Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 4

Brealey−Meyers: I. Value Principles of Corporate Finance, Seventh Edition 4. The Value of Common Stocks © The McGraw−Hill Companies, 2003 C H A P T E R F O U R THE VALUE OF COMMON STOCKS 58 Brealey−Meyers: I. Value Principles of Corporate Finance, Seventh Edition 4. The Value of Common Stocks © The McGraw−Hill Companies, 2003 WE SHOULD WARN you that being a financial expert has its occupational hazards. One is being cor-nered at cocktail parties by people who are eager to explain their system for making creamy profits by investing in common stocks. Fortunately, these bores go into temporary hibernation whenever the market goes down. We may exaggerate the perils of the trade. The point is that there is no easy way to ensure su-perior investment performance. Later in the book we will show that changes in security prices are fundamentally unpredictable and that this result is a natural consequence of well-functioning cap-ital markets. Therefore, in this chapter, when we propose to use the concept of present value to price common stocks, we are not promising you a key to investment success; we simply believe that the idea can help you to understand why some investments are priced higher than others. Why should you care? If you want to know the value of a firm’s stock, why can’t you look up the stock price in the newspaper? Unfortunately, that is not always possible. For example, you may be the founder of a successful business. You currently own all the shares but are thinking of going pub-lic by selling off shares to other investors. You and your advisers need to estimate the price at which those shares can be sold. Or suppose that Establishment Industries is proposing to sell its concate-nator division to another company. It needs to figure out the market value of this division. There is also another, deeper reason why managers need to understand how shares are valued. We have stated that a firm which acts in its shareholders’ interest should accept those investments which increase the value of their stake in the firm. But in order to do this, it is necessary to under-stand what determines the shares’ value. We start the chapter with a brief look at how shares are traded. Then we explain the basic princi-ples of share valuation. We look at the fundamental difference between growth stocks and income stocks and the significance of earnings per share and price–earnings multiples. Finally, we discuss some of the special problems managers and investors encounter when they calculate the present val-ues of entire businesses. A word of caution before we proceed. Everybody knows that common stocks are risky and that some are more risky than others. Therefore, investors will not commit funds to stocks unless the expected rates of return are commensurate with the risks. But we say next to nothing in this chapter about the linkages between risk and expected return. A more careful treatment of risk starts in Chapter 7. 4.1 HOW COMMON STOCKS ARE TRADED There are 9.9 billion shares of General Electric (GE), and at last count these shares were owned by about 2.1 million shareholders. They included large pension funds and insurance companies that each own several million shares, as well as individuals who own a handful of shares. If you owned one GE share, you would own .000002 percent of the company and have a claim on the same tiny fraction of GE’s profits. Of course, the more shares you own, the larger your “share” of the company. If GE wishes to raise additional capital, it may do so by either borrowing or sell-ing new shares to investors. Sales of new shares to raise new capital are said to oc-cur in the primary market.But most trades in GE shares take place in existing shares, which investors buy from each other. These trades do not raise new capital for the firm. This market for secondhand shares is known as the secondary market. The principal secondary marketplace for GE shares is the New York Stock Exchange 59 Brealey−Meyers: I. Value Principles of Corporate Finance, Seventh Edition 4. The Value of Common Stocks © The McGraw−Hill Companies, 2003 60 PART I Value (NYSE).1 This is the largest stock exchange in the world and trades, on an average day, 1 billion shares in some 2,900 companies. Suppose that you are the head trader for a pension fund that wishes to buy 100,000 GE shares. You contact your broker, who then relays the order to the floor of the NYSE. Trading in each stock is the responsibility of a specialist, who keeps a record of orders to buy and sell. When your order arrives, the specialist will check this record to see if an investor is prepared to sell at your price. Alternatively, the specialist may be able to get you a better deal from one of the brokers who is gath-ered around or may sell you some of his or her own stock. If no one is prepared to sell at your price, the specialist will make a note of your order and execute it as soon as possible. The NYSE is not the only stock market in the United States. For example, many stocks are traded over the counter by a network of dealers, who display the prices at which they are prepared to trade on a system of computer terminals known as NASDAQ (National Association of Securities Dealers Automated Quotations Sys-tem). If you like the price that you see on the NASDAQ screen, you simply call the dealer and strike a bargain. The prices at which stocks trade are summarized in the daily press. Here, for ex-ample, is how The Wall Street Journalrecorded the day’s trading in GE on July 2, 2001: YTD 52 Weeks % Chg Hi Lo Vol Stock (SYM) Div Yld % PE 100s Net Last Chg 4.7 60.50 36.42 General Electric (GE) .64 1.3 38 215287 50.20 1.45 You can see that on this day investors traded a total of 215,287 100 21,528,700 shares of GE stock. By the close of the day the stock traded at $50.20 a share, up $1.45 from the day before. The stock had increased by 4.7 percent from the start of 2001. Since there were about 9.9 billion shares of GE outstanding, investors were placing a total value on the stock of $497 billion. Buying stocks is a risky occupation. Over the previous year, GE stock traded as high as $60.50, but at one point dropped to $36.42. An unfortunate investor who bought at the 52-week high and sold at the low would have lost 40 percent of his or her investment. Of course, you don’t come across such people at cocktail par-ties; they either keep quiet or aren’t invited. The Wall Street Journal also provides three other facts about GE’s stock. GE pays an annual dividend of $.64 a share, the dividend yield on the stock is 1.3 percent, and the ratio of the stock price to earnings (P/E ratio) is 38. We will explain shortly why investors pay attention to these figures. 