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A Ch 7 Mini Case

H 5/11/2003

Chapter 7. Mini Case

Situation Sam Strother and Shawna Tibbs are senior vice-presidents of the Mutual of Seattle. They are co-directors of the company's pension fund management division, with Strother having responsibility for fixed income securities (primarily bonds) and Tibbs being responsible for equity investments. A major new client, theNorthwestern Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them. To illustrate the common stock valuation process, Strother and Tibbs have asked you to analyze the Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions. a. Describe briefly the legal rights and privileges of common stockholders. Features of Common Stock 1. Common Stock represents ownership 2. Ownership implies control 3. Stockholders elect directors 4. Directors hire management who attempt to maximize stock price. Classified Stock Classified Stock carries special provisions. For example, shares could be classified as founders shares which come with voting rights but dividend restrictions. b. (1.) Write out a formula that can be used to value any stock, regardless of its dividend pattern. THE DISCOUNTED DIVIDEND APPROACH The value of any financial asset is equal to the present value of future cash flows provided by the asset. When an investor buys a share of stock, he or she typically expects to receive cash in the form of dividends and then, eventually, to sell the stock and to receive cash from the sale. Moreover, the price any investor receives is dependent upon the dividends the next investor expects to earn, and so on for different generations of investors. Thus, the stock's value ultimately depends on the cash dividends the company is expected to provide and the discount rate used to find the present value of those dividends. Here is the basic dividend valuation equation: P0 = D1 (1+rs) + D2 (1+rs)
2

. . . .

Dn ( 1 + r s )n

The dividend stream theoretically extends on out forever, i.e., n = infinity. Obviously, it would not be feasible to deal with an infinite stream of dividends, but fortunately, an equation has been developed that can be used to find the PV of the dividend stream, provided it is growing at a constant rate. Naturally, trying to estimate an infinite series of dividends and interest rates forever would be a tremendously difficult task. Now, we are charged with the purpose of finding a valuation model that is easier to predict and construct. That simplification comes in the form of valuing stocks on the premise that they have a constant growth rate. (2.) What is a constant growth stock? How are constant growth stocks valued? VALUING STOCKS WITH A CONSTANT GROWTH RATE

A 57 58 59 60 61 62 63 64 65 66 67 68 69 70

In this stock valuation model, we first assume that the dividend and stock will grow forever at a constant growth rate. Naturally, assuming a constant growth rate for the rest of eternity is a rather bold statement. However, considering the implications of imperfect information, information asymmetry, and general uncertainty, perhaps our assumption of constant growth is reasonable. It is reasonable to guess that a given will experience ups and downs throughout its life. By assuming constant growth, we are trying to find the average of the good times and the bad times, and we assume that we will see both scenarios over the firm's life. In addition to assuming a constant growth rate, we will be estimating a long-term required return for the stock. By assuming these variables are constant, our price equation for common stock simplifies to the following expression: D1 P0 = (rs-g) In this equation, the long-run growth rate (g) can be approximated by multiplying the firm's return on assets by the retention ratio. Generally speaking, the long-run growth rate of a firm is likely to fall between 5 and 8 percent a year.

In this equation, the long-run growth rate (g) can be approximated by multiplying the firm's return on assets by the A B C D E H I retention ratio. Generally speaking, the long-run growth rate of a firm isFlikely to fallG between 5 and 8 percent a 71 year. 72 73 (c.) What happens if a company has a constant g which exceeds rs? Will many stocks have expected g > rs in the 74 75 short run (i.e., for the next few years)? In the long run (i.e., forever)? Answer: See Chapter 7 Mini Case Show 76 77 78 c. Assume that Temp Force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 percent, 79 and that the market risk premium is 5 percent. What is the required rate of return on the firms stock? 80 81 CAPM = rRF + b (rRF-rM) 82 7% + 1.2(5%) = 13% 83 84 d. Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was 85 $2.00, and whose dividend is expected to grow indefinitely at a 6 percent rate. 86 (1.) What is the firms expected dividend stream over the next 3 years? 87 (2.) What is the firms current stock price? 88 (3.) What is the stock's expected value 1 year from now? 89 90 (4.) What are the expected dividend yield, the capital gains yield, and the total return during the first year? 91 EXAMPLE: CONSTANT GROWTH 92 0 1 2 3 Continue to Infinty 93 Do =2.00 2.12 2.2472 2.3820 94 1.876 95 1.760 96 1.651 97 Etc. 98 ?? 99 Constant Growth Model: 100 D0= $2.00 101 g= 6% 102 r s= 13.0% 103 104 D1 D 0 (1+g) $2.12 P0 = = = 105 (rs-g) (rs-g) 0.07 106 P 0= 107 $30.29 108 109 Stock Price 1 year from now 110 111 D2 P1 = 112 (rs-g) 113 114 2.2472 P1 = 115 0.07 116 P1 = 117 32.10 118 119 Dividend Yield = D1 C&G Yield = P1-P0 120 P0 P0 121 122 Dividend Yield = 2.12 C&G Yield = $1.82 123 $30.29 $30.29 124 125 Dividend Yield = 7.00% C&G Yield = 6.00% 126

