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Slide 9.16 Where Does R Come From
Slide 9.17 Using the DGM to Find R
Rearrange P0 = D1 / (R – g) to find R:
R = (D1 / P0 ) + g
Dividend yield = D1 / P0
Capital gains yield = g, so
R = dividend yield + capital gains yield
Lecture Tip: An interesting question arises as to the relative importance of
the components of required (or total) return in the stocks of
different countries when one considers the differences in dividend
yields and P/E ratios in US and Japanese stocks. The Financial
Times reports that, near the end of 1993, the average dividend
yield on Japanese stocks was approximately .8 percent, or about
one-third that of US stocks. On the other hand, the P/E ratios of
US stocks ranged in the mid-20’s, while the same story reports that
Japanese P/E ratios nearing 90 were not uncommon. You may
wish to ask students to speculate on why such differences could
arise. This facilitates discussion of differential tax laws,
accounting rules, market interest rates, etc. In this context, you
might wish to ask students to evaluate a statement from a
contemporaneous article in the South China Morning Post:
“Japanese companies pay comparatively smaller dividends, so net
earnings per share takes on less importance” to investors.Ethics
Note: The increase in Internet usage has brought many benefits
from an information standpoint; however, students need to
recognize that not everything they read on the Internet is true. It is
incredibly easy for individuals to post fake press releases on the
Internet and move the price of a stock. Unfortunately, even
reputable news organizations often pick up these phony press
releases and run them before they have checked the facts. This
“news” may have a major impact on stock prices. Stephen Sayre
was arrested for posting buy recommendations on eConnect. The
stock price went as high as $22 per share on March 9, 2000, and
was trading as low as $1 by April 24, 2000. Phony press releases
can also be used to move prices down. The case of Emulex is an
excellent example. In this case, the individual had shorted the
stock and placed a phony press release with bad news on the
Internet. The stock price dropped over 62%. It rebounded after it
was discovered that the press release was false, but many investors
lost a substantial amount of money on the way down. An excellent article
discussing this issue can be found in the April 24, 2000 issue of
BusinessWeek (Investors, Beware the Press Release, pp. 153 – 54).
.A A Healthy Sense of Skepticism
Our solutions purely estimate prices, which is a function of the fact
that our inputs (primarily g) are only estimates themselves.
Lecture Tip: It may be useful to rearrange the Dividend Growth
model and solve for g rather than the intrinsic value. Doing so
recognizes that the market’s estimate of price is the most
meaningful. Thereby, students can evaluate stocks by asking the
question “is the implied growth reasonable,” rather than assuming
they are capable of selecting a single value estimate that is better
than the consensus of all market participants.
.B Dividends or Earnings: Which to Discount?
Owners receive dividends, not earnings, as their cash flow.
.C The No-Dividend Firm
Obviously, the Dividend Discount Model is irrelevant for firms
that do not pay a dividend.
Lecture Tip: It may be helpful to discuss that, even in the absence
of dividends, the same underlying valuation framework exists.
Specifically, the firm is the present value of future cash flows.
Whether we choose dividends, earnings, or Free Cash Flow, the
valuation fundamentals remain the same, only the specifics of the
application change.
9.2. Comparables
Slide 9.18 Comparables
Practitioners commonly value stocks using comparables, which are
typically based on multiples of earnings, sales, book value, etc.
.A Price-to-Earnings Ratio
Slide 9.19 Price-Earnings Ratio
The P/E ratio is commonly cited in the financial press and is
typically computed using the current stock price and either trailing
EPS or forecasted EPS.
A stock’s PE ratio is likely the function of three factors:
1. Growth opportunities (positive relation)
2. Risk (negative relation)
3. Accounting practices (conservative accounting
practices are likely related to higher PE ratios)
In reality, the growth opportunities likely have the greatest impact.
You must be careful with applying PE to valuation, however, since
it is not constant either across time or industry.
.B Enterprise Value Ratios
Slide 9.20 Enterprise Value Ratios
The PE ratio focuses on the value of equity, but analysts may often
want the value of the whole firm (i.e., debt and equity). This is
referred to as Enterprise Value.
Enterprise Value = market value of equity + market value of debt –
cash.
Like the PE ratio, this value is often compared to an earnings
measure. However, here it is compared to EBITDA, since we want
to examine overall firm cash flow exclusive of financing decisions.
9.3. Valuing Stocks Using Free Cash Flows
Slide 9.21 Valuing Stocks Using Free Cash Flows
Just like the NPV of a project is the present value of the yearly
cash flows generated by the project, so is a firm. Its overall value is
simply the present value of its future cash flows.
We can use the same valuation models (such as growing
perpetuity) or price multiples. The difference is that we are
focusing on firm cash flow instead of earnings or some other
metric.
