Chapter 8
Risk and Rates of Return
Stand-Alone Risk
Portfolio Risk
Risk and Return: CAPM/SML
8-1
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What is investment risk?
•
•
•
Two types of investment risk
– Stand-alone risk
– Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than expected, or
negative returns, the riskier the investment.
8-2
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Probability Distributions
•
•
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Firm X
Firm Y
-70
0
15
100
Rate of
Return (%)
Expected Rate of Return
8-3
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Selected Realized Returns, 1926-2010
Source: Based on Ibbotson Stocks, Bonds, Bills, and Inflation: 2011 Classic
Yearbook (Chicago: Morningstar, Inc., 2011), p. 32.
8-4
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Hypothetical Investment Alternatives
Economy
Recession
Prob. T-Bills
HT
Coll
0.1 5.5% -27.0% 27.0%
USR
MP
6.0% -17.0%
Below avg
0.2
5.5%
-7.0%
13.0% -14.0% -3.0%
Average
0.4
5.5%
15.0%
0.0%
Above avg
0.2
5.5%
30.0% -11.0% 41.0% 25.0%
Boom
0.1
5.5%
45.0% -21.0% 26.0% 38.0%
3.0%
10.0%
8-5
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Why is the T-bill return independent of the economy?
Do T-bills promise a completely risk-free return?
•
•
•
•
T-bills will return the promised 5.5%, regardless of
the economy.
No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely to
occur over such a short period of time.
T-bills are also risky in terms of reinvestment risk.
T-bills are risk-free in the default sense of the word.
8-6
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How do the returns of High Tech and Collections
behave in relation to the market?
•
•
High Tech: Moves with the economy, and has a
positive correlation. This is typical.
Collections: Is countercyclical with the economy,
and has a negative correlation. This is unusual.
8-7
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Calculating the Expected Return
r̂ = Expected rate of return
N
r̂ = Piri
i=1
r̂ = (0.1)(-27%) + (0.2)(-7%) + (0.4)(15%)
+ (0.2)(30%) + (0.1)(45%)
= 12.4%
8-8
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Summary of Expected Returns
High Tech
Market
US Rubber
T-bills
Collections
Expected Return
12.4%
10.5%
9.8%
5.5%
1.0%
High Tech has the highest expected return, and appears
to be the best investment alternative, but is it really?
Have we failed to account for risk?
8-9
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Calculating Standard Deviation
= Standard deviation
= Variance = 2
=
N
2
(
r
−
r̂
)
Pi
i=1
8-10
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Standard Deviation for Each Investment
=
N
2
(
r
−
r̂
)
Pi
i=1
(5.5 − 5.5) (0.1) + (5.5 − 5.5) (0.2)
= (5.5 − 5.5)2 (0.4) + (5.5 − 5.5)2 (0.2)
2
+
(
5
.
5
−
5
.
5
)
(0.1)
= 0.0%
2
T -bills
T -bills
2
σHT = 20%
σColl = 13.2%
σM = 15.2%
σUSR = 18.8%
1/2
8-11
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Comparing Standard Deviations
Prob.
T-bills
USR
HT
0
5.5
9.8
12.4
Rate of Return (%)
8-12
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Comments on Standard Deviation as a Measure of
Risk
•
•
•
Standard deviation (σi) measures total, or standalone, risk.
The larger σi is, the lower the probability that actual
returns will be close to expected returns.
Larger σi is associated with a wider probability
distribution of returns.
8-13
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Comparing Risk and Return
Security
T-bills
High Tech
Collections*
US Rubber*
Market
Expected Return, r̂
5.5%
12.4
1.0
9.8
10.5
Risk,
0.0%
20.0
13.2
18.8
15.2
*Seems out of place.
8-14
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Coefficient of Variation (CV)
•
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
Standard deviation
CV =
=
Expected return
r̂
8-15
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Illustrating the CV as a Measure of Relative Risk
Prob.
A
B
0
Rate of Return (%)
σA = σB , but A is riskier because of a larger probability
of losses. In other words, the same amount of risk (as
measured by σ) for smaller returns.
8-16
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Risk Rankings by Coefficient of Variation
T-bills
High Tech
Collections
US Rubber
Market
•
•
CV
0.0
1.6
13.2
1.9
1.4
Collections has the highest degree of risk per
unit of return.
High Tech, despite having the highest standard
deviation of returns, has a relatively average CV.
8-17
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Investor Attitude Towards Risk
•
•
Risk aversion: assumes investors dislike risk and
require higher rates of return to encourage them to
hold riskier securities.