4.2 HOW COMMON STOCKS ARE VALUED Think back to the last chapter, where we described how to value future cash flows. The discounted-cash-flow (DCF) formula for the present value of a stock is just the same as it is for the present value of any other asset. We just discount the cash flows 1GE shares are also traded on a number of overseas exchanges. Brealey−Meyers: I. Value Principles of Corporate Finance, Seventh Edition 4. The Value of Common Stocks © The McGraw−Hill Companies, 2003 CHAPTER 4 The Value of Common Stocks 61 by the return that can be earned in the capital market on securities of comparable risk. Shareholders receive cash from the company in the form of a stream of divi-dends. So PV(stock) PV(expected future dividends) At first sight this statement may seem surprising. When investors buy stocks, they usually expect to receive a dividend, but they also hope to make a capital gain. Why does our formula for present value say nothing about capital gains? As we now explain, there is no inconsistency. Today’s Price The cash payoff to owners of common stocks comes in two forms: (1) cash divi-dends and (2) capital gains or losses. Suppose that the current price of a share is P , that the expected price at the end of a year is P , and that the expected divi-dend per share is DIV . The rate of return that investors expect from this share over the next year is defined as the expected dividend per share DIV plus the ex-pected price appreciation per share P P , all divided by the price at the start of the year P0: Expected return r DIV1 P1 P0 0 This expected return is often called the market capitalization rate. Suppose Fledgling Electronics stock is selling for $100 a share (P 100). In-vestors expect a $5 cash dividend over the next year (DIV 5). They also expect the stock to sell for $110 a year hence (P 110). Then the expected return to the stockholders is 15 percent: r 5 110 100 .15, or 15% On the other hand, if you are given investors’ forecasts of dividend and price and the expected return offered by other equally risky stocks, you can predict to-day’s price: Price P0 DIV rP1 For Fledgling Electronics DIV 5 and P 110. If r, the expected return on se-curities in the same risk class as Fledgling, is 15 percent, then today’s price should be $100: P0 5 110 $100 How do we know that $100 is the right price? Because no other price could sur-vive in competitive capital markets. What if P were above $100? Then Fledgling stock would offer an expected rate of return that was lower than other securities of equivalent risk. Investors would shift their capital to the other securities and in the process would force down the price of Fledgling stock. If P were less than $100, the process would reverse. Fledgling’s stock would offer a higher rate of return than comparable securities. In that case, investors would rush to buy, forcing the price up to $100. Brealey−Meyers: I. Value Principles of Corporate Finance, Seventh Edition 4. The Value of Common Stocks © The McGraw−Hill Companies, 2003 62 PART I Value The general conclusion is that at each point in time all securities in an equivalent risk class are priced to offer the same expected return. This is a condition for equilibrium in well-functioning capital markets. It is also common sense. But What Determines Next Year’s Price? We have managed to explain today’s stock price P in terms of the dividend DIV and the expected price next year P . Future stock prices are not easy things to fore-cast directly. But think about what determines next year’s price. If our price for-mula holds now, it ought to hold then as well: DIV2 P2 1 1 r That is, a year from now investors will be looking out at dividends in year 2 and price at the end of year 2. Thus we can forecast P by forecasting DIV and P , and we can express P0 in terms of DIV1, DIV2, and P2: P0 1 r 1DIV1 P12 1 r aDIV1 DI1 rP2 b 1 r DIV r2P2 Take Fledgling Electronics. A plausible explanation why investors expect its stock price to rise by the end of the first year is that they expect higher dividends and still more capital gains in the second. For example, suppose that they are look-ing today for dividends of $5.50 in year 2 and a subsequent price of $121. That would imply a price at the end of year 1 of P1 5.50 121 $110 Today’s price can then be computed either from our original formula P0 DI1 rP1 5.00 110 $100 or from our expanded formula P0 1 r 11 r2P2 1.15 5. 11.152 21 $100 We have succeeded in relating today’s price to the forecasted dividends for two years (DIV and DIV ) plus the forecasted price at the end of the second year (P ). You will probably not be surprised to learn that we could go on to replace P by (DIV P )/(1 r) and relate today’s price to the forecasted dividends for three years (DIV , DIV , and DIV ) plus the forecasted price at the end of the third year (P ). In fact we can look as far out into the future as we like, removing P’s as we go. Let us call this final period H. This gives us a general stock price formula: DIV1 DIV2 DIVH PH 0 1 r 11 r22 11 r2H H DIVt PH t1 11 r2t 11 r2H H The expression simply means the sum of the discounted dividends from year 1 to year H. t1 ... - tailieumienphi.vn