A 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181

Total Yield = Total Yield =

Dividend Yield + 13.00%

C&G Yield

e. Now assume that the stock is currently selling at $30.29. What is the expected rate of return on the stock? Rearrange to rate of return formula rs = D1 P1 + g

rs =

2.12 32.10 13%

0.06

rs =

f. What would the stock price be if its dividends were expected to have zero growth? EXAMPLE: PREFERRED STOCK (I.E., STOCK WITH ZERO GROWTH) The dividend stream would be a perpetuity. P = P = P = PMT $2.00 $15.38

r 13.00%

An important consideration to be made is that this kind of constant growth assumption only makes sense if you are valuing a mature firm with somewhat stable growth rates. There are some special scenarios when the Gordon DCF constant growth model will not make sense, which will be discussed later. g. Now assume that Temp Force is expected to experience supernormal growth of 30 percent for the next 3 years, then to return to its long-run constant growth rate of 6 percent. What is the stock's value under these conditions? What is its expected dividend yield and capital gains yield in Year 1? In Year 4? VALUING STOCKS WITH NON-CONSTANT GROWTH

For many companies, it is unreasonable to assume that it grows at a constant growth rate. Hence, valuation for these companies proves a little more complicated. The valuation process, in this case, requires us to estimate the short-run non-constant growth rate and predict future dividends. Then, we must estimate a constant long-term growth rate that the firm is expected to grow at. Generally, we assume that after a certain point of time, all firms begin to grow at a rather constant rate. Of course, the difficulty in this framework is estimating the short-term growth rate, how long the short-term growth will hold, and the long-term growth rate. Specifically, we will predict as many future dividends as we can and discount them back to the present. Then we will treat all dividends to be received after the convention of constant growth rate with the Gordon constant growth model described above. The point in time when the dividend begins to grow constantly is called the horizon date. When we calculate the constant growth dividends, we solve for a terminal value (or a continuing value) as of the horizon date. The terminal value can be summarized as: TV N = PN = D N+1 (rs-g) = DN (1+g) (rs-g)

A B C D E F G H I 182 183 This condition holds true, where N is the terminal date. The terminal value can be described as the expected value of 184 the firm in the time period corresponding to the horizon date. 185 186 D0 $2.00 187 rs 13.0% 188 gs 30% Short-run g; for Years 1-3 only. 189 gL 6% Long-run g; for Year 4 and all following years. 190 30% 6%

191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244

A Year Dividend

B 0 $2.00

C 1 2.6

D 2 3.38

E 3 4.394

F 4 4.6576

PV of dividends $2.3009 2.6470 3.0453 $7.9932 $46.1140 $54.1072 = P0

4.6576 P4 = 66.5377 = Terminal value = 7.0% = r - gL

h. Is the stock price based more on long-term or short-term expectations? Answer this by finding the percentage of Temp Force current stock price based on dividends expected more than 3 years in the future. Dividend and C&G Yields at t=0 Dividend Yield = C & G Yield = Total Return = 4.8% 8.2% 13.0% Dividend and C&G Yields at t=4 P4 = 66.5377143 Dividend Yield = C & G Yield = Total Return = 7.0% 6.0% 13.0%

h. Is the stock price based more on long-term or short-term expectations? Answer this by finding the percentage of Temp Force current stock price based on dividends expected more than 3 years in the future. DO STOCK PRICES REFLECT LONG-TERM OR SHORT-TERM CASH FLOWS? Managers often claim that stock prices are "short-term" in nature in the sense that they reflect what is happening in the short-term and ignore the long-term. We can use the results for the non-constant model to test this claim.