Risk premium: the difference between the return
on a risky asset and a riskless asset, which serves as
compensation for investors to hold riskier
securities.
8-18
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Portfolio Construction: Risk and Return
•
•
•
Assume a two-stock portfolio is created with $50,000
invested in both High Tech and Collections.
A portfolio’s expected return is a weighted average of
the returns of the portfolio’s component assets.
Standard deviation is a little more tricky and requires
that a new probability distribution for the portfolio
returns be constructed.
8-19
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Calculating Portfolio Expected Return
r̂p is a weighted average :
N
r̂p = wir̂i
i=1
r̂p = 0.5(12.4%) + 0.5(1.0%) = 6.7%
8-20
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An Alternative Method for Determining Portfolio
Expected Return
Economy
Recession
Below avg
Average
Above avg
Boom
Prob
0.1
0.2
0.4
0.2
0.1
HT
-27.0%
-7.0%
15.0%
30.0%
45.0%
Coll
27.0%
13.0%
0.0%
-11.0%
-21.0%
Port
0.0%
3.0%
7.5%
9.5%
12.0%
r̂p = 0.10 (0.0%) + 0.20 (3.0%) + 0.40 (7.5%)
+ 0.20 (9.5%) + 0.10 (12.0%) = 6.7%
8-21
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Calculating Portfolio Standard Deviation and CV
0.10 (0.0 - 6.7)
2
+ 0.20 (3.0 - 6.7)
p = + 0.40 (7.5 - 6.7)2
+ 0.20 (9.5 - 6.7)2
2
+ 0.10 (12.0 - 6.7)
2
1
2
= 3.4%
3.4%
CVp =
= 0.51
6.7%
8-22
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Comments on Portfolio Risk Measures
•
•
•
•
σp = 3.4% is much lower than the σi of either stock
(σHT = 20.0%; σColl = 13.2%).
σp = 3.4% is lower than the weighted average of
High Tech and Collections’ σ (16.6%).
Therefore, the portfolio provides the average return
of component stocks, but lower than the average
risk.
Why? Negative correlation between stocks.
8-23
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General Comments about Risk
•
•
•
σ 35% for an average stock.
Most stocks are positively (though not perfectly)
correlated with the market (i.e., ρ between 0 and 1).
Combining stocks in a portfolio generally lowers risk.
8-24
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Returns Distribution for Two Perfectly Negatively
Correlated Stocks (ρ = -1.0)
8-25
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Returns Distribution for Two Perfectly Positively
Correlated Stocks (ρ = 1.0)
Stock M’
Stock M
Portfolio MM’
25
25
25
15
15
15
0
0
0
-10
-10
-10
8-26
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Partial Correlation, ρ = +0.35
8-27
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Creating a Portfolio: Beginning with One Stock and
Adding Randomly Selected Stocks to Portfolio
•
•
•
σp decreases as stocks are added, because they
would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would remain
relatively constant.
Eventually the diversification benefits of adding
more stocks dissipates (after about 40 stocks), and
for large stock portfolios, σp tends to converge to
20%.
8-28
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Illustrating Diversification Effects of a Stock
Portfolio
8-29
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Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk
•
•
Market risk: portion of a security’s stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
Diversifiable risk: portion of a security’s standalone risk that can be eliminated through proper
diversification.
8-30
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Failure to Diversify
•
If an investor chooses to hold a one-stock portfolio
(doesn’t diversify), would the investor be
compensated for the extra risk they bear?
– NO!
– Stand-alone risk is not important to a well-diversified
–
–
–
investor.
Rational, risk-averse investors are concerned with σp,
which is based upon market risk.
There can be only one price (the market return) for a
given security.
No compensation should be earned for holding
unnecessary, diversifiable risk.
8-31
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Capital Asset Pricing Model (CAPM)
•
Model linking risk and required returns. CAPM
suggests that there is a Security Market Line (SML)
that states that a stock’s required return equals the
risk-free return plus a risk premium that reflects the
stock’s risk after diversification.
ri = rRF + (rM – rRF)bi
•
Primary conclusion: The relevant riskiness of a stock
is its contribution to the riskiness of a well-diversified
portfolio.
8-32
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Beta
•
•
Measures a stock’s market risk, and shows a stock’s
volatility relative to the market.
Indicates how risky a stock is if the stock is held in a
well-diversified portfolio.
8-33
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Comments on Beta
•
•
•
•
If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than average.
Most stocks have betas in the range of 0.5 to 1.5.
8-34
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Can the beta of a security be negative?
•
•
•
Yes, if the correlation between Stock i and the
market is negative (i.e., ρi,m < 0).
