acceptable for mature
companies with low to moderate growth rates.

16/37

Example
Company Zs earnings and dividends per share are expected to
grow indefinitely by 5% a year. If next years dividend is $10 and
the market capitalization rate is 8%, what is the current stock
price?

17/37

Example
Current stock price:

P0 =

10
= $333.33
0.08 0.05

The rate of return is 8% per year:

For example, the prices in year 1, year 2, and year 3.:

Divt
Pricet

Year 1
$10
350

Year 2
$10.5
367.5

Year 3
$11.03
385.88

18/37

Example
333.33
From year 0 to year 1: 10+350
= 0.08
333.33
350
From year 1 to year 2: 10.5+367.5
= 0.08
350
367.50
From year 2 to year 3: 11.03+385.88
= 0.08
367.50

A two-year inverstor expects 8% in each of the first 2 periods.

Similarly, a three-year investor expects 8% in each of the first three
years.

19/37

Zero Growth
If the company does not grow at all and all of its earnings are paid
out as dividends to shareholders. The firm simply produces a
constant stream of dividends.

Here we assume that:

Div1 = Div2 =

Applying the perpetuity formula:

Div2
Div1
+
+
P0 =
1+r
(1 + r )2
P0 =

Div1
r

If dividends are constant, then the expected return on equity,

r = Div
P0 , is equal to the Dividend Yield.

20/37

Exercise
Consider the following three stocks:
1

Stock A is expected to provide a dividend of $10 a share

forever.
Stock B is expected to pay a dividend of $5 next year.
Thereafter, dividend growth is expected to be 4% a year
forever.
Stock C is expected to pay a dividend of $5 next year.
Thereafter, dividend growth is expected to be 20% a year for
five years (i.e., until year 6) and zero thereafter.

If the market capitalization rate for each stock is 10%, which stock
is the most valuable?
21/37

Dividends vs Investment Growth

Stock prices increase with (1) dividends Div1 and (2) growth g .
There is a trade-off:
More dividends less $ for investment less growth and

viceversa.

Consider Dividend Payout Ratio (PR) as the fraction of

earnings that the firm pays in dividends each year.

PRt =

Divt
,
EPSt

22/37

Dividends vs Investment Growth

EPS are earnings per share. If the company has Nsharest of
shares outstanding at year t and annual earnigns Et , then:

Divt =

Et
PRt ,
Nsharest

To increase dividends, the firm must:

increase total earnings (E ).
decrease shares outstanding.
increase the dividend payout rate (PR).

23/37

Growth Rate in Dividends g

The growth rate in dividends, g , is not zero if some earnings
are not paid out as dividends. That is, only if some earnings are
retained.
Hence, it is important to consider the Plowback Ratio:
Plowback Ratio: Fraction of earnings retained by the firm.
Plowback ratio = 1 payout ratio = 1 PRt ,
then,
Divt

= (1 Plowback Ratio) x EPSt

How can we obtain the growth g ?

24/37

Growth Rate in Dividends g

Growth can be derived from applying the return on equity to
the percentage earnings plowed back into operations:

g = return on equity x plowback ratio

25/37

Growth Rate in Dividends g

The change in the Book Equity (BE) depends on the plowback
ratio and earnings.
BEt BEt 1 = EPSt x Plowback Ratio

Earnings depend on the Return on Equity:

EPSt = BEt 1 x ROE

Then,
BEt BEt 1 = BEt 1 x ROE x Plowback Ratio
26/37

Growth Rate in Dividends g

This implies that:
BEt BEt 1
BEt 1

= ROE x Plowback Ratio

Recalling that:
Divt
EPSt

= (1 Plowback Ratio) x EPSt , and

= BEt 1 x ROE

Then,
Divt
Divt 1

= (1 Plowback Ratio) x ROE x BEt 1 ,

= (1 Plowback Ratio) x ROE x BEt 2
27/37

Growth Rate in Dividends g

Growth g is:
Divt Divt 1
Divt 1

(1 Plowback Ratio) x ROE x(BEt 1 BEt 2 )