The terminal value, or price at year 3, reflects the value of all dividends from year 4 and beyond, discounted back to year 3. Therefore, the PV of the terminal value is the present value of all dividends that will be paid in year 4 and beyond. This PV represents the part of the current stock price that is due to long-term cash flows. Stock price due to long-term cash flows (PV of terminal value): Current price: Percent of current price that is due to long-term cash flows (PV of terminal value / Current price):

$46.1140 $54.1072 85.2%

For most stocks, the percentage of the current price that is due to long-term cash flows is over 80%. i. Suppose Temp Force is expected to experience zero growth during the first 3 years and then to resume its steadystate growth of 6 percent in the fourth year. What is the stock's value now? What is its expected dividend yield and its capital gains yield in Year 1? In Year 4? D0 rs g 1-3 g4 Year Dividend PV of dividends $2.00 13.0% 0% 6% 0% 0 $2.00

1 $2.00

2 $2.00

6% 3 $2.00

4 2.1200

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A B $1.7699 1.5663 1.3861 $4.7223 $20.9895 $25.7118 = P0

2.1200 P4 = 30.2857 = Terminal value = 7.0% = r - g4

j. Finally, assume that Temp Forces earnings and dividends are expected to decline by a constant 6 percent per year, that is, g = -6%. Why would anyone be willing to buy such a stock and at what price should it sell? What would be the dividend yield and capital gains yield in each year?

D0= g= r s= P0 = P 0= C & G Yield = Dividend Yield = Total Return =

$2.00 -6% 13.0% D1 (rs-g) $9.89 -6.00% 19.00% 13.0% = D 0 (1+g) (rs-g) = $1.88 0.19

k. What is market multiple analysis? Answer: See Chapter 7 Mini Case Show l. Why do stock prices change? Suppose the expected D1 is $2, the growth rate is 5 percent, and rs is 10 percent. Using the constant growth model, what is the impact on stock price if g is 4 percent of 6 percent? If rs is 9 percent or 11 percent? D0= g= r s= P0 = P 0= 2.00 5.0% 10.0% D1 (rs-g) $42.00 Resulting Price $42.00 $34.67 $42.00 $53.00 Resulting Price $42.00 $52.50 $42.00 $35.00 = D 0 (1+g) (rs-g) = $2.10 0.05

% growth in D0 4% 5% 6%

Last Dividend, D0 Dividend, D0 Dividend, D0 Dividend, D0

rs 9% 10% 11%

Last Dividend, D0 Dividend, D0 Dividend, D0 Dividend, D0

m. What does market equilibrium mean? Market Equilibrium

299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324 325 326

A B C D E F G H I In equilibrium, stock prices are stable. There is no general tendency for people to buy or sell. The expected price must equal the actual price. In other words, the fundamental value must be the same as the price. In equilibrium, expected returns must equal required returns. Achieving equilibrium D1 If: rs = P0

>

rs

P0 is too low If the price is lower than the fundamental value, then the stock is a bargain. Buy orders will exceed sell orders and the price will be bid up. n. If equilibrium does not exist, how will it be established? o. What is the Efficient Markets Hypothesis, what are its three forms, and what are its implications? Efficient Market Hypothesis Securities are normally in equilibrium and are "fairly priced." One cannot "beat the market" except through luck or good inside information. Weak form EMH States that one cannot profit by looking at past trends. A recent decline is no reason to think stocks will go up or down in the future. Semistrong form EMH All publicly available information is reflected in stock prices. It does not pay to pore over annual reports looking for undervalued stocks.

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Strong form EHM All information, including inside information, is reflected in stock prices. p. Schmid Company recently issued preferred stock. It pays an annual dividend of $5, and the issue price was $50 per share. What is the expected return to an investor on this preferred stock? Preferred Stock Vps = Dividend = rps = PMT P 5 50 10% 50 5

rps =

rps =

A 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360 361 362 363 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382

A 383

384 385 386 387

A 388 389 390 391 392 393 394 395 396 397 398 399 400 401 402 403 404 405 406 407 408 409 410 411 412 413 414 415 416 417