If the correlation is negative, the regression line
would slope downward, and the beta would be
negative.
However, a negative beta is highly unlikely.
8-35
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Calculating Betas
•
•
•
Well-diversified investors are primarily concerned
with how a stock is expected to move relative to the
market in the future.
Without a crystal ball to predict the future, analysts
are forced to rely on historical data. A typical
approach to estimate beta is to run a regression of
the security’s past returns against the past returns
of the market.
The slope of the regression line is defined as the
beta coefficient for the security.
8-36
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Illustrating the Calculation of Beta
_
ri
20
.
15
.
10
Year
1
2
3
rM
15%
-5
12
ri
18%
-10
16
5
-5
0
.
-5
-10
5
10
15
20
rM
Regression line:
^
ri = -2.59 + 1.44 ^rM
8-37
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Beta Coefficients for High Tech, Collections, and
T-Bills
HT: b = 1.32
ri
40
20
T-bills: b = 0
-20
0
20
40
rM
Coll: b = -0.87
-20
8-38
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Comparing Expected Returns and Beta Coefficients
Security
High Tech
Market
US Rubber
T-Bills
Collections
Expected Return
12.4%
10.5
9.8
5.5
1.0
Beta
1.32
1.00
0.88
0.00
-0.87
Riskier securities have higher returns, so the rank order
is OK.
8-39
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The Security Market Line (SML): Calculating
Required Rates of Return
SML: ri = rRF + (rM – rRF)bi
ri = rRF + (RPM)bi
•
Assume the yield curve is flat and that rRF = 5.5%
and
RPM = rM − rRF = 10.5% − 5.5% = 5.0%.
8-40
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What is the market risk premium?
•
•
•
Additional return over the risk-free rate needed to
compensate investors for assuming an average
amount of risk.
Its size depends on the perceived risk of the stock
market and investors’ degree of risk aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per year.
8-41
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Calculating Required Rates of Return
rHT
= 5.5% + (5.0%)(1.32)
= 5.5% + 6.6%
= 12.10%
rM
= 5.5% + (5.0%)(1.00)
= 10.50%
rUSR
= 5.5% +(5.0%)(0.88)
=
9.90%
rT-bill
= 5.5% + (5.0)(0.00)
=
5.50%
rColl
= 5.5% + (5.0%)(-0.87) =
1.15%
8-42
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Expected vs. Required Returns
r̂
High Tech
Market
US Rubber
T-bills
Collections
r
12.4% 12.1%
10.5
10.5
9.8
9.9
5.5
5.5
1.0
1.15
Undervalued (r̂ r)
Fairly valued (r̂ = r)
(r̂ r)
Overvalued
Fairly valued (r̂ = r)
(r̂ r)
Overvalued
8-43
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Illustrating the Security Market Line
SML: ri = 5.5% + (5.0%)bi
ri (%)
SML
.
..
HT
rM = 10.5
rRF = 5.5
.
-1 Coll
0
.T-bills
USR
1
2
Risk, bi
8-44
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An Example:
Equally-Weighted Two-Stock Portfolio
•
•
Create a portfolio with 50% invested in High Tech
and 50% invested in Collections.
The beta of a portfolio is the weighted average of
each of the stock’s betas.
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225
8-45
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Calculating Portfolio Required Returns
•
•
The required return of a portfolio is the weighted
average of each of the stock’s required returns.
rP = wHTrHT + wCollrColl
rP = 0.5(12.10%) + 0.5(1.15%)
rP = 6.625%
Or, using the portfolio’s beta, CAPM can be used to
solve for expected return.
rP = rRF + (RPM)bP
rP = 5.5% + (5.0%)(0.225)
rP = 6.625%
8-46
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Factors That Change the SML
•
What if investors raise inflation expectations by 3%,
what would happen to the SML?
ri (%)
SML2
ΔI = 3%
SML1
13.5
10.5
8.5
5.5
Risk, bi
0
0.5
1.0
1.5
8-47
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Factors That Change the SML
•
What if investors’ risk aversion increased, causing
the market risk premium to increase by 3%, what
would happen to the SML?
ri (%)
SML2
ΔRPM = 3%
SML1
13.5
10.5
5.5
Risk, bi
0
0.5
1.0
1.5
8-48
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Verifying the CAPM Empirically
•
•
•
The CAPM has not been verified completely.
Statistical tests have problems that make
verification almost impossible.
Some argue that there are additional risk factors,
other than the market risk premium, that must be
considered.