9.4. The Stock Markets
Slide 9.22 The Stock Markets
.A Dealers and Brokers
Primary market – the market in which new securities are originally sold to
investors
Secondary market – the market in which existing securities trade among
investors
Lecture Tip: Some students find it hard to grasp the relative importance of
primary and secondary market transactions. Suggest that they
consider automobile sales rather than stocks. New automobiles are
sold through a network of dealers and salesman (brokers) to the
public. In any given year, however, the majority of transactions are
between people buying and selling existing automobiles, i.e., the
secondary (used) car market. As with secondary market
transactions in stocks, used car purchases do not directly benefit
the issuer/manufacturer. You can also introduce the notion of
information asymmetry and signaling at this point, see the classic
article by George Akerlof titled “Market for Lemons.”
Broker – one who arranges security transactions among investors
Dealer – one who buys and sells securities from inventory
Bid price – the price at which a dealer is willing to buy a security
Ask price – the price at which a dealer is willing to sell a security
Spread – the difference between the bid and ask prices
.B Organization of the NYSE
Historically, the right to trade on the NYSE was held by 1,366 “members”
who owned seats on the exchange, with seats trading for as much
as $4 million each. After the reorganization of the NYSE as a
public company in 2006, this structure was replaced by licenses
that, as of 2014, cost approximately $40,000 per year. Changes
have continued, as in 2007 the NYSE merged with Euronext then
in 2008 with the American Stock Exchange. In 2013 it was
acquired by ICE (the Intercontinental Exchange).
DMM (designated market maker) –acts as a dealer on the exchange floor,
previously called specialists
Lecture Tip: The role of the DMM is an interesting one. He is
entrusted with the knowledge of pending buy and sell orders (in
other words, he knows the shapes of the market supply and
demand curves) for the stock he deals in, and he is to provide
liquidity and continuity in pricing by buying when the market is
selling and selling when the market is buying. Interestingly, while
studies
performed in the early 1970s indicated that specialists were able to earn
excess returns, studies of the crash of 1987 suggest that specialists
were unable (and, in some cases, unwilling) to buy as the market
crashed on October 19th. And in the April 24, 1998, issue of Money
Daily, John Gutfreund, former Salomon Brothers CEO states that
he “is not certain that the obligation of the market markers is to
anyone other than themselves.” For these reasons, among others,
some who study markets question the efficacy of the
specialist/DMM system.
Floor brokers – NYSE members who execute orders for customers. They have
become less important as SuperDOT (electronic trading) has
grown.
Supplemental liquidity providers (SLPs) – investment firms that agree to be
active participants in assigned stocks
Order flow – the flow of customer orders to buy and sell securities
DMM’s post – fixed place on the exchange floor where the specialist operates
Trading in the crowd – trading that occurs directly between brokers around the
specialist’s post
.C Types of Orders
Slide 9.23 Market and Limit Orders
Market order: A customer order to buy or sell securities marked for
immediate execution at the current market price.
Most of the activity on the floor of the exchange takes place
around the DDM’s post. The clerks operate behind the counters,
and the commission brokers receive customer orders and walk to
the DDM's post to execute the orders. When a customer issues a
market order, they want to buy or sell at the current market price,
with the order marked for immediate execution. The broker will try
to get the best price possible.
Limit order: Customer order to buy or sell securities with a
specified "limit" price. The order can be executed only at the limit
price or a better price.
Slide 9.24 Stop Orders
Stop order: Customer order to buy or sell securities when a preset
"stop" price is reached. The order converts to a market order when
the trigger is hit.
Limit and stop orders can be entered as either a day order
(canceled at the end of the trading day if it is not executed) or a
good-til-canceled order.
.D NASDAQ Operations
Slide 9.25 NASDAQ
NYSE operations represent a premier example of the trading of “listed”
securities. NASDAQ operations, on the other hand, represent the
evolution of “over-the-counter” trading of securities that do not
rely on a physical market place.
NASDAQ – National Association of Securities Dealers Automated Quotation
system – computer network of securities dealers who disseminate
timely security price quotes to NASDAQ subscribers.
Electronic Communication Networks (ECNs) allow individual
investors to transact directly with one another rather than with a
dealer. ECN orders are displayed with market maker orders,
thereby “opening” up the market.
.E Stock Market Reporting
Slide 9.26 Stock Market Reporting
Given the availability and speed of data on the internet, most
traders have decreased their reliance on quotes provided by The
Wall Street Journal and other financial publications.
Lecture Tip: A useful assignment is to require students to obtain a recent Wall
Street Journal and examine the financial section. Have the
students examine the dividend column for various stocks and point
out the number of non-dividend paying stocks. Also have them
identify the information available in each quote. This allows them
to see more information at once than they would normally see with
online quotes and illustrates that the Journal is still a valuable
resource.
Slide 9.27 Quick Quiz