(1 Plowback Ratio) x ROE xBEt 2
BEt 1 BEt 2
=
BEt 2
= ROE x Plowback Ratio
=

and
EPSt EPSt 1
EPSt 1

Divt Divt 1
1Plowback Ratio
Divt 1
1Plowback Ratio

= ROE x Plowback Ratio

28/37

Growth Rate in Dividends g

Hence,
g = ROE x Plowback Ratio

29/37

Growth Opportunities
Consider a company that does not grow at all. The company
does not plow back any earnings and all of them are paid out as
dividends. The firm simply produces a constant stream of
dividends.
Recalling the perpetuity formula, the return is equal to the
dividend yield. Since all the earnings are paid out as dividends, the
expected return is also equal to the earnings per share divided by
the share price (EPS ratio). In math. words:
r=

Div1
EPS1
=
P0
P0

The price:
P0 =

Div1
EPS1
=
r
r
30/37

Exercise
Recalling Company Z: The earnings and dividends per share are
expected to grow indefinitely by 5 percent a year. If next years
earnings are $15, dividend is $10 and the market capitalization rate
is 8%, what is the current stock price?

P0 =

10
= $333.33
0.08 0.05

What if the growth of this company would stop after year 4 and
starting with year 5 it will pay out all earnings as dividends?

31/37

Example
First company forecasts to pay a $8.33 dividend next year,
which represents 100% of its earnings. This will provide investors
with a 15% expected return. Second company decides to plow
back 40% of the earnings at the firms current return on equity of
25%. What are the values of the stocks of both companies?
First company (no growth)

P0 =

8.33
= $55.53
0.15

Second company (with growth)

g
P0

= 0.25 x 0.4 = 0.1

5.00
=
= $100
0.15 0.1
32/37

Example
If the company did not plowback some earnings, the stock

price is $55.53.
If the company did plowback some earnings then the price

rose to $100.
The difference between these two numbers is called the

Present Value of Growing Opportunities (PVGO = $44.47)

33/37

Growth Opportunities
Many companies have growth opportunities. In this case, we
can think of stock price as the sum of two terms:

P0 =

EPS1
+ PVGO.
r

PVGO is the net present value of investments that the firm will
make in order to grow. This is the additional value if the firm
retains earnings in order to fund new projects.
EPS1 /r is the capitalized value of earnings per share that the

firm would generate under a no-growth policy. This is the

value of the firm if it simply distributes all earnings to the
stockholders.
34/37

Example
Remember the example about the company Z growing at an
annual 5% with the next years dividend at $10 and the market
capitalization rate at 8%
If this company were to redistribute all its earnings, it could
maintain a level dividend stream of $15 a share. How much is the
market actually paying per share for growth opportunities?

P0 =

15
+ PVGO = $333.33
0.08

therefore, PVGO=$145.83.

35/37

Growth Opportunities
Recalling:

P0 =

EPS1
+ PVGO
r

Rearranging terms, we can obtain the earnings to price ratio:



PVGO
EPS1
= r 1
P0
P0

36/37

Exercise
1
2

Complete the table.

Assume that the opportunity cost of capital is 12%. Calculate
the value of the companys stock (i.e. at year zero).
What part of that value reflects the discounted value of P3 ,
the price forecasted for year 3?
What part of P3 reflects the present value of growth
opportunities (PVGO) after year 3?
Suppose that competition will catch up with the company by
year 4, so that it can earn only its cost of capital on any
investments made in year 4 or subsequently. What is the
stock worth now under this assummption?
1

Book equity at start of year

Earnings per share, EPS
Return on equity, ROE
Payout ratio
Dividends per share
Growth rate of dividends

0.25
0.2

0.16
0.5

0.16
0.5

10.00
0.25
0.2

37/37