8-49
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More Thoughts on the CAPM
•
Investors seem to be concerned with both market
risk and total risk. Therefore, the SML may not
produce a correct estimate of ri.
ri = rRF + (rM – rRF)bi + ???
•
CAPM/SML concepts are based upon expectations,
but betas are calculated using historical data. A
company’s historical data may not reflect investors’
expectations about future riskiness.
8-50
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Chapter 9
Stocks and Their Valuation
Features of Common Stock
Determining Common Stock Values
Preferred Stock
9-1
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Facts about Common Stock
•
•
•
•
•
Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Management’s goal: Maximize the stock price
9-2
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Intrinsic Value and Stock Price
•
•
Outside investors, corporate insiders, and analysts
use a variety of approaches to estimate a stock’s
intrinsic value (P0).
In equilibrium we assume that a stock’s price equals
its intrinsic value.
– Outsiders estimate intrinsic value to help determine
which stocks are attractive to buy and/or sell.
– Stocks with a price below (above) its intrinsic value
are undervalued (overvalued).
9-3
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Determinants of Intrinsic Value and Stock Prices
Managerial Actions, the Economic Environment,
Taxes, and the Political Climate
“True” Investor
Cash Flows
“True” Risk
“Perceived” Investor
Cash Flows
Stock’s
Intrinsic Value
“Perceived”
Risk
Stock’s
Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
9-4
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Different Approaches for Estimating the Intrinsic
Value of a Common Stock
•
•
•
•
Discounted dividend model
Corporate valuation model
P/E multiple approach
EVA approach
9-5
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Discounted Dividend Model
•
Value of a stock is the present value of the future
dividends expected to be generated by the stock.
D3
D1
D2
D
P̂0 =
+
+
+ ... +
1
2
3
(1 + rs ) (1 + rs ) (1 + rs )
(1 + rs )
9-6
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Constant Growth Stock
•
A stock whose dividends are expected to grow
forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
•
If g is constant, the discounted dividend formula
converges to:
D0 (1 + g) D1
P̂0 =
=
rs − g
rs − g
9-7
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Future Dividends and Their Present Values
$
0.25
D t = D0 (1 + g)t
PVD t =
Dt
( 1 + r )t
P0 = PVDt
0
Years (t)
9-8
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What happens if g > rs?
•
•
If g > rs, the constant growth formula leads to a
negative stock price, which does not make sense.
The constant growth model can only be used if:
– rs > g.
– g is expected to be constant forever.
9-9
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Use the SML to Calculate the Required
Rate of Return (rs)
•
If rRF = 7%, rM = 12%, and b = 1.2, what is the
required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b
= 7% + (12% – 7%)1.2
= 13%
9-10
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Find the Expected Dividend Stream for the Next
3 Years and Their PVs
D0 = $2 and g is a constant 6%.
0
g = 6%
1
2
2.12
2.247
3
2.382
1.8761
1.7599
rs = 13%
1.6509
9-11
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What is the stock’s intrinsic value?
Using the constant growth model:
D1
$2.12
P̂0 =
=
rs − g 0.13 − 0.06
$2.12
=
0.07
= $30.29
9-12
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What is the stock’s expected value, one year
from now?
•
D1 will have been paid out already. So, expected P1
is the present value (as of Year 1) of D2, D3, D4, etc.
P̂1 =
D2
$2.247
=
rs − g 0.13 − 0.06
= $32.10
•
Could also find expected P1 as:
P̂1 = P0 (1.06) = $32.10
9-13
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Find Expected Dividend Yield, Capital Gains Yield, and
Total Return During First Year
•
Dividend yield
= D1/P0 = $2.12/$30.29 = 7.0%
•
Capital gains yield
= (P1 – P0)/P0
= ($32.10 – $30.29)/$30.29 = 6.0%
•
Total return (rs)
= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
9-14
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What would the expected price today be,
if g = 0?
The dividend stream would be a perpetuity.
0
rs = 13%
1
2
3
2.00
2.00
2.00
PMT $2.00
P̂0 =
=
= $15.38
r
0.13
9-15
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Supernormal Growth: What if g = 30% for 3 years
before achieving long-run growth of 6%?
•
•
Can no longer use just the constant growth model
to find stock value.
However, the growth does become constant after 3
years.
9-16
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Valuing Common Stock with Nonconstant Growth
D0 = $2.00.
0 rs = 13%
g = 30%
1
2
g = 30%
2.600
2.301
2.647
3.045
46.114
54.107 = P̂0
3
g = 30%
3.380
4
g = 6%
4.394
4.658
4.658
P̂3 =
= $66.54
0.13 − 0.06
9-17
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Find Expected Dividend and Capital Gains Yields
During the First and Fourth Years
•
•
•
•
Dividend yield (first year)
= $2.60/$54.11 = 4.81%
Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%
During nonconstant growth, dividend yield and
capital gains yield are not constant, and capital
gains yield ≠ g.
After t = 3, the stock has constant growth and
dividend yield = 7%, while capital gains yield = 6%.
9-18
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Nonconstant Growth: What if g = 0% for 3 years
before long-run growth of 6%?
D0 = $2.00.
0 r = 13%
s
g = 0%
1
2
g = 0%
2.00
3
g = 0%
2.00
4
g = 6%
2.00
2.12
1.77
1.57
1.39
20.99
25.72 = P̂0
P̂3 =
2.12
= $30.29
0.13 − 0.06
9-19
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Find Expected Dividend and Capital Gains Yields
During the First and Fourth Years
•
Dividend yield (first year)
= $2.00/$25.72 = 7.78%
•
Capital gains yield (first year)
= 13.00% – 7.78% = 5.22%
•
After t = 3, the stock has constant growth and
dividend yield = 7%, while capital gains yield = 6%.
9-20
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If the stock was expected to have negative growth (g = -6%),
would anyone buy the stock, and what is its value?
•
Yes. Even though the dividends are declining, the stock
is still producing cash flows and therefore has positive
value.
D (1 + g)
D1
= 0
rs − g
rs − g
$2.00 (0.94) $1.88
=
=
= $9.89
0.13 − (-0.06) 0.19
P̂0 =
9-21
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Find Expected Annual Dividend and Capital
Gains Yields
•
Capital gains yield
= g = -6.00%
•
Dividend yield
= 13.00% – (-6.00%) = 19.00%
•
Since the stock is experiencing constant growth,
dividend yield and capital gains yield are constant.
Dividend yield is sufficiently large (19%) to offset
negative capital gains.
9-22
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Corporate Valuation Model
•
•
Also called the free cash flow method. Suggests the
value of the entire firm equals the present value of
the firm’s free cash flows.
Remember, free cash flow is the firm’s after-tax
operating income less the net capital investment.
Depr. and Capital
FCF = EBIT(1 − T) +
−
+ NOWC
amortizati on expenditur es
9-23
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Applying the Corporate Valuation Model
•
•
•
Find the market value (MV) of the firm, by finding
the PV of the firm’s future FCFs.
Subtract MV of firm’s debt and preferred stock to
get MV of common stock.
Divide MV of common stock by the number of
shares outstanding to get intrinsic stock price
(value).
9-24
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Issues Regarding the Corporate Valuation Model
•
•
•
Often preferred to the discounted dividend model,
especially when considering number of firms that
don’t pay dividends or when dividends are hard to
forecast.
Similar to discounted dividend model, assumes at
some point free cash flow will grow at a constant
rate.
Horizon value (HVN) represents value of firm at the
point that growth becomes constant.
9-25
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Use the Corporate Valuation Model to Find the
Firm’s Intrinsic Value
Given: Long-Run gFCF = 6% and WACC = 10%
0
r = 10%
1
-5
-4.545
8.264
15.026
398.197
416.942
2
10
3
20
4
g = 6%
21.20
21.20
530 =
= HV3
0.10 − 0.06
9-26
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What is the firm’s intrinsic value per share?
The firm has $40 million total in debt and
preferred stock and has 10 million shares of
common stock.
MV of equity = MV of firm − MV of debt and preferred
= $416.94 − $40
= $376.94 million
Value per share = MV of equity/# of shares
= $376.94 /10
= $37.69
9-27
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Firm Multiples Method
•
Analysts often use the following multiples to value
stocks.
– P/E
– P/CF
– P/Sales
•
EXAMPLE: Based on comparable firms, estimate
the appropriate P/E. Multiply this by expected
earnings to back out an estimate of the stock price.
9-28
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EVA Approach
EVA = Equity capital(ROE – Cost of equity)
MVEquity = BVEquity + PV of all future EVAs
Value per share = MVEquity/# of shares
9-29
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Preferred Stock
•
•
•
Hybrid security.
Like bonds, preferred stockholders receive a fixed
dividend that must be paid before dividends are
paid to common stockholders.
However, companies can omit preferred dividend
payments without fear of pushing the firm into
bankruptcy.
9-30
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If preferred stock with an annual dividend of $5 sells for
$50, what is the preferred stock’s expected return?
D
Vp =
rp
$5
$50 =
rp
$5
r̂p =
$50
= 0.10 = 10%
9-31
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